Defective Grantor Trust Overview

Irrevocable trusts are an essential part of sophisticated estate planning. Such trusts are normally used to hold assets that have been gifted or otherwise transferred by a grantor. Assets within irrevocable trusts, including future appreciation, are not included in the grantor’s estate for estate tax purposes.

A standard irrevocable trust is treated as a separate entity for income tax purposes and will be taxed on the income at the trust level. However, if an irrevocable trust is “defective,” the deemed grantor of the trust will be taxed on the income of the trust instead. This means the trust is disregarded for federal income tax purposes; such trusts are known as “grantor trusts.”

An intentionally defective grantor trust can be an effective planning technique for several important reasons. First, as with any irrevocable trust, the assets held within the trust are generally protected from creditors.

Second, since the trust is not a separate taxpayer, a sale to the trust by the grantor is not a recognizable transaction for income tax purposes and no gain will be recognized. Such a sale is often structured as an installment sale with a promissory note that has a self-cancelling feature effective upon the death of the grantor. This results in the balance of the note being excluded from the estate of the grantor; similarly, any increase in the value of the asset will also occur outside of the grantor’s taxable estate.

Third, since income generated by the irrevocable grantor trust is taxed to the grantor, the payment of that tax liability by the grantor is, in effect, a gift-tax free benefit to the trust and ultimately to the trust's beneficiaries. Since the trust is irrevocable, the trust principal will not be included in the taxable estate of the grantor. Therefore, the grantor can transfer assets into the trust by sale without the recognition of an income tax event, not have the trust assets included in his or her gross estate at death, and continue to reduce the value of his or her estate by the income tax payments on the trust income.

Although President Obama's current budget proposal would eliminate the value of using intentionally defective grantor trusts as an estate planning strategy, such trusts currently remain a useful tool.