Intentionally-Defective Grantor Trusts (IDGTs) for Asset Protection and Tax Planning
Through some toying around with the tax code, a trust is able to have its income taxed to the grantor as personal income tax, but be excluded from the grantor's estate for estate tax purposes. A trust with this characteristic is known as an intentionally-defective grantor trust.
Creating an Intentionally-Defective Grantor Trust (IDGT)
Internal Revenue Code §§ 671–79 provides when a trust's income is to be taxed to the grantor. §§ 2035–42 provide when a trust's assets are to be included within the estate of the grantor at death.
Grantor trusts trigger one or multiple provisions out of each set of sections of the Code. Non Grantor trusts trigger neither set. The Intentionally-Defective Grantor Trust triggers a provision from the first set, but not the second set.
Why would I not want to take advantage of the estate advantages such as step up in basis and instead have that part of the trust be defective?
Once the IDGT is created, the premise is to fund it and have it buy assets through a promissory note that are expected to appreciate in value and are not expected to receive a step up in basis on death. Your house should not be transferred into the IDGT; your stock portfolio should. The transferred assets appreciate at a rate above the interest rate used on your promissory note (which uses the applicable federal rate, the lowest rate of interest possible), resulting in more wealth transferring into the trust than back into the estate. The net result is reduced gift tax liability and reduced estate taxes.