How IDGTs Help High-Net-Worth Families Minimize Estate Taxes

An Overlooked but Powerful Tool for Estate Planning

For high-net-worth individuals and families seeking efficient ways to transfer wealth and reduce estate taxes, the Intentionally Defective Grantor Trust (IDGT) is a compelling yet often underutilized tool. The term “defective” might sound negative, but in the context of estate planning, it’s a strategic advantage. In the right situation, an IDGT can be a key component of an advanced estate plan.

What Is an IDGT?

An Intentionally Defective Grantor Trust is an irrevocable trust that is treated as a grantor trust for income tax purposes but not included in the grantor’s estate for federal estate and gift tax purposes. The “defect” refers to specific provisions intentionally included in the trust that trigger the grantor trust rules under IRC §§ 671–679.

As a result, the grantor is responsible for paying income taxes on the trust’s earnings, even though the trust is a separate legal entity and is not part of the grantor’s taxable estate. This tax treatment allows the trust assets to grow without the drag of income taxes, effectively serving as a tax-free gift to beneficiaries. This is an important distinction since in most cases, an irrevocable trust is its own tax-paying entity and incurs taxes within the trust at tax rates that are less favorable than personal income tax rates.

Why Use an IDGT?

An IDGT can help achieve several goals:

Estate Tax Reduction – By removing appreciating assets from the grantor’s estate, future estate taxes are reduced or avoided.
Tax-Free Growth – Since the grantor pays the taxes, assets within the trust grow unencumbered by income tax.
Asset Protection – The irrevocable nature of the trust can help shield assets from creditors.
Valuation Discounts – If assets are sold to the IDGT using a promissory note, valuation discounts (e.g., lack of marketability or minority interest) may apply.

Key Components of an IDGT

Irrevocable: Once established, the grantor cannot revoke or amend the trust.
Grantor Trust Status: Specific provisions ensure that the trust is treated as a grantor trust for income tax purposes (e.g., allowing the grantor to substitute assets).
Separate Estate Tax Entity: For estate tax purposes, the trust is separate and not part of the grantor’s estate.
Beneficiaries: Typically children, grandchildren, or other heirs.

How Is an IDGT Funded?

An IDGT can be funded in one of two primary ways:

1. Gift
The grantor makes a completed gift of assets to the trust. This is typically the most common and easiest method to fund an IDGT. With this approach, the grantor makes an irrevocable gift of the asset to the trust and the grantor will pay income taxes produced by the assets within the trust. This approach uses part of the grantor’s lifetime gift exemption (currently $13.99 million per person in 2025).

2. Sale to the IDGT
The grantor sells assets (usually closely held business interests or marketable securities) to the trust in exchange for a promissory note. Since the sale is to a grantor trust, it's not a taxable event under current tax law. To avoid the sale being recharacterized as a gift, the trust must have sufficient “seed money” – typically at least 10% of the asset value being sold.

Example 1: Sale of a Business Interest to an IDGT

Let’s say Jane, a successful entrepreneur, owns a business valued at $10 million. She expects the business to grow substantially. Jane sets up an IDGT and gifts $1 million in seed capital. She then sells the remaining $9 million of her business interest to the trust in exchange for a 9-year promissory note using the Applicable Federal Rate (AFR) as the interest rate for the loan repayment.

Assuming the business grows to $20 million over the next decade, that appreciation occurs outside Jane’s estate. Jane pays the income taxes on the trust’s earnings, further reducing her taxable estate.
The beneficiaries – her children – eventually receive the business, free of estate taxes, while Jane has effectively frozen the value of her estate at the original $10 million level (minus note repayments).

Example 2: Marketable Securities and Tax-Free Growth

Robert, a wealthy investor, transfers $5 million of dividend-paying stocks into an IDGT. Because the trust is a grantor trust, he continues to pay the income taxes on the trust’s earnings – say $200,000 per year.

Over 20 years, the assets in the trust grow to $15 million, free from any income tax liability to the trust itself. Robert’s estate is reduced by the cumulative taxes he paid – approximately $4 million – and the trust’s assets pass to his heirs without estate tax exposure.

Don’t Forget About State Estate Taxes

As noted with the examples above, an IDGT can be an effective tool when managing the impact of federal estate taxes. But what about estate taxes at the state level? Here in our home state of Massachusetts, estate planning is important due to the relatively low state estate tax exemption amount of $2,000,000 per person. An IDGT can be implemented in the right scenario to help with state estate taxes as illustrated by the following example.

Example: Using an IDGT to Minimize Massachusetts Estate Tax

The Situation:
John and Lisa are married and live in Massachusetts. John owns a closely held business valued at $5 million, which he expects to grow significantly over the next decade. His total net worth, including other assets, is around $8 million. If he dies with these assets in his name, his estate could face a Massachusetts estate tax bill well into six figures, even though his estate is under the federal exemption.

The Strategy:

He creates an Intentionally Defective Grantor Trust (IDGT) for the benefit of his children.
He gifts $500,000 to seed the trust.
He then sells the $4.5 million business interest to the IDGT in exchange for a 9-year promissory note, with interest set at the Applicable Federal Rate (AFR).
The IDGT is structured to be outside of John’s Massachusetts taxable estate but “defective” for income tax purposes—so John continues to pay income taxes on the trust’s income, allowing the trust assets to grow tax-free.

The Outcome:

The future appreciation of the business (e.g., it grows to $10 million over 10 years) occurs outside John’s estate, avoiding Massachusetts estate tax on that growth.
The value of the note is “frozen” in John’s estate. Only the outstanding balance of the promissory note will be included if he dies before it is fully repaid.
Because John pays the income tax on the trust's earnings, the IDGT grows faster, and his taxable estate continues to shrink through income tax payments—a stealth wealth transfer strategy.
If John outlives the note term and it's repaid, those payments (principal and interest) will be reinvested or spent, potentially reducing his estate further.

Tax Savings:

By moving $4.5 million of appreciating business value out of his estate:

John may reduce or eliminate hundreds of thousands in Massachusetts estate tax.
The business remains in the family and is passed to heirs more efficiently.

Why This Works in Massachusetts

The Massachusetts estate tax applies to the value of the estate exceeding the $2 million exemption.
By using an IDGT, the appreciating asset is no longer part of the taxable estate, even though the grantor still pays the income tax.
Over time, this removes both the asset and the tax “drag” from the estate, leading to a compounding advantage.
The Massachusetts estate tax exemption of $2M per person is not adjusted annually for inflation under the current law.

Tax Implications

Income Tax

The grantor reports all trust income, deductions, and credits on their personal tax return. While this increases the grantor’s tax liability, it’s beneficial for the trust beneficiaries and keeps trust assets growing tax-free.

Estate Tax

Because the grantor has made a completed gift or sale to the IDGT, the assets (and all their future appreciation) are not included in the grantor’s taxable estate.

Gift Tax

If the trust is funded with a gift, it may consume some of the grantor’s lifetime gift and estate tax exemption. If a sale is used, it must be done at fair market value with appropriate documentation to avoid triggering gift tax.

Risks and Considerations

Grantor’s Death – If the grantor dies during the term of a promissory note, the note may be included in the estate.
Loss of Control – An irrevocable trust means the grantor loses control of the assets.
Tax Burden – The grantor must be willing and able to pay income taxes on assets they no longer own.
Valuation Challenges – Transferring closely held business interests requires accurate, defensible valuations to withstand IRS scrutiny.
Legislative Risk – Tax laws may change. While IDGTs are currently respected strategies, future legislation could diminish their benefits.

When to Use an IDGT

IDGTs are particularly useful for:

Business owners planning succession
Investors with large, appreciating assets
Families with taxable estates (over $13.99M single / $27.98M married) in 2025
Individuals seeking to “freeze” their estate value

Final Thoughts

An Intentionally Defective Grantor Trust is a sophisticated yet flexible estate planning vehicle that allows high-net-worth individuals to transfer wealth efficiently while minimizing taxes. When structured and administered correctly, an IDGT can provide significant long-term tax savings and help families preserve wealth for future generations.

Before implementing an IDGT, it's essential to consult with a qualified estate planning attorney to draft the document, along with obtaining tax and financial advice from CPAs, and financial advisors to clarify tax implications and your liquidity needs. The strategy must be tailored to your specific financial goals, family dynamics, and asset structure.

At Stonehearth Capital Management, we help clients integrate advanced strategies like IDGTs into their broader wealth plans. If you're considering legacy planning strategies, we’re here to guide you through the options and help you make smart, informed decisions.