In estate planning, an Intentionally Defective Grantor Trust (IDGT) is a masterpiece of tax engineering. It exploits a mismatch between the IRS rules for income taxes and the rules for estate taxes. By including specific 'defective' clauses, the trust is treated one way for income tax and another way for estate tax.
The Tax Mismatch
For estate tax purposes, the IDGT is a completed gift. The assets are removed from your taxable estate. However, for income tax purposes, the trust is 'defective'—meaning the IRS still considers you the owner. Therefore, you (the grantor) must pay all the income taxes generated by the trust's assets.
Best Practice
The Ultimate Tax-Free Gift
Because you are paying the income taxes out of your own pocket, the trust assets grow 100% tax-free for your heirs. The IRS does not consider your payment of these taxes to be an additional taxable gift.
Selling Assets to an IDGT
A common strategy is to sell a highly appreciating asset (like a business) to the IDGT in exchange for a promissory note. Because you are selling the asset to 'yourself' (for income tax purposes), there is no capital gains tax on the sale. The asset then appreciates inside the trust, outside of your taxable estate.