Irrevocable trusts are typically non-grantor trusts as opposed to grantor trusts. See here what this means. The Intentionally Defective Grantor Trust is a special type of irrevocable trust which is also a grantor trust (as opposed to a non-grantor trust). This means the grantor is responsible for paying taxes on the income the trust generates. Trust assets are not counted toward the owner’s estate. This would not be the case if the trust would be revocable (ordinary grantor trust) where the assets would apply to a grantor’s estate. This is because the IRS views the grantor as still in effect owning the property held by the trust. Let’s break the concept of the intentionally defective grantor trust down further.
First off, the drafters of the trust instrument intended to convert an irrevocable non-grantor trust into a grantor trust, something which was not desirable in the past (‘defective’), but under the current tax environment may be of advantage. Setting up an ‘intentionally defective grantor trust’ (IDGR) may serve as an estate-freezing technique—by giving the beneficiaries appreciated property without incurring additional transfer taxes—and as a way to remove assets completely from the grantor’s estate by putting them in an irrevocable trust. The income taxes paid by the grantor further reduce the value of the estate, and these taxes are not considered additional gifts to the trust or its beneficiaries.
To understand how this work lets briefly recap the difference between grantor and non-grantor trusts (see also What’s the difference between a grantor and non-grantor trust?). The grantor trust rules were enacted to prevent abuse where high net-worth individuals using a trust would shift their income to individuals with lower tax brackets, but still maintain control over the trust. The rules required that these grantors had to pay all the taxes of the trust personally and could thus not shift income to lower bracket payers to lower the tax bill. Nowadays the reason for the grantor trust rules for abuse prevention are no longer present because the progression of the trust tax rate is faster than the progression of the income tax rate. Instead, grantor trusts are now being used affirmatively by estate planners. The grantor pays all taxes so that nobody else has to pay them.
All revocable living trusts are grantor trusts. Most irrevocable trusts are non-grantor trusts. However, an irrevocable living trust can be made intentionally defective, i.e., making it a grantor trust on purpose rather than a non-grantor trust, for example in the following ways:
- A reversionary interest that exceeds more than 5 percent of the trust’s value when the reversionary interest is created
- The power to determine who will receive income or principal
- The right to buy, borrow, or substitute trust property under terms that favor the grantor
- The right to revoke (this makes it a revocable living trust(
- The right to use income to pay life insurance premiums on the life of the grantor or the spouse
The income earned by the trust incurs no income tax liability to anyone other than the grantor. This becomes increasingly more important over time. Because the tax rate schedule for trusts is compressed, i.e., progresses more quickly, the grantor is usually in a lower tax bracket than the trust, which makes funding the IDGT with appreciating assets also suitable for income tax savings.
As mentioned above, by nature a grantor trust comes with the grantor’s ability to control (to some extent) the beneficial enjoyment of the trust. Many forms of irrevocable trusts that do not include the grantor trust provisions require the grantor to relinquish all rights and powers with respect to the trust and the trust assets, with no retained interest. The IDGT intentionally reserves some of these interests (as outlined in the bulleted list above) and is therefore more flexible.
Here is a synopsis:
| Type of trust (from an IRS perspective) | Definition | Taxpayer ID (EIN) required | Who pays taxes on trust income | Who pays taxes on trust principal (corpus) | Tax planning relevance |
| Non-Grantor Trust | Not a Grantor Trust. See below for Grantor Trust. | yes | Beneficiaries pay tax on the distributions they receive | Trust pays taxes on the additions to principal that are not distributed | In the past used to shift income to lower bracket beneficiaries, or to accumulate income at relatively lower tax rates. Current compressed tax schedule for trusts makes this unattractive. |
| Grantor Trust | An inter-vivos (living) trust where Grantor retains power to revoke or right to receive trust income (details IRC 676, 677). All revocable trusts are Grantor Trusts. | no | Grantor pays taxes on trust income | Grantor pays all applicable taxes at her personal income tax rate (not trust tax rate) | The IRS established the Grantor trust rules to prevent inappropriate shifting of income to lower bracket family members at a time when individual and trust tax schedules were similar, currently trust tax rates progress much more quickly. The original rationale for the grantor trust rules (to combat income shifting) for the most part no longer applies |
| Intentionally Defective Grantor Trust | Intentionally making an irrevocable trust a grantor trust. Defective means it contains provisions that prevent it from being a non-grantor trust. | no | Grantor pays taxes on trust income | Grantor pays all applicable taxes | More flexible than an irrevocable trust. Income earned by the trust incurs no income tax liability to anyone other than the grantor. This becomes increasingly more important over time. Because of the compressed tax rate schedule for trusts , i.e., more rapid progression, the grantor is usually in a lower tax bracket than the trust, which makes funding the IDGT with appreciating assets also suitable for income tax savings. |
