A Defective Grantor Trust (“DGT”) allows you to transfer assets out of your estate and ultimately reduce your estate tax liability. The DGT may also be referred to as an “Intentionally Defective Grantor Trust (IDGT),” a “defective trust” or a “grantor trust.” This tool is most effective when you have an asset that will appreciate overtime, because the trust locks in the value of the asset at the time of transfer, meaning that future appreciation of the asset passes tax free to the beneficiaries. However, when a grantor creates a DGT, he or she is responsible to pay any income taxes generated by the trust. This is why the trust is called a defective trust, because the grantor must pay the taxes on the trust income.
To create a DGT, the grantor would first create and transfer assets into a Limited Liability Company (LLC) or a Family Limited Partnership (FLP). If the grantor created an FLP, he would retain a general partnership interest and transfer a limited partnership interest to the DGT. By doing this, the grantor retains control over the assets and has the power to make decisions for the FLP. This process works similar with an LLC, except that the grantor retains a voting interest and transfers a nonvoting interest to the DGT.
The grantor transfers the limited or nonvoting interest to the DGT either through a gift or a sale. If the grantor makes a gift to the trust, then a gift tax return must be filed. If the grantor makes a sale to the trust, then he will receive a note for a term of years payable from the DGT to the grantor. The note payments are normally paid from the trust income. Only the amount of unpaid principal on the note is included in the estate when the grantor passes away. Otherwise, if all principal of the note has been paid by the time the grantor dies, then the DGT is not included in the grantor’s estate.
A DGT has many advantages. One is that it allows grantors to reduce the value of their estate for estate tax purposes. Also, appreciation of the assets transferred into the DGT pass tax free to the beneficiaries. Further, by the grantor paying the income tax, the beneficiaries do not have to otherwise pay the taxes and the grantor continues to reduce the value of his estate for estate tax purposes. Additionally, by making a sale to the trust, the beneficiaries do not have to pay income tax as they would if the assets were gifted outright to the beneficiaries. Grantors can also preserve their estate tax exemption by making a sale, rather than gifting all of the assets into the trust. Moreover, a DGT also allows grantors flexibility in setting up the trust and the note payments from the sale.
A DGT can be complicated and must be set up carefully, otherwise it can expose the grantor to significant estate and gift tax liabilities. The process requires a competent estate planning attorney who understands the law, is thorough in making sure the DGT is executed properly, and who is able to help the client understand why a DGT is useful and how it works. The Morris Estate Planning Attorneys provide this level of expertise and professionalism in helping clients setting up DGTs.