Changes to Law May Eliminate Intentionally Defective Grantor Trusts

Estate planning professionals have long used intentionally defective grantor trusts as a means of reducing estate taxes and preserving assets. However, President Obama's proposed 2013 budget would eliminate the savings that IDGTs offer. People should be aware of the potential changes to tax laws and how they could affect IDGTs.

What Is an IDGT?

An IDGT is a trust that takes advantage of the split between the income tax laws and the tax rules governing gifts or money transfers. These trusts are a means of freezing the appreciation of assets for the purposes of calculating estate taxes and transferring assets out of the estate without incurring a gift tax penalty.

To create an IDGT, the grantor creates an irrevocable trust and transfers assets to the trust completely for the purposes of estate taxes, but incompletely for income tax purposes - which is why the trusts are "intentionally defective." Although the trust is irrevocable, the grantor retains the right to remove assets from the trust by substituting assets of equal value. As such, the grantor does not free him or herself from responsibility for income taxes on trust assets. The grantor continues to pay income taxes on the assets in the trust, rather than the trust assets themselves going to pay taxes on appreciation of trust assets.

What Are the Benefits of IDGTs?

If an IDGT is properly executed, the trust itself will receive the income that the assets in the trust generate, tax-free, which means that the trust beneficiaries will receive the greatest possible value from the trust. Furthermore, the grantor reduces the overall size of his or her taxable estate without incurring a gift tax. The grantor also has the opportunity to retain control over the assets in the trust because of the ability to substitute assets of equivalent value.

What Are the Possible Changes to IDGT Laws?

The 2013 federal budget may change tax law so that any assets that a grantor transfers to an IDGT would still be included in the total estate for estate tax purposes. Additionally, any assets the trust distributes during the grantor's lifetime would be subject to the gift tax. Finally, should the grantor cease ownership of the trust for income tax purposes while still living, the entire contents of the trust would be subject to the gift tax.

Experts believe that if the new rules pass as part of the 2013 budget, they would only apply to trusts created after new rules went into effect. However, some suggest the new rules could also apply to any transfers made to existing trusts after the new rules are in operation.

Navigating the ever-changing tax and estate planning laws can be challenging. If you have questions about a trust you have established or would like to set up, speak with a qualified estate planning attorney.