An intentionally defective grantor (IDGT) trust is an estate-planning tool used to freeze certain assets of an individual for estate-tax purposes, but not for income-tax purposes. The intentionally defective trust is created as a grantor trust with a purposeful flaw that ensures the individual continues to pay income taxes, as income tax laws will not recognize that assets have been transferred away from the individual.

Because the grantor must pay the taxes on all trust income annually, the assets in the trust are allowed to grow tax-free, and thereby avoid gift taxation to the grantor’s beneficiaries.Thus, it is a loophole used to reduce estate tax exposure.

Grantor trust rules outline certain conditions when an irrevocable trust can receive some of the same treatments as a revocable trust by the Internal Revenue Service (IRS). These situations sometimes lead to the creation of what are known as intentionally defective grantor trusts. In these cases, a grantor is responsible for paying taxes on the income the trust generates, but trust assets are not counted toward the owner’s estate. Such assets would apply to a grantor’s estate if the individual runs a revocable trust, however, because the individual would effectively still own property held by the trust.

For estate-tax purposes, though, the value of the grantor’s estate is reduced by the amount of the asset transfer. The individual will “sell” assets to the trust in exchange for a promissory note of some length, such as 10 or 15 years. The note will pay enough interest to classify the trust as above market, but the underlying assets are expected to appreciate at a faster rate.

The beneficiaries of IDGTs are typically children or grandchildren who will receive assets that have been able to grow without reductions for income taxes, which the grantor has paid. The IDGT can be a very effective estate-planning tool if structured properly, allowing a person to lower his or her taxable estate while gifting assets to beneficiaries at a locked-in value. The trust’s grantor can also lower his or her taxable estate by paying income taxes on the trust assets, essentially gifting extra wealth to beneficiaries.