9012 / How can an intentionally defective grantor trust be used in family business succession planning?

A trust structure called an intentionally defective grantor trust (IDGT) is another trust structure that can be used by a small business owner to transfer business interests to the next generation. In using this strategy, the business owner actually sells all interests in the business to the IDGT, naming the children or other heirs as beneficiaries of the trust.

An IDGT is an irrevocable trust that is valid for estate tax purposes, but “defective” for income tax purposes. This means the business owner (as the grantor of the IDGT) is the owner of the IDGT for income-tax purposes, but is not treated as the owner of the IDGT for estate tax purposes. Since the business interests are sold to the IDGT, there are no gift taxes.

Further, there are no capital gains taxes to the business owner because sales between a grantor and an IDGT are disregarded for income tax purposes. Typically, the business owner will structure the sale so that there is no down payment by the IDGT, annual interest payments are at the lowest rate permitted by the IRS, and a balloon principal payment is due in nine or more years. This technique is similar to a GRAT, but without the mortality risk. The value of the business is taken outside of the business owner’s estate for estate tax purposes, because future appreciation and interest are sheltered within the IDGT. The business owner’s estate is also reduced by the income and capital gains taxes to be paid on the IDGT’s income. In other words, the business owner is not taxed separately on the interest payments but instead is taxed on all of the capital gains and income realized by the IDGT. The taxes paid by the business owner on the IDGT’s income and capital gains are effectively tax-free gifts to the beneficiaries of the IDGT.