Many advanced planning articles have been written about the tax benefits of intentionally defective trusts, particularly on the topic of sales transactions. Although tax benefits are very important, there are many non-tax benefits as well when such trusts are used in an irrevocable life insurance trust or ILIT.
An intentionally defective grantor trust (IDGT) is an irrevocable trust under which the grantor (or sometimes the beneficiary) is treated as the owner for income tax purposes by the intentional assigning of powers to the grantor that subject the trust to provisions under the grantor trust rules of IRC. ??671-679. The tax consequence is that the grantor is treated as the owner of the trust for income tax purposes, but the underlying assets of the trust are removed from his or her estate.
The word “defective” is applied because most irrevocable trusts are not set up as a grantor trust. An example of a grantor trust is a living trust that is included in the grantor’s estate. The goal of an intentionally defective grantor trust is merely to make the irrevocable trust defective for income tax purposes, while excluding the assets from the grantor’s estate for estate tax purposes.
A grantor will be treated as owner of a trust for income tax purposes if any of the following powers are inserted into the trust:
? The ability to add beneficiaries to the trust agreement after inception, except for children born or adopted afterward, without the consent or approval of an adverse party (i.e., any person having a substantial beneficial interest in the trust, which would be adversely affected by the exercise of a power).
? The ability to appoint trust income and principal during the grantor’s lifetime without the consent or approval of an adverse party.
? The power to substitute or reacquire assets in a non-fiduciary capacity by exchanging assets of equivalent value.
? The power to borrow from all or part of a trust without adequate interest or security. (Only the part of the trust that is subject to this power is income taxable to the grantor.)
? The power to use trust income to make premium payments on an insurance policy on the life of the grantor or the grantor’s spouse without the consent or approval of an adverse party.