Perhaps two of the most unfortunate vocabulary choices in the estate planning field lie with the “Crummey Trust” and the “Intentionally Defective Grantor Trust,” or IDGT. There’s nothing crummy about a Crummey trust. These trusts, which got their name from Clifford Crummey, a Methodist minister who won a fight with the Internal Revenue Service in the 1960s, are typically used to protect life insurance from federal estate taxes, though they often contain a variety of other assets as well. If annual exclusion gifts of premiums on insurance owned by an irrevocable trust meet the simple Crummey test requirements, then the insurance in the trust does not become part of the grantor’s estate.
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And while the use of the term defective may also cause clients to cringe, there is nothing to fear about the IDGT’s legality or effectiveness. Let’s analyze the acronym:
Grantor Trust. Classifying a trust as a “Grantor Trust” under the tax code is important for federal income tax purposes. The grantor’s retention of one of the powers listed under the grantor trust provisions of the tax code will qualify the trust as a grantor trust, and as a result, the grantor will pay all income taxes tied to the trust assets.
Intentionally Defective. So what is defective? Essentially nothing – the term defective just relates to the grantor’s retention of a power that makes the trust fail to be a completed gift and remain a Grantor trust for income tax purposes. The trust at its core is an irrevocable trust. An irrevocable trust is a separate taxable entity. By retaining one of the listed powers under the tax code, you make it a Grantor trust. Done! There’s the defect. Your trust just defected from the irrevocable trust world, partially, in order to pay income taxes. However, it only partially defected because it is still an irrevocable trust that moves assets out of your estate like all good irrevocable trusts do.
So what does grantor tax status achieve in the grand scheme of things? This schism creates two planning opportunities. First, you cannot sell something to yourself for tax purposes. That is, a sale transaction where you are both the seller and the buyer is not considered a “transfer” for income tax purposes. That means you can create and fund an intentionally defective irrevocable grantor trust, which is outside your estate for estate tax purposes, and then sell an asset to that trust without incurring any capital gains tax on the sale. The second key benefit is that, when the grantor pays income tax on the trust’s income, he is effectively making a tax-free gift to the beneficiaries equal to the amount of the income tax the trust would otherwise have to pay out of funds the grantor has already removed from his estate. So the benefits of the sale to an IDGT include an “estate tax freeze” of the appreciating asset; no income tax consequence to the sale; additional gifting opportunity without using lifetime estate tax exemption and creditor protection for the asset inside the trust. That doesn’t sound so defective now, does it?
