An intentionally defective grantor trust (IDGT) is a type of irrevocable trust used to transfer property (often the ownership interest in a business) to a subsequent generation while minimizing gift and estate taxes. As an irrevocable trust, the IDGT's grantor losses control of the assets, does not retain the right to revoke the trust, cannot be the trustee, cannot control the trust and is not a beneficiary. They are considered “defective” because any income generated by the trust's assets is taxed to the grantor.
IDGTs are used to transfer property that is expected to substantially appreciate during the grantor's life to their children and grandchildren without being included in the grantor's taxable estate. The grantor's payment of the taxes on the trust's income further reduces the size of their taxable estate, further reducing estate taxes. The payment of the income taxes is not treated as an additional taxable gift to the trust's beneficiaries.
The payment of estate taxes is frequently a problem for the families of many small business owners. The estate often lacks the funds to pay the taxes without the sale of the business or some of its assets. An intentionally defective grantor trust is a method used to remove the value of a business from the grantor's taxable estate. It can freeze the business value for gift and estate taxes and transfer significant wealth to the next generation in a tax-favorable way.