Intentionally Defective Grantor Trusts (IDGT): A Smart Estate Planning Strategy for Minimizing Taxes

When it comes to sophisticated estate planning strategies, few tools are as powerful — or as misunderstood — as the Intentionally Defective Grantor Trust (IDGT). Despite the misleading name, a defective grantor trust is a highly effective method for transferring wealth, minimizing estate taxes, and leveraging favorable income tax treatment.

In this article, we’ll break down everything you need to know about IDGTs — what they are, how they work, and why they might be the right move for reducing your tax liabilities and preserving wealth for future generations.

What Is an Intentionally Defective Grantor Trust?

An Intentionally Defective Grantor Trust (IDGT) is a type of irrevocable trust designed to remove assets from the grantor’s estate, reducing future estate tax exposure while maintaining grantor trust status for income tax purposes.

It is “defective” only in the sense that, for income tax purposes, the trust is still treated as a grantor trust — meaning the grantor pays income tax on the trust’s income. However, for estate tax purposes, the trust is treated as a separate legal entity. This allows the assets inside the trust to grow outside of the grantor’s estate, ultimately passing estate tax free to the next generation.

How Does an IDGT Work?

The basic strategy behind an IDGT is to transfer assets to the trust in a way that removes them from the grantor’s taxable estate, while retaining the grantor trust status for income tax purposes.

Here’s how it typically works:

1. The grantor either gifts assets or sells assets (often via a promissory note) to the trust.
2. The grantor pays the income tax on all income generated by the trust — further reducing their taxable estate without using additional gift tax exemption.
3. The trust assets appreciate in value outside the estate, ultimately passing to trust beneficiaries free from additional estate taxes.

Because the grantor pays income tax, the trust’s value grows more rapidly — as it’s not burdened by its own income tax liability. It’s a smart, entirely legal method of tax avoidance that leverages both income tax and estate tax rules.

Estate and Income Tax Benefits of an IDGT

There are several compelling tax advantages that make an IDGT a powerful estate planning tool:

1. Reduction of Estate Taxes

By transferring appreciating assets to an IDGT, the future growth of those assets is excluded from the grantor’s estate, reducing estate tax exposure.

2. Leveraging the Gift Tax Exemption

When the grantor gifts assets to the IDGT, the value of the gift may be covered by their lifetime exemption, removing it from both gift tax and estate tax calculations.

3. Paying Income Taxes on Behalf of the Trust

Because the grantor pays taxes on the trust’s earnings, this is effectively an additional gift that doesn’t count against the gift tax exemption. It also lets the trust assets grow faster — unburdened by paying taxes on the income.

This tax treatment creates a planning advantage: although the income is taxable, the trust itself is not responsible for the income tax liability, allowing its assets to grow more efficiently over time.

4. Freezing Fair Market Value

By selling a highly appreciated asset to the trust in exchange for a promissory note (typically with interest based on the applicable federal rate), the fair market value is frozen. All future appreciation occurs outside the estate.

Key Components of an IDGT

Setting up an IDGT properly involves a few key elements:

• Irrevocable Trust Structure: The trust cannot be amended or revoked by the grantor once created. This structure is what removes trust assets from the grantor’s estate.
• Defective Grantor Provisions: The trust includes specific powers retained by the grantor — such as the ability to swap assets or borrow without adequate security — that trigger grantor trust status for income tax purposes, while still meeting the requirements of an irrevocable trust for estate tax purposes.
• Trust Beneficiaries: Usually children or grandchildren who will ultimately receive the trust income or assets.
• Promissory Notes: Used in asset sales to the trust, with structured interest payments.
• Substitute Assets Clause: Allows the grantor to retain the right to swap equivalent value assets for trust assets, adding flexibility.

Who Should Consider an IDGT?

This strategy is especially useful for:

• High-net-worth individuals with significant estate tax exposure.
• Those who expect their assets — especially high-growth assets like real estate or a closely held business — to appreciate significantly.
• Families seeking to transfer wealth to the next generation while minimizing transfer tax consequences.
• Individuals who have already maximized their gift tax exemption but still want to reduce their grantor’s estate.

Disadvantages of an Intentionally Defective Grantor Trust (IDGT)

While the Intentionally Defective Grantor Trust offers powerful estate and income tax benefits, it’s not a one-size-fits-all solution. As with any advanced estate planning strategy, there are trade-offs to consider.

1. The Grantor Pays Income Tax Without Receiving Income

One of the defining features of an IDGT is that the grantor pays income tax on all trust income, even though the income is retained by the trust or distributed to beneficiaries. While this is a strategic way to reduce the grantor’s taxable estate, it can also create cash flow issues if the grantor doesn’t have liquid funds or other income sources to cover the taxes.

✅ Pro: Helps reduce the estate tax burden
❌ Con: May require careful planning to manage the income tax liability

2. Loss of Control Over Transferred Assets

Because an IDGT is an irrevocable trust, any assets gifted or sold to the trust are no longer owned or controlled by the grantor. This can be a difficult adjustment, especially for clients who are used to maintaining full control over their wealth.

The grantor can set terms during trust creation that control how and when beneficiaries receive distributions, but cannot retain ongoing control. Doing so risks pulling assets back into the grantor’s gross estate for estate tax purposes. While powers such as asset substitution can provide some flexibility, they don’t allow for unrestricted access or changes once the trust is established.

✅ Pro: Assets removed from grantor’s gross estate
❌ Con: Limited control and no personal use of trust assets

3. Requires Complex Setup and Ongoing Oversight

Creating an IDGT is not a DIY project. It requires a carefully drafted trust document that balances grantor trust status with estate tax objectives. Additionally, if you plan to sell assets to the trust, you’ll need to follow strict guidelines around valuation, structuring a promissory note, and setting the applicable federal rate.

Because of these complexities, working with an experienced California estate planning attorney and tax advisor is essential.

✅ Pro: Strategic tax planning tool
❌ Con: Upfront legal costs and long-term compliance requirements

Real-World Example of an IDGT

Let’s say Alex owns a business valued at $5 million. She expects it to grow substantially. She creates an Intentionally Defective Grantor Trust and sells the business to the trust using a promissory note with fair interest payments.

Although Alex no longer owns the business, she continues paying income tax on the trust income. The company grows in value — now worth $10 million — and all that growth occurs outside of Alex’s taxable estate. When she passes, her children inherit the business — passing estate tax-free with no additional gift tax or estate tax owed on the appreciation.

Is an IDGT Right for You?

If you’re looking to reduce federal estate taxes, protect other assets, and pass on wealth efficiently, an Intentionally Defective Grantor Trust could be the ideal solution. However, it requires detailed planning and precise execution.

An experienced estate planning attorney can help you structure the trust correctly, assess your estate tax exposure, and ensure your plan is aligned with your long-term goals.

Though the name may sound like a red flag, the Intentionally Defective Grantor Trust is one of the most effective estate planning strategies available. It allows you to reduce your grantor’s taxable estate, pay income taxes on behalf of your heirs, and transfer assets with powerful tax benefits.

If you’re interested in setting up a defective grantor trust IDGT or exploring whether it fits into your plan, our team at Evolution Tax & Legal is here to help. With years of experience handling defective grantor trusts, we’re ready to guide you through every step.

Frequently Asked Questions: Intentionally Defective Grantor Trust (IDGT)

What makes a trust an intentionally defective grantor trust?

Specific provisions within the trust trigger grantor trust status for income tax purposes, while still qualifying as an irrevocable trust for estate tax purposes.

Who gets the income from an IDGT?

The trust beneficiaries benefit from the assets and trust income, but the grantor pays income tax on it.

Can an IDGT make distributions to beneficiaries?

Yes — although many are designed to retain assets and maximize long-term growth.

What’s the difference between an IDGT and a SLAT?

A SLAT allows the grantor’s spouse to benefit from trust assets during his or her life. An IDGT, by contrast, excludes both spouses from access, making it more powerful from an estate tax perspective.

Does a defective grantor trust file a tax return?

Generally, no. The grantor trust is disregarded for tax purposes, so taxable income is reported on the grantor’s personal return.

Does an IDGT offer creditor protection?

Yes, in many cases. Because an Intentionally Defective Grantor Trust is an irrevocable trust, the assets transferred to it are generally no longer considered part of the grantor’s personal assets — which means they’re typically shielded from the grantor’s creditors, assuming the trust wasn’t created to avoid known debts.

Additionally, the trust can include spendthrift provisions to help protect assets from the creditors of the trust beneficiaries. That said, creditor protection is not the primary purpose of an IDGT, and results can vary depending on state law and how the trust is drafted. For anyone concerned about creditor exposure, it’s important to work with an estate planning attorney who can ensure those protections are built into the trust.