The Complete 2025 Guide to Defective Grantor Trusts: Advanced Estate Freeze Strategy for High-Net-Worth Individuals
Updated for 2025. Defective grantor trusts (DGTs), often structured as intentionally defective grantor trusts (IDGTs), have become one of the most sophisticated—and IRS-accepted—estate freeze techniques for high-net-worth clients. This guide covers everything you need to know about IDGTs under the 2025 tax regime: the fundamentals, tax benefits, proper structure, IRS audit risks, practical how-tos, and a detailed high-net-worth case study.
Table of Contents
- What Is a Defective Grantor Trust and How Does It Work?
- Key Takeaways
- Mechanics of IDGT Transactions and Sales (2025)
- Main Tax Benefits of Defective Grantor Trusts
- Estate Freeze Strategy Explained (2025)
- Key Risks and How to Mitigate Them
- What Powers Create Grantor Trust Status (IRC §§671-679)?
- High-Net-Worth Client Case Study (2025)
- Next Steps
- Frequently Asked Questions
- Related Resources
Key Takeaways
- IDGTs allow you to move appreciating assets outside your taxable estate but still pay the income taxes yourself—boosting wealth transfer.
- With the $15,000,000 (per person) estate tax exemption in 2025, this may be a “final window” before the exemption drops in 2026.
- Compliance with IRC §§671-679 and avoiding IRC §2036 is crucial to IRS acceptance.
- Future appreciation escapes estate tax, while grantor-paid income tax acts as an indirect, unlimited estate-tax-free gift to heirs.
What Is a Defective Grantor Trust and How Does It Work?
An intentionally defective grantor trust is an irrevocable trust structured to be a grantor trust for income tax purposes but outside your estate for estate/gift tax. You pay the trust’s income tax, enabling all trust value growth to benefit heirs. The “defect” is intentional—involving retained powers—so the trust qualifies as grantor status under the IRS (IRC §§671-679).
In practical terms: You fund the IDGT, pay the taxes, and the assets grow outside your taxable estate. Well-structured IDGTs do not count against your $15,000,000 estate tax exemption (2025 rules), and the income taxes you pay further reduce your own estate without gift tax.
Mechanics of IDGT Transactions and Sales (2025)
The IDGT transfer commonly takes two main forms:
- Gift: You gift assets directly to the trust within your annual/lifetime exemption.
- Sale to IDGT with Promissory Note: You sell appreciating assets to the trust for a note (using the Applicable Federal Rate, AFR, e.g. ~3.5% in 2025). The trust pays back over 5-20 years. You retain the note (counted in your estate). The asset’s future appreciation passes outside your estate. IRS compliance requires a “seed gift,” independent appraisal, formal note paperwork, and adequate interest per AFR.
Proper structure (substitution power, no income enjoyment, independent appraiser) protects against step-transaction and valuation challenge by the IRS.
Main Tax Benefits of Defective Grantor Trusts
- Estate Tax Savings: If $5,000,000 of appreciating assets are sold to an IDGT and grow to $15,000,000, only $5M is in your estate (the note), $10M escapes estate tax.
- Income Tax “Gift”: You, not the trust or heirs, pay income tax, allowing the trust to grow uninhibited—effectively an unlimited tax-free gift.
| Scenario | Year 1 | Year 10 | Year 20 |
|---|---|---|---|
| Traditional Hold | $5,000,000 | $8,954,238 | $16,035,679 |
| IDGT Freeze | $5M Note in Estate | $5M Note | $5M Note |
| Trust Growth (outside estate) | – | $3,954,238 | $11,035,679 |
Estate Freeze Strategy Explained (2025)
A properly implemented IDGT “freezes” your estate at today’s asset values, shifting all future growth to heirs. It’s especially powerful for fast-growing businesses, pre-IPO equity, or undervalued investments. With 2025’s higher exemption (and possible sunset), the value is immense.
Key Risks and How to Mitigate Them
- IRC §2036 Estate Inclusion: Retain only a substitution power (not income or enjoyment); use an independent trustee to avoid IRS challenge.
- Valuation Missteps: Get a professional, arms-length, independent appraisal of illiquid assets with supporting documentation.
- Note Repayment on Death: Outstanding note is included in estate; mitigate with shorter amortization or life insurance.
What Powers Create Grantor Trust Status (IRC §§671-679)?
| Grantor Power | IRC Section | Typical IDGT Use? | Estate Tax Risk? |
|---|---|---|---|
| Substitution Power | §675(4) | Yes | Low if drafted carefully |
| Revocation Power | §676 | No (too risky) | High |
| Distribution Control | §674 | Rarely | High |
| Administrative Powers | §675 | Sometimes | Depends |
Case Study: $3.2 Million Estate Tax Savings via IDGT (2025)
“Sarah,” age 58, tech executive, $12M in investments + $4M company stock, married, net worth $24M. She structured an IDGT to move $5M in high-growth assets out of her estate. She received a $5M, 10-year note at 3.75% interest. In 15 years, trust assets are projected at almost $14M, saving over $3.2M in potential estate tax. All legal and compliance steps—including independent trustee, seed gift ($50,000), and independent appraisal—were completed.
Next Steps
- Assess total net worth; project likely appreciation.
- Identify which assets make ideal IDGT candidates.
- Consult with a specialized estate planning attorney (advanced entity structuring).
- Secure independent valuations for any non-marketable assets.
- Coordinate with your tax strategist for future income tax optimization and reporting.
Frequently Asked Questions
Can an IDGT cause assets to be included back in my estate?
Yes, improperly structured trusts (retained income/beneficial enjoyment or poor trustee selection) can fall afoul of IRC §2036. Use only substitution powers and an independent trustee for safety.
What if I die before the note is paid?
The outstanding balance is included in your taxable estate. Proper note planning or life insurance helps mitigate this.
Minimum transfer to justify IDGT costs?
Typically, $500,000-$1M is the practical minimum due to legal/appraisal costs, though anticipated appreciation may justify smaller amounts.
Can I be my own trustee?
Not advisable; safest to have an independent or co-trustee.
How does IDGT planning interact with GRATs?
IDGTs may be more suitable for illiquid or high-growth assets; GRATs are best for predictable, short-term appreciation.
Related Resources
- High-Net-Worth Tax Planning Strategies for Millionaires
- IRS Publication 950: Introduction to Estate and Gift Taxes
- Advanced Entity Structuring for Multi-Generational Wealth
- IRS Form 709: Gift and Generation-Skipping Transfer Tax Return
- Professional Tax Advisory Services for Wealth Preservation
Last updated: December, 2025
