Estate Planning for Founders – Part III: Intentionally Defective Grantor Trusts
This is the third of a four-part series focusing on estate planning for founders. In this installment, we will cover why an Intentionally Defective Grantor Trust (IDGT) may be an effective estate planning tool for founders.
An IDGT is an irrevocable trust that a grantor creates and funds during the grantor’s lifetime. Unlike a revocable trust which may be amended or revoked, an IDGT may not be amended or revoked (although very limited changes may be permissible through various means, such as “decanting” or administrative amendments made by an independent trustee).
An IDGT is “intentionally defective” because it is treated as a “grantor trust” for income tax purposes, which means that the grantor remains responsible for paying the income taxes. However, any asset transferred to an IDGT is treated as a completed gift that is excluded from the grantor’s gross estate for estate tax purposes. Generally, it is not advisable to make gifts of Qualified Small Business Stock (QSBS) to IDGTs. (See Estate Planning for Founders – Part II for more information.) If the equity in a company is not QSBS eligible, then an IDGT may be an effective strategy.
There are two common ways to fund an IDGT. The first and most straightforward way is to make a gift. If an IPO or other acquisition is anticipated that may result in significant appreciation of company equity, gifting that equity to the IDGT may be beneficial. Although this approach uses a portion of the lifetime gift tax exemption, any future appreciation of the equity will be excluded from the grantor’s estate, thereby reducing potential estate tax exposure and allowing the equity to remain in trust for the benefit of descendants free of additional gift and estate tax. Additionally, because the grantor pays the income tax for the trust, the trust assets may grow income tax free for the beneficiaries. Trust documents may also include a power of substitution permitting the grantor to exchange assets of equivalent value with the trust, providing flexibility to reacquire company equity if desired.
A second method of funding an IDGT is through a sale. Under this approach, company equity or other assets are sold to the IDGT in exchange for an interest-bearing promissory note at the minimum interest rate required by the IRS. Beneficiaries ultimately receive the assets remaining in the IDGT after repayment of the note without incurring gift tax, as the sale is not treated as a gift. Additionally, because the IDGT is a grantor trust for income tax purposes, the sale is disregarded for income tax purposes. The trust agreement may also be structured to permit the trustee, in his or her discretion and subject to applicable rules, to reimburse the grantor for income tax liabilities attributable to trust assets. As with a gift, all future appreciation of the transferred equity is excluded from the grantor’s estate. However, for this to be an effective strategy, the trust must have its own assets equal to at least 1/9th of the total sale amount. Generally, this requirement is typically met when the trust has been previously funded.
An IDGT can be a strategic estate planning option for founders. Non-tax considerations, such as trustee selection, are equally important and will be discussed in our next article. Check back soon!
An IDGT is an irrevocable trust that a grantor creates and funds during the grantor’s lifetime. Unlike a revocable trust which may be amended or revoked, an IDGT may not be amended or revoked (although very limited changes may be permissible through various means, such as “decanting” or administrative amendments made by an independent trustee).
An IDGT is “intentionally defective” because it is treated as a “grantor trust” for income tax purposes, which means that the grantor remains responsible for paying the income taxes. However, any asset transferred to an IDGT is treated as a completed gift that is excluded from the grantor’s gross estate for estate tax purposes. Generally, it is not advisable to make gifts of Qualified Small Business Stock (QSBS) to IDGTs. (See Estate Planning for Founders – Part II for more information.) If the equity in a company is not QSBS eligible, then an IDGT may be an effective strategy.
There are two common ways to fund an IDGT. The first and most straightforward way is to make a gift. If an IPO or other acquisition is anticipated that may result in significant appreciation of company equity, gifting that equity to the IDGT may be beneficial. Although this approach uses a portion of the lifetime gift tax exemption, any future appreciation of the equity will be excluded from the grantor’s estate, thereby reducing potential estate tax exposure and allowing the equity to remain in trust for the benefit of descendants free of additional gift and estate tax. Additionally, because the grantor pays the income tax for the trust, the trust assets may grow income tax free for the beneficiaries. Trust documents may also include a power of substitution permitting the grantor to exchange assets of equivalent value with the trust, providing flexibility to reacquire company equity if desired.
A second method of funding an IDGT is through a sale. Under this approach, company equity or other assets are sold to the IDGT in exchange for an interest-bearing promissory note at the minimum interest rate required by the IRS. Beneficiaries ultimately receive the assets remaining in the IDGT after repayment of the note without incurring gift tax, as the sale is not treated as a gift. Additionally, because the IDGT is a grantor trust for income tax purposes, the sale is disregarded for income tax purposes. The trust agreement may also be structured to permit the trustee, in his or her discretion and subject to applicable rules, to reimburse the grantor for income tax liabilities attributable to trust assets. As with a gift, all future appreciation of the transferred equity is excluded from the grantor’s estate. However, for this to be an effective strategy, the trust must have its own assets equal to at least 1/9th of the total sale amount. Generally, this requirement is typically met when the trust has been previously funded.
An IDGT can be a strategic estate planning option for founders. Non-tax considerations, such as trustee selection, are equally important and will be discussed in our next article. Check back soon!