As mentioned previously in our article Accounting for Revocable and Irrevocable Trusts, estate planning is an in-depth process to ensure that you’re maximizing your assets and earnings during your lifetime, and when you pass, your life’s assets are passed appropriately without any hassle of interfering legal systems.
An intentionally defective grantor trust (IDGT) is a type of irrevocable trust that is commonly used to transfer assets to its’ beneficiaries during the life of the grantor. There are many benefits to using an IDGT for both the grantor and the beneficiary.
Like other irrevocable trusts, once the assets are placed into a trust, they are no longer in possession of the grantor’s estate – although there are provisions to enable adjustments to the assets within the trust. With the assets no longer in possession of the grantor, it makes this trust effective for estate tax purposes. Upon the grantor’s passing, beneficiaries will not have to pay estate taxes. However, the grantor still pays the taxes on the trust, making it defective for income taxes compared to a standard trust. Furthermore, when taxes are paid for the trust, they are taxed at the grantor’s tax level, not the trust’s tax level. This gives many advantages to those involved in the trust allowing everyone to maximize their earnings and assets.
Altering Assets
Different than other trust, the IDGT has provisions enabling the grantor to alter assets in the trust. The grantor may substitute items of equal value, take a loan from the trust without substantial interest, and may change or add noncharitable beneficiaries for distribution. While these provisions may change the details of the trust, the overall value will remain the same. There are also still exceptions to these provisions and without a proper understanding, the trust’s assets could be placed back into the grantor’s estate for tax purposes. This is why it is imperative to consult your accountant before making any changes.
Four Types of Taxes to Consider:
Estate
As mentioned previously, the IDGT is not subject to estate taxes. Any assets were taxed at a set percentage prior to transferring. The current threshold is $12.06 million per person, but anything above this threshold will be subject to a tax rate of 40%. Of course, there are exemptions that may apply, such as the marital deduction or the charitable deduction. Both of these deductions allow the assets to pass tax-free. Certain states, like New York, don’t impose a gift tax, but they do instill a state estate tax that’s a lower than the federal estate tax rate.
Gift
Gifting the asset essentially freezes the value of the asset so that any appreciation can be passed to the beneficiary tax free. However, there is a lifetime exemption limit to transfer gifts to the IDGT. Any gifts that exceed the threshold are taxed at 40%. There are exclusions to avoid immediate payment of the taxes, but it’s then included in the taxable estate at death.
Generation-Skipping Transfer (GST)
Typically, assets are taxed at death. When those assets are taxed and passed on to the beneficiaries, they must be taxed again if they choose to leave those to their beneficiaries. For instance, Grandmother to children to grandchildren. Assets are taxed upon each passing. However, this can be omitted by using the GST exemption. This allows the grantor to pay the price to skip and avoid double taxation. Up to $12.06 million may be contributed as a gift before being taxed at 40%
Income
Where the IDGT becomes defective is with the income taxes. Unlike other trusts that pay their own taxes based on a tax rate driven by the trust’s income, the grantor pays the taxes on an IDGT. While the grantor pays the taxes for the trust, it is based on the grantor’s tax rate, not the trust’s tax rate. This allows for a lower tax rate, for the grantor to benefit from any potential deductions, and for the assets to appreciate faster. While this makes it defective in the idea of a trust, it is intentional and benefits everyone.
Variations of the IDGT
There are different types of IDGT that can accommodate different needs. A pot trust, also called a spray or sprinkle) is a type of IDGT that is intended for numerous beneficiaries and allows the grantor to distribute assets at their discretion. There can also be a spendthrift trust which helps protect assets from the beneficiary whose judgment may have become clouded by substance abuse or improper influences. A SLAT (Spousal Lifetime Access Trust) is another type of IDGT that is specifically created to benefit the spouse upon the grantor’s passing without including it in the estate so that the remaining partner can still have access to the assets.
Considerations
Before creating an IDGT, the grantor needs to take aspects into consideration to ensure that the proper steps are taken to design the perfect trust. If the grantor needs access to the assets, an IDGT may not be appropriate. This kind of trust is not made to be revocable or easily accessible. Items not expected to appreciate, may not be meant for this trust either. With the IDGT, the appreciation of the assets benefits the grantor by reducing the estate by the amount of appreciation accumulated in the trust. Control over the trust’s assets can be of concern to the grantor as well, but, with an IDGT, significant control can be maintained. Under certain guidelines, the grantor may be able to hire/fire trustees or change provisions of the trust. Choosing the right trustee for the trust is another consideration to be thought of carefully, choosing the wrong person can lead to tax issues.
Why IDGT
The intentionally defective grantor trust can hold many benefits for all involved. However, there are many tax types and considerations to contemplate before drafting your trust to maximize your benefits. Estate planning involves many factors making it essential to consult with your accountant. Consulting with Kislay Shah CPA can help ensure that you’re making the right choice. You can reach Shah at kislay@shahcpaus.com or call at 646-328-1326.