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Get to Know Intentionally Defective Grantor Trusts
intentionally defective grantor I trusts (IDGTs-pronounced "idjits") have become popular in estate tax planning techniques in recent years. This article will serve as an introduction for those who are unfamiliar with this type of trust entity and its use in estate tax planning stratagems.
What's an IDGT?
An IDGT is a term used to describe a specific type of trust. Conceptually, it's a trust entity that's set up to be an irrevocable trust. However, in drafting the trust agreement, certain provisions are "intentionally" included or excluded. Such provisions will allow the grantor of the trust to retain certain powers.
For example, a common power that may be retained by the grantor as a result of the defective provisions is the power to exchange assets within the trust for other assets of an equal fair market value. The retention of such powers by the grantor will violate the provisions for allowable grantor powers set forth in the IRC. This violation will cause the IRS to consider the trust to be "defective" and, by default, the trust will be deemed to be a grantor trust for income tax purposes, i.e., a trust that is disregarded for income tax purposes.
When the trust agreement is properly drafted, the result of this defective creation is a dichotomy in the treatment of the trust, the trust assets and the income and deductions arising from these assets. The IDGT will be treated differently for legal and estate tax purposes versus the treatment for income tax purposes. Because the trust has been created as irrevocable (and provided that none of the powers retained by the grantor would cause estate tax inclusion) it will be respected as a legally valid trust entity for estate tax purposes.