Defective trusts, such as intentionally defective donor trusts (IDGTs), can provide tax breaks and increase the wealth of descendants. These trusts must be carefully constructed to withstand tax scrutiny and can be detrimental if assets depreciate in value. They allow grantors to leave wealth to trustees while avoiding expensive estate taxes. To establish a defective trust, a grantor must loan the trust some of its funds, and the trust uses these funds to purchase assets from the grantor’s estate. However, if the trust fails to comply with tax laws or assets depreciate in value, it can end up costing heirs more than expected.
A defective trust is specifically established to allow tax breaks and increase the wealth of the descendants of the person granting the trust. The most common type of this trust is an intentionally defective donor trust, or IDGT, which basically leaves assets in the trust that are held tax-free. In addition, the person granting the defective trust, also known as the grantor, pays income taxes on the assets, further reducing the tax burden for descendants. These trusts must be carefully constructed to withstand tax scrutiny and can be detrimental if the assets left behind depreciate in value.
Trusts are financial entities created by one person, also known as a grantor, to leave wealth to descendants, also known as trustees. The benefit of these trusts is that they can generally help descendants avoid expensive estate taxes that are incurred when the grantor dies. Although the trustees generally lack control of the assets within the trust and must comply with the grantor’s stipulations, it is often still a beneficial financial arrangement. A private trust, a defective trust, is particularly effective in protecting the trustees from excess financial burden.
To establish a defective trust, a grantor must first loan the trust some of its funds. In exchange for this loan, the IDGT must make periodic interest payments to the grantor at a rate determined by tax officials. The trust then uses the funds obtained from the loan to purchase an asset or multiple assets from the grantor’s estate. These assets often include real estate or investment securities, which can appreciate in value over time.
By doing this, the defective trust writes off the value of the estate, which lowers the estate tax burden when the grantor dies. In addition, the grantor continues to pay income tax on any accrued gain on the assets, further decreasing the value of the estate. The heirs of the trust are allowed access to these assets or the funds generated from them as stipulated by the trust.
One of the problems with a faulty trust is that your efforts to avoid taxes can put you on the radar of tax officials. If the trust fails to comply with tax laws, the trust may end up costing the heirs more than they could expect. Also, if the assets depreciate in value, the grantor could take a double hit. He or she could still pay income taxes, and the trust would still have to repay the loan.
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