Intentionally Defective Grantor Trusts (IDGTs)

An intentionally defective grantor trust (IDGT) is an irrevocable trust structured so that transfers are completed gifts for estate tax purposes, but the trust is treated as a grantor trust for income tax purposes.

Under the grantor trust rules ( IRC §§671–679 and Rev. Rul. 85-13), the grantor is responsible for paying all income taxes generated by the trust assets. This creates two estate planning benefits:

1.

The trust assets grow unencumbered by income tax liabilities.

2.

The grantor’s payment of the trust’s tax liability is not treated as a taxable gift to the beneficiaries (Rev. Rul. 2004-64), effectively allowing the grantor to make tax-free transfers to the trust while reducing their own taxable estate.

Note: The IRS has signaled increased scrutiny on certain grantor trust transactions (see IRS memorandum ILM 202352018).

Sale to an IDGT A common strategy is for the grantor to sell highly appreciating assets, such as shares in a closely held business or Family Limited Partnership (FLP) interests, to the IDGT in exchange for a promissory note. Under Rev. Rul. 85-13, the sale is not recognized for income tax purposes, meaning no capital gains tax is triggered. The promissory note pays interest at the IRS Applicable Federal Rate (AFR), freezing the asset value in the grantor’s estate at the face value of the note, while all appreciation above the AFR accumulates tax-free inside the trust for the beneficiaries.

Valuation Discounts When funding an IDGT with FLP or LLC interests, the transfer may qualify for minority interest and lack of marketability discounts. Because limited partners lack control over operations and cannot easily liquidate their shares, appraisers routinely discount the value of the gifted interests by 20% to 40%. Under Rev. Rul. 93-12, the IRS recognizes these valuation discounts even when family members collectively control the underlying entity. This allows grantors to transfer substantial asset values while consuming less of their lifetime gift tax exemption (Form 709). Consult IRS Pub. 561 for asset valuation guidelines.