Don’t worry; this is a totally legal and valid trust. The “defective” part only describes the fact that it’s not valid for income tax shifting purposes.
Because it’s a Grantor Trust, all of the income, deductions, and credits are reported on the individual income tax return of the person creating the IDGT, who is called the Grantor or Settlor. This is all explained well in a recent article appearing in The Nevada Appeal: “What is an ‘IDGT?’”
An IDGT is valid for gift or estate tax purposes. The Grantor is also called the “deemed owner” and is separate from the trust. A big benefit of the IDGT is that significant wealth can be transferred by the Grantor without transfer taxes. This is due to the lack of coordination between the regulations for income tax and those concerning gift and estate (transfer) taxes that apply to grantor trusts.
A grantor trust—which is also known as a “living trust”—is revocable. The owner or grantor is allowed to modify the terms, add assets and remove assets from the trust. Income is reported on the individual income tax return, and the grantor trust isn’t required to file Form 1041, an income tax return for estates and trusts.
A typical transaction involves the grantor selling an asset that is expected to grow in value to the IDGT in exchange for a promissory note for the fair market value of the item, with interest at the applicable federal rate (AFR). Since the transaction is a sale for gift tax purposes, the gift tax doesn’t apply. It’s also a sale for estate tax purposes. The grantor owns only the promissory note, and when he or she dies, only the value of the note is included in the grantor’s estate. The appreciation passes to the beneficiaries of the trust without any gift or estate tax liability.
The transaction doesn’t mean that the trust pays income taxes. In fact, the “defective” part of the IDGT means the grantor still reports and pays taxes on trust income—like dividends or rents. The grantor pays those income taxes out of other assets, so it further reduces his or her estate. But the payment of those income taxes is not a gift.
An IDGT can help your family transfer wealth gift and estate tax free. Call us to find out how it benefit your family.
One of the main goals of our law practice is to help families like yours plan for the safe, successful transfer of wealth to the next generation. Call our office today to schedule a time for us to sit down and talk about your estate plan, where we can identify the best strategies for you and your family to ensure your legacy of love and financial security. Our office is located in Santa Ana, CA but we serve all of California including Irvine, Orange, Tustin, Newport Beach, and Anaheim.
Reference: Nevada Appeal (January 23, 2017) “What is an ‘IDGT?’”