Fact 1: Defective doesn’t mean Ineffective
Despite the name, an intentionally defective grantor trust can be a very useful estate planning tool. The intentionally defective trust, often abbreviated as IDGT, will not be able to help you reduce your income tax liability, but it will allow you to shelter some of your assets for estate tax purposes. This is why the trust is known as defective, because it doesn’t completely separate you—the grantor—from the property and thus does not provide for income tax protections.
Fact 2: You can reduce the size of your estate.
When you create an intentionally defective trust you transfer some of your property to the trust to own. Because the trustee is irrevocable that property will no longer be included when it comes time to value the size of your estate. This means that upon your death the trust beneficiaries can receive the property without it being subject to estate taxes.
Fact 3: The Grantor is the Owner of Trust Property for Income Taxes
When you create an intentionally defective grantor trust you still have to pay income taxes on the trust property. Any income, deductions, credits, and any other taxable interest that applies to the trust property is something you will have to report to the IRS as if you were the owner and not the trust.
On the other hand, the value of the property transferred to the trust is effectively frozen regardless if it later appreciates. The details of how this works can be a little complicated, so you’ll have to speak to your lawyer about the fine points.