For families in New York with substantial assets, preserving wealth across generations takes more than a will or a revocable trust. Estate tax exposure, capital gains and the difficulty of moving appreciating assets to the next generation call for more deliberate planning. One of the most powerful tools available under current tax law is the Intentionally Defective Grantor Trust (IDGT), a vehicle that, when properly structured, transfers significant wealth to heirs with minimal tax cost.
We design and implement IDGT structures for clients with closely held business interests, real estate portfolios and concentrated investment positions, fitting each trust to the client’s finances, family and long-term goals.
What Is an Intentionally Defective Grantor Trust?
An IDGT is an irrevocable trust drafted to be treated one way for income tax purposes and another way for estate and gift tax purposes. The word “defective” is misleading. The trust is not flawed; it is deliberately built to take advantage of a specific feature of the federal tax code.
The grantor, the person creating the trust, is treated as the owner of the trust assets for income tax purposes under the grantor trust rules of Internal Revenue Code Sections 671–679. At the same time, the trust assets are removed from the grantor’s taxable estate for federal estate and gift tax purposes. Because the grantor pays the income tax on trust earnings personally, the trust grows undiminished by tax, which amounts to an additional tax-free gift to the beneficiaries every year in the form of the income tax payments.
Why IDGTs Matter for New York Residents
New York imposes its own estate tax in addition to the federal estate tax, and the New York estate tax has a “cliff”: an estate that exceeds the New York exemption by more than 5% loses the entire exemption and pays tax on the full estate value. Because the New York exemption is substantially lower than the federal exemption, many families who would owe no federal estate tax still face a significant New York estate tax bill.
An IDGT can reduce the size of the taxable New York estate, shift future appreciation out of the estate, leverage the federal lifetime gift and generation-skipping transfer (GST) tax exemptions, give beneficiaries creditor and divorce protection, and move family business interests at discounted valuations.
How an IDGT Is Typically Funded
An IDGT can simply be funded by gift, but the most powerful technique combines a small seed gift with an installment sale to the trust, often called a “sale to a defective grantor trust.”
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The Seed Gift
The grantor first makes a gift to the IDGT, typically equal to at least 10% of the value of the assets that will later be sold to the trust. The gift gives the trust economic substance and uses a portion of the grantor’s lifetime gift tax exemption.
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The Installment Sale
The grantor then sells appreciating assets, such as closely held business interests, real estate or marketable securities, to the trust in exchange for a promissory note. The note bears interest at the applicable federal rate (AFR), which is generally lower than expected investment returns.
Because the grantor and the trust are the same taxpayer for income tax purposes, the sale triggers no capital gains tax, and the interest payments on the note are not taxable income to the grantor. Any appreciation above the AFR passes to the trust beneficiaries free of gift and estate tax.
Key Advantages of an IDGT
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Estate freeze
The value of the assets in the grantor’s estate is fixed at the sale price, while future growth accumulates outside the estate.
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Tax-free growth funding
The grantor’s payment of income tax on trust earnings transfers additional wealth without using any gift tax exemption.
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Valuation discounts
Transfers of minority interests in family businesses or LLCs may qualify for lack-of-control and lack-of-marketability discounts.
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GST planning
With GST exemption properly allocated, an IDGT can benefit grandchildren and more remote descendants free of generation-skipping transfer tax.
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Asset protection
A properly drafted irrevocable trust shields the assets from beneficiaries’ creditors and divorcing spouses.
Risks and Considerations
IDGTs are not right for every client, and they require careful drafting and ongoing administration.
| Consideration | Why it matters |
|---|---|
| Irrevocability | Once assets are transferred, the grantor cannot reclaim them. |
| Cash flow for tax payments | The grantor must have enough outside resources to pay the income tax on trust earnings. |
| IRS scrutiny | The valuation of transferred assets, particularly business interests, must be supported by qualified appraisals. |
| Death of the grantor | If the grantor dies while the installment note is outstanding, complex income tax issues may arise. |
| Legislative risk | Congress has periodically considered eliminating or curtailing grantor trust benefits, which makes timely planning important. |
Who Should Consider an IDGT?
An IDGT is generally most useful for someone whose taxable estate exceeds the New York estate tax exemption, who owns appreciating assets such as a closely held business, real estate or concentrated stock positions, who wants to provide for children and grandchildren tax-efficiently, who has enough liquid assets to pay the income tax on trust earnings without strain, and who wants long-term asset protection for the beneficiaries.
How We Design an IDGT
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Estate analysis
We project federal and New York estate tax exposure under various scenarios.
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Asset selection
We identify suitable assets for transfer, weighing growth potential, valuation flexibility and liquidity.
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Appraisers and accountants
We coordinate with appraisers and accountants to substantiate valuations and ensure proper tax reporting.
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Drafting
We draft the trust instrument with carefully selected grantor trust triggers and beneficiary provisions.
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Seed gift and sale
We structure the seed gift and installment sale with the documentation they need, including promissory notes and security arrangements.
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Ongoing administration
We support the trustee afterward with annual gift tax returns, review of trust performance, and trust accountings when a beneficiary asks for one or the trust requires it.
Coordinating the IDGT With the Rest of Your Estate Plan
An IDGT should never exist in isolation. We integrate it with the other parts of a complete plan: revocable living trusts, irrevocable life insurance trusts (ILITs), grantor retained annuity trusts (GRATs), charitable remainder trusts and family limited partnerships. The goal is a single coherent structure that addresses estate tax, income tax, asset protection, business succession and family governance.
To discuss whether an IDGT fits your situation, call us at 212-233-1233 or email [email protected].
