Despite its name, a “defective grantor trust” is a legal and valid trust. The “defective” part only describes the fact that it’s not valid for income tax shifting purposes.
Because it’s a Grantor Trust, all of the income, deductions, and credits are reported on the individual income tax return of the person creating the IDGT, who is called the Grantor or Settlor. An IDGT is valid for gift or estate tax purposes. The Grantor is also called the “deemed owner” and is separate from the trust.
A big benefit of the IDGT is that significant wealth can be transferred by the Grantor without transfer taxes. This is due to the lack of coordination between the regulations for income tax and those concerning gift and estate (transfer) taxes that apply to grantor trusts.
A grantor trust—also known as a “living trust”—is revocable. The owner or grantor is allowed to modify the terms, add assets and remove assets from the trust. Income is reported on the individual income tax return, and the grantor trust is not required to file Form 1041, an income tax return for estates and trusts.
A typical transaction involves the grantor selling an asset that is expected to grow in value to the IDGT in exchange for a promissory note for the fair market value of the item, with interest at the applicable federal rate (AFR). Since the transaction is a sale for gift tax purposes, the gift tax doesn’t apply. It’s also a sale for estate tax purposes.
The grantor owns only the promissory note, and when he or she dies, only the value of the note is included in the grantor’s estate. The appreciation passes to the beneficiaries of the trust without any gift or estate tax liability.
The transaction doesn’t mean that the trust pays income taxes. In fact, the “defective” part of the IDGT means the grantor still reports and pays taxes on trust income—like dividends or rents. The grantor pays those income taxes out of other assets, so it further reduces his or her estate. But the payment of those income taxes is not a gift.