Intentionally Defective Grantor Trust (IDGT) Strategies: Sales, Swaps, and Basis

Few estate planning 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 taking advantage of favorable income tax treatment.

Two strategies do most of the work. An installment sale transfers an appreciating asset to the trust for a promissory note, freezing its value in the estate. A substitution power lets the grantor swap those assets back out late in life, so they qualify for a step-up in basis at death

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 federal 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 under IRC §§671 through 679. However, for gift tax and 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 to the next generation without inclusion in the grantor’s estate.

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 covers 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.

The sale itself produces no taxable gain, because a sale between a grantor and a trust the grantor is treated as owning is disregarded for income tax purposes under Rev. Rul. 85-13.

Because that liability sits with the grantor, the trust’s value grows more rapidly as it’s not burdened by its own income tax liability. Its a method of tax planning that uses both income tax and estate tax rules.

Estate and Income Tax Benefits of an IDGT

An IDGT produces three separate tax results. Growth in the assets transferred to the trust is excluded from the grantor’s estate, so long as the grantor retains no interest or control of the kind that causes inclusion under IRC §2036. The gift is measured once, at the value on the date of transfer, so everything the asset earns afterward passes without further gift or estate tax. And because the grantor stays liable for the trust’s income tax, the trust compounds without ever funding that tax itself.

Using the Lifetime 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. That exemption is $15,000,000 per person for 2026, or $30,000,000 for a married couple, under IRC §2010(c)(3)(A).

The figure is permanent. P.L. 119-21 §70106(a) rewrote the base amount and struck the temporary subparagraph that had been scheduled to expire, effective for gifts made after December 31, 2025. The seed gift no longer has to beat a sunset, which means it can be sized to the transaction rather than to a deadline.

Freezing Value With a Promissory Note

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.

The note has to carry interest at least at the applicable federal rate for its term under IRC §1274(d). The IRS republishes those rates every month, and they have risen through 2026. The mid-term rate, which governs notes of three to nine years, moved from 3.81 percent in January to 4.49 percent in September. The long-term rate went from 4.63 to 5.12 percent over the same period.

The rate sets the bar the asset has to clear. Value reaches the beneficiaries only to the extent the asset outearns the interest payments the trust owes, so an asset compounding at 9 percent against a note at 4.5 percent shifts roughly that spread out of the estate each year. An asset earning less than its note rate transfers nothing.

Paying the Trust’s Income Tax

The income tax liability sits with the grantor, not the trust, under IRC §671. Paying it is therefore not a gift to the beneficiaries, even though the economic effect is to move more value to them (Rev. Rul. 2004-64). The trust grows faster because it never funds its own tax bill.

Mandatory Versus Discretionary Reimbursement

Most instruments say something about whether the trustee may reimburse the grantor for that tax, and how that clause is drafted decides whether the benefit survives. A clause that requires reimbursement pulls the full fair market value of the trust into the grantor’s estate because the grantor has retained the right to have trust property applied to a legal obligation under IRC §2036(a)(1). A clause that leaves reimbursement to the trustee’s discretion does not, by itself (Rev. Rul. 2004-64). The ruling applies prospectively, so it does not reach trusts created before October 4, 2004.

Discretion alone does not end the analysis. The same ruling names three facts that can still cause inclusion: an understanding or pre-existing arrangement between the grantor and the trustee about how the discretion will be exercised, a power retained by the grantor to remove the trustee and name himself as successor, or local law subjecting the trust assets to the claims of the grantor’s creditors.

California has answered the third by statute. A settlor is not treated as a beneficiary of an irrevocable trust solely because the trustee holds discretionary authority to pay or reimburse the settlor’s income tax, and a creditor may not reach any amount solely by reason of that authority, under Cal. Prob. Code §15304(c).

Key Components of an IDGT

Setting up an IDGT properly involves a few key elements:

The structure depends on a few elements working together. The trust has to be irrevocable, which is what removes the assets from the grantor’s estate. It also has to contain at least one power that triggers grantor trust status for income tax purposes without causing estate inclusion, most often the power to borrow without adequate security or to substitute assets of equivalent value, under IRC §675. Any sale to the trust is documented by a promissory note carrying a stated term and interest payments, and the beneficiaries are usually children or grandchildren.

The substitution power deserves more attention than it usually gets, because it does two jobs. It keeps the trust defective for income tax purposes, and it gives the grantor a way to address the basis problem decades later. For the first job it has to be exercisable in a nonfiduciary capacity and without the approval or consent of any person acting in a fiduciary capacity, under IRC §675(4)(C).

Swapping Assets Back Out for a Basis Step-Up

The substitution power is the most useful provision in the document, and not for the reason it is usually cited.

Assets held in an irrevocable grantor trust do not receive a basis step-up at the grantor’s death, because they are not included in the gross estate (Rev. Rul. 2023-2). A business sold to an IDGT at $5,000,000 and worth $30,000,000 when the grantor dies passes to the beneficiaries with the original basis intact, and their eventual sale carries the whole built-in gain.

The substitution power is what answers that. Late in life the grantor exchanges cash or high-basis property of equivalent value for the appreciated asset, which brings the appreciated asset back into the estate where IRC §1014 reaches it and leaves the high-basis property in the trust. The exchange is not a taxable event, because the grantor and the trust are the same taxpayer for income tax purposes.

Exercising the power does not pull the trust into the estate, provided the trustee has a fiduciary obligation to confirm that the substituted property is in fact of equivalent value and the power cannot be used to shift benefits among the beneficiaries (Rev. Rul. 2008-22).

The tradeoff is real. Bringing the asset back into the estate exposes its full value to estate tax, so the swap pays only where there is exemption left to absorb it or the built-in gain is large next to the estate tax cost. For a grantor whose estate sits well above the exemption, leaving the asset in the trust is often still the better answer.

Who Should Consider an IDGT?

The structure fits a grantor who holds an asset expected to appreciate sharply, usually real estate or a closely held business, and who has enough estate tax exposure that keeping the growth out matters. It fits best where the asset can be valued defensibly and where the grantor can afford to pay income tax on income the trust keeps.

Families planning across more than one generation have a second consideration, because moving assets out of the estate does not by itself move them past a grandchild. That requires allocating GST exemption so the trust stays exempt across generations, which is a separate election with its own timing rules.

A grantor who has already used the full lifetime exemption and still wants to reduce their estate has a narrower set of options, since there is nothing left to cover a seed gift. That is the case where a grantor retained annuity trust, which freezes value without using exemption, is usually the better instrument.

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.

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.

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.

The Structure Requires Precise Drafting 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 estate planning attorney and tax advisor is essential.

Trust Assets Do Not Receive a Basis Step-Up

Assets that stay in the trust take the grantor’s basis rather than a new one at death. The gain that accumulated across the entire term is still there when the beneficiaries sell, and at a long enough hold it can exceed the transfer tax the structure saved.

The substitution power answers this, but only for a grantor who has cash or high-basis property of equivalent value to exchange for the appreciated asset. A grantor whose wealth is concentrated in the asset sold to the trust frequently does not, and the liquidity problem tends to be worst at exactly the point the swap would matter most.

Where the swap is not available, the real choice is between estate tax on the asset and capital gains tax on the built-in gain. That comparison is worth running before the trust is funded rather than after, because the answer sometimes argues against funding it at all.

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.

Before the sale, Alex makes a completed gift to the trust so that it holds assets of its own, here $500,000. That is a taxable gift for gift tax purposes, reported on a gift tax return and applied against her lifetime exemption. Practice converges on roughly 10 percent of the purchase price, though that is convention rather than a statutory safe harbor. Without something behind the note, the trust has nothing supporting its obligation and the transaction is harder to respect as a sale.

Although Alex no longer owns the business, she continues paying income tax on the trust income. The company grows in value, now worth $30 million, with all that growth occurring outside of Alex’s taxable estate. When she passes, her children receive the business while none of the appreciation is included in Alex’s estate or subject to additional gift or estate tax at her death.

Is an IDGT Right for You?

An experienced estate planning attorney can help you structure the trust correctly, assess your estate tax exposure, and weigh the estate tax saved against the basis your heirs give up.

If you’re interested in setting up a defective grantor trust or exploring whether it fits into your plan, our team at Evolution Tax & Legal is here to help. Our attorneys and CPAs work on defective grantor trusts regularly.

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 spousal lifetime access trust, where a spouse retains indirect access, lets the grantor’s spouse 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. The choice between them turns on whether the couple can afford to give up access, which is covered in how a GRAT and a SLAT compare, and which to fund first.

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.

Does an IDGT still make sense now that the estate tax exemption is permanent?

For estates above the exemption, yes, and the case is unchanged. What changed is the timing. The exemption is $15,000,000 per person and it is no longer scheduled to expire, so a seed gift can be sized to the transaction rather than rushed to beat a deadline. For an estate comfortably below $30,000,000 for a married couple, the answer is often no, because assets left in the estate receive a basis adjustment at death that trust assets do not.

Do assets in an IDGT get a step-up in basis when the grantor dies?

No. Assets that are not included in the grantor’s gross estate receive no basis adjustment at death, so the beneficiaries take the grantor’s original basis (Rev. Rul. 2023-2). A grantor who wants the step-up has to bring the asset back into the estate before death, which is what the substitution power is for.

This article is for informational purposes only and does not constitute legal or tax advice. Tax laws and regulations change frequently and may affect the accuracy of this information. Consult a qualified tax attorney or CPA before making any decisions based on the content of this article.