Intentionally Defective Grantor Trusts (IDGT): The “Tax Burn” Estate Freezer
Intentionally Defective Grantor Trusts (IDGT): The “Tax Burn” Estate Freezer
๐ WHO THIS IS FOR (Prerequisites)
- Required Profile: UHNW individuals holding high-growth assets (Pre-IPO stock, Commercial Real Estate) who have sufficient liquidity to pay taxes on behalf of their heirs.
- Primary Objective: Estate Freeze & Compression (Locking in asset value today and reducing the estate size by “burning” cash to pay taxes).
- Disqualifying Factor: Lack of cash flow to pay the ongoing income tax liability generated by the trust’s assets.
โ ๏ธ STRATEGY ELIGIBILITY CHECK
The IDGT involves selling an asset to a trust rather than gifting it. To work, the sale must be commercially reasonable.
- โ๏ธ Seed Capital: You must make a “Seed Gift” (usually 10% of the asset value) to the trust first, so it has equity to buy the asset.
- โ๏ธ Promissory Note: The Trust pays you with a Note. The interest rate must match the Applicable Federal Rate (AFR), which is typically lower than commercial rates.
- โ๏ธ The “Defect”: You must retain a specific power (e.g., power to substitute assets) that forces the IRS to treat you as the owner for Income Tax, but the Trust as the owner for Estate Tax.
- โ๏ธ Cash Flow: The asset inside the trust must generate enough cash (or appreciation) to pay the interest on the Note back to you.
EXECUTIVE SUMMARY
- The Premise: You want to transfer a $10M business to your kids. A direct gift triggers $4M tax.
- The Edge: You Sell the business to an IDGT in exchange for a $10M Note. No Gift Tax is triggered because it’s a sale for fair value.
- The “Burn”: The business earns $1M/year profit inside the trust. Under normal rules, the Trust would pay tax. Under IDGT rules, YOU pay the tax on that $1M.
- The Result: The Trust grows tax-free (like a Roth IRA). Your personal estate shrinks by the amount of tax you pay (a tax-free gift to heirs). The asset appreciation happens outside your estate.
In the world of Dynasty Trusts, the IDGT is the “Supercharged Roth.” It allows the parent to act as a tax shield for the next generation, compounding wealth completely tax-free. Source: ACTEC / Bessemer Trust
- Transaction: Sale of $10M Asset to IDGT.
- Note Terms: 9-Year Interest Only Note at Mid-Term AFR (e.g., 4.0%).
- Asset Growth: 10% Annual Appreciation.
- Tax Rate: 40% (Paid by Grantor).
Performance Simulation (The “Tax Burn” Effect)
| Metric | Hold Personally | IDGT Strategy | Delta (Wealth Shift) |
|---|---|---|---|
| Initial Asset Value | $10,000,000 | $10,000,000 | – |
| Asset Value (Year 10) | $25,937,000 | $25,937,000 (In Trust) | – |
| Estate Tax Exposure (40%) | ($10,374,800) | $0 (Asset is out) | Save ~$10.4M |
| Note Repayment | N/A | ($10,000,000) back to You | Principal Return |
| Net to Heirs | $15,562,200 | $25,937,000 | +$10.3M Transfer |
*Chart Note: The Alpha comes from two places: 1) The growth ($15.9M) happens outside the estate. 2) The Grantor paid the income taxes on that growth, which is effectively an additional tax-free gift not shown in the simple math.
Advanced Mechanics: The “Toggle” Switch
*Managing the tax burden.
| Scenario | Action | Result |
|---|---|---|
| Aggressive Growth | Grantor keeps “Defect” on. | Grantor pays all taxes. Trust compounds at gross pre-tax rates. Maximum wealth transfer. |
| Cash Flow Crunch | Grantor “Toggles Off” the Defect (Renounces powers). | The Trust becomes a separate taxpayer. The Trust starts paying its own taxes. Grantor relief. |
| Basis Step-Up | Asset has appreciated massively. Grantor is near death. | Grantor uses “Swap Power” to exchange cash for the low-basis asset. Asset returns to estate to get Step-Up. |
Why IDGT beats GRAT for the Super-Rich:
- No Mortality Risk: Unlike a GRAT, if you die during the note term, the asset does not claw back into your estate (mostly). Only the Note value is included.
- Generation Skipping: You can allocate GST Exemption to the seed gift immediately. IDGTs are the primary vehicle for creating multi-generational Dynasty Trusts. GRATs are generally for one generation.
โ BOUNDARY CLAUSE: Structural Limitations
- Step Transaction Risk: If you fund the trust with $1M seed and immediately sell the $9M asset the next day, the IRS may argue the seed was illusory. Wait 30-60 days (“Seasoning”) between funding and sale.
- Valuation Risk: If the IRS revalues the sold asset (e.g., says it was worth $15M, not $10M), the difference is a “Gift.” Use a formula clause (“Wandry Clause”) to adjust ownership automatically to avoid tax.
๐ค DECISION BRANCH (Logic Tree)
IF Asset = High Cash Flow (Business):
โข Input: Company generates cash to pay note interest.
โข Output: Execute IDGT. Use cash flow to service debt; keep appreciation for heirs.
IF Asset = High Volatility (Crypto/Startup):
โข Input: Asset might go to zero.
โข Output: Use GRAT (#557). If a GRAT fails, you lose nothing. If an IDGT fails (asset drops), the Trust still owes you the $10M note, bankrupting the trust and wasting your seed gift.
“I would rather pay your income tax than pay the government’s estate tax.” The IDGT turns the Grantor’s tax liability into the Heir’s greatest asset.