An intentionally defective grantor trust (IDGT) is a popular wealth transfer planning technique. It can be an excellent tool for transferring wealth to future generations.

A transfer to an IDGT is generally treated as a completed transfer for estate and gift tax purposes but not for income tax purposes. This allows the IDGT assets to appreciate outside of the grantor’s estate while the grantor is still treated as the owner of the IDGT for income tax purposes. Since the grantor is still the owner for income tax purposes, they are still responsible for paying the tax associated with any income earned by the IDGT. These income tax payments are not considered gifts, allowing the grantor to further reduce their estate without using any of their remaining lifetime exemption. This structure also allows for more sophisticated wealth transfer planning techniques that are beyond the scope of this article.

Be aware of possible impacts

After a while, a grantor may no longer want to pay the income taxes associated with their trust. In many cases, it is possible for the grantor to “turn off” grantor trust status. Once grantor trust status is turned off, the trust will become a separate taxpaying entity responsible for paying its own taxes.

While the process of turning off grantor trust status may be relatively simple, analysis and coordination with the grantor’s advisor team (accountant, attorney, etc.) is essential prior to making such a decision. Turning off grantor trust status requires special analysis and may have unintended consequences if not properly analyzed. A few common examples include:  

• An IDGT that owns a pass-through entity with a negative capital account may recognize taxable gain upon turning off grantor trust status;

• A previously nonpassive activity could now be treated as a passive activity subject to net investment income tax; and

• The trust could become an ineligible S Corporation shareholder if a QSST or ESBT election is not made.

Seek guidance before changing status

Additional analysis will be required to determine any state filing requirements as well as what will happen to any tax attributes related to the IDGT prior to turning off grantor trust status. Discussing any potential issues prior to turning off grantor trust status will allow the grantor to make an informed decision. Consulting with the grantor’s advisor team can help identify any issues early in the process and allow the team to recommend alternatives or additional steps to alleviate any potential issues.