On this episode of Your Life Simplified, Valerie Escobar, senior wealth advisor, and Jake Kern, managing director and senior wealth advisor, discuss the powerful strategy of Intentionally Defective Grantor Trusts (IDGTs) and how they can benefit you. An IDGT is a trust that is intentionally drafted to be “defective” for income tax purposes. This allows the grantor of the trust to transfer assets to the trust without triggering gift or estate taxes. The grantor also pays the income tax on the trust’s income, thus reducing the value of the grantor’s estate. One of the key benefits of an IDGT is that it can help you transfer assets to future generations with minimal tax liability. Since the grantor pays the income tax on the trust’s income, the assets in the trust can grow tax-free, increasing the value of the trust’s assets over time.

Transcript

Valerie Escobar: Intentionally defective grantor trusts. Kind of sounds like a dumb joke for some lawyer, but these are real things. And today we’re going to discuss why we would want to intentionally make a trust defective, but more importantly, how these can help high-net-worth families save significant amounts of tax dollars.

I’m Valerie Escobar, senior wealth advisor with Mariner. This is Jacob Kern, fellow senior wealth advisor here at the headquarters location, and you’re listening to Your Life Simplified. Be sure to follow and subscribe wherever you are tuning in. Jake, thanks so much for joining us today.

Jake Kern: Excited to be here.

Valerie: So Jake, we are going to talk about intentionally defective grantor trusts, otherwise known as IDGTs or idiot trusts. I don’t know if you’ve ever… I’ve heard it called that as another hilarious joke. And these are a bit complex. As we were talking before, the word “defective” is a little provocative, but that is an important part, and we’ll discuss that in a bit.

But first, let’s touch on this using an example. So let’s say I walk in your office and I tell you, “I am a business owner. I’ve had this thing for 40 years and I’m tired. I want to retire in a few years. My family has been instrumental in helping me run my business. They’ve worked in the business factory with me. And I’ve heard that I can structure it so that my kids really benefit from the proceeds of the sale and not so much Uncle Sam. So I got lots of questions. My first one is, just what on earth is a trust?”

Jake: So at the end of the day, a trust is a vehicle that allows our clients or yourself to be able to really do a lot of different things with your money. And so before we kind of start into what a trust does, let’s talk about the components of a trust. And really there are three components to every trust. There’s the grantor, there’s the trustee, and there’s the beneficiary. So let’s go through each one of those.

So the grantor is essentially the person who funds the trust. So the person who’s putting the assets inside of the trust, or the cash or a property or anything that’s going into the trust. Two is the trustee. The trustee, I think we all have heard of trustees before. It’s someone sitting in a big wood office that you have to go ask for your money and everything else. But that’s not really what a trustee is. A trustee, at the end of the day, is the person who’s administering the trust and being able to do everything from investment selection to distributions to really following the letters of the law of what’s going on with the trust. And then there’s the beneficiary. And the beneficiary is the person who’s going to have a beneficial interest to that trust.

And so as we talk through all these things, it’s really important to understand those three components. Those three components really lie in what we’re going to be talking about moving forward.

Valerie: Perfect. And so, I’m still alive. I’m doing well. And so right now, while I’m trying to make a trust, who am I in that?

Jake: So let’s just walk through this process. So a lot of people have living trust or what we like to refer to as revocable trust. So let’s go back to that. A revocable trust, you are the grantor, you’re the trustee, and you’re the beneficiary. You’re all three components of that. So at the end of the day, if you write the trust on a Wednesday and you want to change it on a Thursday, that’s fine. Because again, you’re the grantor, you’re the trustee, and you’re the beneficiary.

But when we start getting into talking about intentionally defective grantor trust, there are some different components there. And so to give you an example, when you make something irrevocable, you can be the grantor, but you’re not going to be the trustee, and you’re not going to be the beneficiary. And so that’s where things get a little bit different.

Valerie: Okay. And so, with this specific kind of trust, the IDGT trust, or IDGT, this is, we’re talking about irrevocable.

Jake: Yep. It is irrevocable.

Valerie: No more changing.

Jake: No more changing. Once it’s set in place, it’s set in place, and the trustee and the beneficiaries are there to benefit and to operate the trust that’s written.

Valerie: Okay, perfect. And so I have a will that tells me, okay, I want Johnny and Kate to get 50/50 and then their kids to get the rest. What is it that a trust would do that’s different?

Jake: Yeah. So when we think about a will, a will, at the end of the day, is really telling the probate court where you want your money to go. So you pass away and you say, “Hey, I want my money to go my kids.” You go in front of the probate judge, the probate judge looks at the will, says, “Yep, that looks great.” And you end up transferring the assets that way. It’s really an inefficient process. And in fact, a will is a really inefficient document, at the end of the day.

The other thing for a lot of people is, a will, everything’s public. So when you think about, again, and this is a little different, we’re talking a little bit about revocable trust, and we’ll kind of get into the IDGT here in a second. But with any trust, it’s a very effective and efficient way to transfer assets. So when you think about it, what the trust is really doing is saying, hey, I have passed away. You’re no more, the grantor is gone. The trustee is now the trustee that you’ve appointed, and the beneficiaries are the beneficiaries that you appointed. Because again, while you were alive on your revocable trust, you were all three. Now you have passed away, and the trust allows you now to move those assets without going to probate court. And the big one for a lot of our clients is everything is private. So there’s no court filings, there’s no court orders or anything like that.

Valerie: Okay, perfect. And so while I’m alive, it’s revocable, that this kind of trust that we’re talking about, and then when I die, it becomes irrevocable, we can’t change it. But with an IDGT, this component, it’s irrevocable from the beginning.

Jake: Yes. So, let’s just get to that point. I’m here to advocate that at the end of the day, I think everyone, no matter if you’re worth $10,000 or $10 billion, you should have a revocable trust. And I think it’s important to get that across to everyone.

But now we’re going to kind of take another step up. And when we start talking about IDGTs, around it, it is really from a tax planning standpoint and also from a wealth transfer standpoint. So there’s two taxing systems that we’re really concerned about in the U.S. One is income tax. But then there’s another taxing system for people who have accumulated quite a bit of wealth, and that is the transfer tax or the estate tax, or what some people like to call the death tax around that.

And so, when you think about it, right now in the U.S, every person has a $12.9 million estate tax exemption. So the government has given you a coupon. So, as long as you’re worth less than $12.9 million, this secondary taxing system is not in place. But to give you a little history on this, back in the late ’90s, the exemption was sub a million dollars. So it affected a lot of people. And over the years, and really since about 2008 moving forward, we’ve seen this exemption move up, move up and move up. So if you think about it right now, when we’re talking about estate tax, right now, if you were a married couple, you roughly have $26 million of exemption before you pay any estate tax.

But, this is very important, and this is where a lot of people get tripped up and don’t think about planning. In 2026, the exemption essentially gets cut in half. It won’t be quite cut in half, but right now you have $12.9 million. It’ll probably be somewhere between $6 and $7 million in 2026. And so, this is really important for people to be looking at, especially small-business owners that may have a business that’s on a trajectory that could be worth significantly more money than it is today.

Valerie: Okay. And so for us, so I’m married, and so if we possibly, let’s say it’s $20 million, that’s what I’ve been hearing. If I sell for $20 million and then we die without having done any planning and the exemption has gone down, so what’s our situation? What happens there?

Jake: Any amount of money that your estate is worth that is over that exemption is taxed at 40%. So let’s just use easy numbers. At the end of the day, you end up passing away, and the total exemption that you haven’t used is $20 million. And your estate is worth $22 million. That $2 million will be taxed at 40%. So you’re essentially writing a check for almost $800,000 to the government just because you were over that exemption. And the thing that’s really neat, and IDGTs is a tool that we use, is you can plan around the estate tax as long as you have time, you understand what you’re giving up to be able to try to keep your estate below that exemption.

Valerie: Okay, perfect. And so I heard you say, if I haven’t used any of my exemption. So how do I use my exemption?

Jake: Well, that really plays into what we’re talking about today. So let’s just go through an example. You have a business owner, and the business owner is at the end of their working career and they, let’s say, have the kids working in the business. Okay? Let’s just lay some facts out here. The business is worth $12 million, and the first generation, refer to the parents as generation one and the kids as generation two, they’ve used none of their lifetime exemption.

So during their life, they can go ahead and use some of that exemption. So again, the business is worth $12 million. They turn around and they say, “We’re going to give half the business to an IDGT.” And so, they’re going to use $6 million of their exemption. And so, that ends up coming out of their estate, going into the IDGT, and now their exemption under today’s rules, instead of having $26 million, they now have $20 million.

Okay, so why did we do that? Well, let’s say that that business is growing very fast, and they got maybe a big new client and that business is going to be potentially worth $30 million in 20 years. What they’ve done is all that growth is now sitting in the IDGT. So you put $6 million of value over there. When that in, let’s say that the generation one lives for another 20 years, when they pass away, let’s say that that $6 million is now worth $20 million. That $14 million of growth is outside of their estate and will not be subject to estate tax. People ask, “Why is that? Why is an irrevocable trust not subject to estate tax?” Well, people pay estate tax, entities don’t. And a trust is an entity. Everyone kind of goes, “Well, how is this possible?”

Valerie: Is this legal?

Jake: Is this legal? Is this a trick? Well, really the fundamental core of it is people pay estate tax, entities don’t, and an irrevocable trust is an entity.

Valerie: And so let’s say today we’re looking at $26 million as the exemption. And so I know I’ve done my financial plan with my planner, and I know that I only need, let’s say, $5 million, but now my business is selling for $30 million, and I want to use it all, right? I want to use all of my $26 million, get rid of it all. Plus the truth is, even going forward, I just don’t spend a lot of money, and I’d rather give it to the next generation. I mean, am I just cut off, I’m limited to that $26 million that I put in the IDGT?

Jake: So just to clarify two points, $26 million is for a married couple.

Valerie: Right, okay.

Jake: So 12.9 and 12.9. But let’s just make the assumption that’s a married couple and ownership is split 50/50. So, then you end up using all your exemption, and you end up putting it into the IDGT and you have $5 million to live on, and the $26 million that you put over there ends up growing, and hopefully at the end of the day, you have reduced your estate tax burden pretty well.

The problem is, again, is that you’ve used all your exemption. So remember, you’ve used that $26 million. So that $5 million that you still have in your estate, that will be subject to estate tax around it. But again, you hope that you’re spending down that $5 million and the $26 million is growing around that.

I think the other thing that’s really important that we hit on here is that the IDGT, that $26 million that you put into the IDGT, the income tax can go back to the grantor. So you’re the grantor, and that IDGT creates a $5 million income tax liability. You as the grantor can pay that. That is a huge benefit because at the end of the day, it’s kind of another free exemption. It’s another free way to get money out of your estate. And again, that’s kind of the cool thing why people use IDGTs at the end of the day is because they can get money out of their estate and then the estate can pay the taxes for the IDGT.

So, kind of roundabout way of answering your question, Is that all you can do? No, you can do the $26 million, then you get the IDGT character, the defective characterization inside of there to pay the taxes. And then the other thing is you still have your yearly exemption that you can get. Right now, that’s $17,000 per person. So I could give you $17,000. I could give everyone here at Mariner $17,000. And that does not go against your lifetime exemption.

Valerie: It makes you very popular, though.

Jake: It does make me popular. Exactly.

Valerie: And so obviously, this is not a problem that a lot of people have, but certainly it does exist. And so we’ve helped several clients with this. And there is a balancing act because you’ve got to figure out, well, how much do I need, but how do I spend that down so that I don’t end up with a whole lot? And so have you ever experienced where a client, they’ve kind of spent down what they need and they’re like, “You know what? I don’t want to pay the taxes for that estate, for the money that I put into the IDGT. I don’t want to pay those taxes over there. Now what?”

Jake: You can actually turn it off. So that’s one of the cool things that happens is, and we see this happen a lot, is that you end up putting money over into an IDGT and the grantor pays the taxes. And over time, that tax bill, that tax burden on that IDGT, again, from the income-taxing side of things, becomes burdensome. And so you can turn that switch off. We kind of call it turning the light switch off because at the end of the day, you got to balance it out.

And I think that one of the points you just made, though, is also really important because a lot of times people know that they have this issue, and they get really concerned about the idea of giving money away. Will I have enough? What does this mean? And so what happens is that people end up kind of getting paralyzed and saying, “I know I’ve got this problem down the road, but all these other steps between where I am now and where I know I’m going to be, I just don’t understand them all.”

That’s really where a good planner comes in, because to execute these strategies appropriately, it takes a lot of modeling. It takes a lot of understanding because you have to sit there and really kind of say, “How much do I want to leave in my estate? How much am I going to spend in my estate? And what does that look like? What’s my growth rate in my estate? And then how much am I willing to move over to let grow outside of my estate and let that balancing act work?”

And I think the reason people don’t do this, I think that everyone goes to their estate planning attorney, and again, and all these things, we are using estate planning attorneys and really walking hand in hand with them to get these strategies done. But at the end of the day, people will present these ideas and then everyone will say, “Wow, that’s a great idea, but man, I don’t feel comfortable about it.” And where our job is, and what’s a lot of fun for us is we come in and say, “Here’s the idea, but here’s actual numbers, here’s scenarios that we think we could play out. The business might continue to grow at a 30% CAGR, and holy cow, we’ve got to move more money. Or what if the business goes out of business? How does that affect you and how does that change that?”

Valerie: Yeah, so there’s lots of stress testing, but I think one of the perhaps comforts is that we do have a lot of levers that we can be pulling along the way, and we can adjust. Obviously, it’s irrevocable, so what we’ve given away, we can’t pull back. But I think that’s why we keep meeting and making adjustments.

Jake: Yeah, I think that’s a great point, Valerie, is that, again, I think why people don’t move forward with these strategies also is the term “irrevocability.” You can’t change it, and we can’t predict the future. And what I always think about is you can design a plan that allows you to have escape hatches when things change. And what I always talk about with people is don’t get caught up in the idea of the structure of the trust. Really turn around and write in the trust the trust language that you want to see happen for your family. And so lean into the structure, but then customize and curate the verbiage within the trust that really applies to you and your family.

Valerie: Yeah, no, I’ve always enjoyed helping clients craft what is the legacy you want? What is it that you want your family, your successor, your heirs to help carry forward about you? You can say within your trust, I really want this for education and health and not for a bunch of Lamborghinis, things like that. So, it does kind of put some control in there to some extent, and I think just allows for some flexibility, too.

Jake: Yeah, it does. And one of the things that just kind of popped into my head, too, that I think people should understand is when we talk about irrevocable trust, everyone says, “Oh, that’s for the ultra-wealthy and that’s for all these people. And that’s not me.” I’m originally from Idaho, very agricultural state, and the town I grew up in was very agricultural. And when people think about their net worth, it’s not just the cash that you have, it’s the assets that you have. And you think about family farms and things of that nature and making sure that those farms are being passed appropriately to the next generation or how you want to do it without incurring a huge tax bill. And that’s the worst part about all of this is that if your assets are illiquid and you have an untimely death, and you don’t have things structured, especially with the prices that we’ve seen with land and everything after COVID, is you may have a tax bill that you were not prepared for, and you have to sell that asset at an untimely time to pay the government.

That’s the worst-case scenario we talk about. It’s not just trying to save people money and have the most efficient estate tax system set up. It’s really saying, if we don’t do this correctly, it could really change your trajectory of your legacy.

Valerie: Yeah, yeah, for sure. Well, Jake, thank you so much for joining us.

Jake: Thank you.

Valerie: Thank you, everybody who listened and tuned in today. Again, be sure to subscribe and follow us. You’ve been listening to Your Life Simplified. I’m Valerie Escobar, and we hope to see you next time.

Mariner Wealth Advisors, or MWA, is an SEC registered investment advisor with its principal place of business in the State of Kansas. Registration of an investment advisor does not imply a certain level of skill or training. MWA is in compliance with the current notice filing requirements imposed upon registered investment advisors by those states in which MWA maintains clients. MWA may only transact business in those states in which it is notice filed or qualifies for an exemption or exclusion from notice filing requirements. Any subsequent, direct communication by MWA with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For additional information about MWA, including fees and services, please contact MWA or refer to the Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov. Please read the disclosure statement carefully before you invest or send money.

The views expressed in this podcast is for educational purposes only and do not take into account any individual personal, financial, legal or tax considerations. As such, the information contained herein is not intended to be personal, legal, investment or tax advice. Nothing herein should be relied upon as such, and there is no guarantee that any claims made will come to pass. The opinions are based on information and sources of information deemed to be reliable, but Mariner Wealth Advisors does not warrant the accuracy of the information.

For 2023, the federal estate tax threshold is $12.92 million for individuals. However, for estates of married couples, this figure doubles to $25.84 million. The amounts referenced in the video were rounded for simplicity.

Federal estate taxes max out at 40% for taxable amounts greater than $1 million. If you die as a resident of certain parts of the country, your estate may also be subject to a state tax.

No illustrations are tailored to any specific person; they are hypothetical. The illustrations also do not capture all possible outcomes but are based on a limited set of assumptions. The use of trusts involves complex laws, tax rules, and regulations. Interested parties are strongly encouraged to seek advice from qualified tax, legal, and financial professionals before making any financial-related decisions.

CERTIFIED FINANCIAL PLANNER™, CFP® and federally registered CFP (with flame design) marks (collectively, the “CFP® marks”) are professional certification marks granted in the United States by Certified Financial Planner Board of Standards, Inc. (“CFP Board”). The CFP® certification is a voluntary certification; no federal or state law or regulation requires financial planners to hold the CFP® certification.