Most parents want their children to inherit as much wealth as possible, which drives their focus to shield heirs from unnecessary taxes when they inherit. As of this writing, federal gift and estate tax laws are very friendly for building generational wealth, says a recent article from Kiplinger, “One Way to Secure Your Child’s Inheritance in an Uncertain Tax Future.” However, this is temporary, as the Tax Cuts and Jobs Act will expire in 2025. When it does, gift and estate tax exemptions will be cut in half.
The incentive to take advantage of the current tax laws is even greater for those living in one of the 17 states with their own estate or inheritance taxes, especially considering those states’ exemptions are considerably lower than the federal estate taxes.
How can you transfer the most wealth possible to heirs? The best tool is often the Intentionally Defective Grantor Trust or IDGT.
The IDGT, despite its name, is not at all defective. Removing assets from an estate lowers or eliminates taxation on the estate and heirs. By selling assets from the estate to a grantor trust, they are no longer subject to estate taxes. The trust then pays an installment note over a number of years, which is designated when the trust is created.
So, why is it called Intentionally Defective? The term refers to the fact that the trust is not responsible for paying its own income taxes. Instead, they pass to the grantor or person who created the trust. Consider an estate with $20 million placed in an IDGT. This might generate a $500,000 tax bill, paid by the grantor. This accomplishes two things: The $500,000 paid in taxes is removed from the estate, lowering the estate’s value and the estate tax. Second, the trust is not responsible for paying income taxes on the appreciation of assets so that it can grow faster. Since the trust is not subject to estate taxes, any appreciation of assets inside the trust won’t add to any estate taxes due upon the grantor’s passing.
IDGTs and S Corporations. Many family-owned businesses are S-corporations that shield personal assets from business-related liabilities. If someone successfully sues the business, any judgment will be placed on the business, not the family’s assets. S corp owners hold shares in the corporation, which can be transferred to the IDGT. When family members move their stock into the trust, business ownership is transferred to heirs free of estate tax. If the business grows between the time the trust is established and your death, the growth happens separately from the estate, so there is no estate tax implication to continued business growth.
What’s the downside? The IDGT removes assets from the estate and provides cash flow in installment payments to fund retirement. However, if you die before the installment term ends, the trust pays out the rest of what it owes to your estate, which increases the value of your estate and the estate taxes owed. However, there’s a remedy for this. The IDGT can be set up with a self-canceling installment note or SCIN. The SCIN automatically cancels the trust’s obligation to pay installments upon your death.
Remember that you will be responsible for the trust's tax liability, so don’t gift so many assets to the trust that you’re scrambling to pay the tax bill.
IDGTs are complex and require the help of an experienced estate planning attorney to ensure that they follow all IRS requirements.
Reference: Kiplinger (July 28, 2023) “One Way to Secure Your Child’s Inheritance in an Uncertain Tax Future”