An intentionally defective grantor trust (IDGT) is an irrevocable trust designed to exploit a split in how the IRS treats it: for estate tax purposes, the assets are considered outside the grantor’s estate, but for income tax purposes, the grantor is still treated as the owner. This split lets wealthy individuals transfer appreciating assets to heirs while shrinking the size of the taxable estate. The word “defective” is intentional and strategic, not accidental.
Why It’s Called “Defective”
The IRS has a set of grantor trust rules that determine who is responsible for paying taxes on a trust’s income. When a trust is set up so that the grantor retains certain powers or interests, such as the ability to swap assets of equal value or to borrow from the trust without adequate security, the IRS considers the trust “defective” for income tax purposes. That means the grantor, not the trust, reports all of the trust’s income on their personal tax return.
Here’s the key: while the IRS treats the grantor as the income tax owner, the trust is still irrevocable. The assets inside it have been legally transferred out of the grantor’s possession. So when the grantor dies, those assets are not counted as part of their estate for federal estate tax purposes. You get the best of both worlds: income tax ownership without estate tax inclusion.
How the Tax Benefits Work
The grantor paying income taxes on the trust’s earnings is not a drawback. It’s actually one of the biggest advantages of the structure. Every dollar the grantor pays in income tax on the trust’s behalf is a dollar that leaves the grantor’s taxable estate without being treated as an additional gift. The trust’s assets, meanwhile, grow tax-free because the trust itself owes nothing to the IRS. Over time, this produces a compounding effect: the trust’s assets appreciate faster than they would if the trust were paying its own taxes, and the grantor’s estate shrinks with each tax payment.
Think of it in concrete terms. If a trust earns $200,000 in a year and the grantor pays $50,000 in income tax on that amount, the full $200,000 stays in the trust growing for the beneficiaries. That $50,000 tax payment is money the grantor spent from their own pocket, reducing the estate, but the IRS does not treat it as a taxable gift to the trust. It’s simply the grantor paying their own tax bill.
The Installment Sale Strategy
One of the most common ways to move assets into an IDGT is through an installment sale. The grantor sells an asset, often a stake in a family business or other appreciating property, to the trust in exchange for a promissory note. The trust pays back the note over time with interest, using income generated by the asset itself.
The interest rate on the note only needs to meet the Applicable Federal Rate (AFR), which is a minimum rate the IRS publishes monthly. These rates are typically well below market lending rates, which means the trust can acquire a valuable, fast-growing asset while paying relatively little in interest. Any growth in the asset’s value above the AFR rate effectively passes to the beneficiaries free of gift and estate tax.
Because the grantor and the trust are treated as the same taxpayer for income tax purposes, the sale itself does not trigger a capital gains tax event. The grantor is essentially selling to themselves in the eyes of the income tax code, even though the asset has moved out of their estate.
Seed Capital Requirement
For the installment sale to hold up under IRS scrutiny, the trust typically needs to have some independent assets before the purchase. The standard practice is to “seed” the IDGT with a gift equal to at least 10% of the expected purchase price. This gives the trust economic substance beyond just the note, making the transaction look more like a genuine sale and less like a disguised gift. That initial seed gift does count against the grantor’s lifetime gift and estate tax exemption.
What Happens When the Grantor Dies
At the grantor’s death, the assets inside the IDGT are not included in the taxable estate. That’s the whole point of the structure. However, this exclusion comes with a tradeoff on cost basis.
Normally, when someone inherits property from a deceased person, the property’s tax basis “steps up” to its fair market value at the date of death. This can erase decades of unrealized capital gains. But in 2023, the IRS issued Revenue Ruling 2023-2, which clarified that assets held in an irrevocable grantor trust that are not included in the grantor’s gross estate do not receive a step-up in basis at the grantor’s death. Since IDGT assets are deliberately excluded from the estate, the beneficiaries typically inherit the grantor’s original cost basis. If they later sell the assets, they could owe capital gains tax on all the appreciation that occurred while the assets sat in the trust.
This doesn’t necessarily make the IDGT a bad deal. The estate tax rate is 40% on amounts above the exemption, while long-term capital gains rates max out at 20% (plus a potential 3.8% net investment income tax). For large estates, avoiding the 40% estate tax on millions of dollars of appreciation is often worth accepting a future capital gains tax bill at a lower rate.
Who Benefits Most From an IDGT
IDGTs are built for people whose estates are large enough to face federal estate tax. The federal estate and gift tax exemption is $13.99 million per individual for 2025, rising to $15 million per individual in 2026. A married couple can shield up to $30 million in 2026. Under the One Big Beautiful Bill Act, this higher exemption is now permanent and will continue to be adjusted for inflation, with no sunset provision.
If your estate is well below those thresholds, an IDGT likely isn’t worth the legal cost and complexity. But for estates that exceed the exemption, or that hold rapidly appreciating assets like a growing business, the IDGT can transfer significant wealth to the next generation at a fraction of the tax cost of simply leaving everything through a will.
The strategy works especially well when the grantor holds assets expected to appreciate substantially, when AFR interest rates are low (making installment sales cheaper), and when the grantor can comfortably afford to pay income taxes on the trust’s earnings out of their remaining personal assets. If paying those taxes would strain the grantor’s finances, the structure loses its appeal.
How an IDGT Gets Set Up
Creating an IDGT involves drafting an irrevocable trust document that deliberately includes one or more provisions triggering grantor trust status for income tax purposes. Common triggers include giving the grantor the power to substitute trust assets for assets of equal value, or naming the grantor’s spouse as a permissible beneficiary of the trust. The trust document must be carefully written so that these provisions create income tax ownership without pulling the assets back into the estate for estate tax purposes.
Once the trust is established and funded (either through an outright gift, an installment sale, or both), it operates as its own legal entity. It holds title to its assets, can have its own bank and investment accounts, and makes distributions to beneficiaries according to its terms. The grantor reports the trust’s income on their personal Form 1040 each year but has no right to reclaim the assets or redirect them for personal use.
The setup typically involves an estate planning attorney to draft the trust, a financial advisor or CPA to structure the installment sale and valuation, and often an independent appraiser if the asset being transferred is a business interest or real estate. Legal and appraisal fees vary widely depending on the complexity of the estate, but the costs are generally modest relative to the potential tax savings for estates well above the exemption threshold.