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A defective trust is one that is set up specifically to both allow tax breaks and increase the wealth of the descendants of the person granting the trust. The most common type of this trust is an intentionally defective grantor trust, or IDGT, which basically leaves assets in the trust that are kept free from taxes. In addition, the person endowing the defective trust, also known as the grantor, pays the income taxes on the assets, further reducing the tax burden for descendants. These trusts must be carefully constructed to withstand tax scrutiny and can be damaging if the assets left behind depreciate in value.
Trusts are financial entities that are set up by a person, also known as the grantor, to leave wealth behind to descendants, also known as trustees. The benefit of these trusts is that they can generally help descendants avoid costly estate taxes that are incurred when the grantor dies. Although the trustees generally lack control of the assets within the trust and must abide by the stipulations of the grantor, it is still often a beneficial financial arrangement. One particular trust, a defective trust, is particularly effective in shielding trustees from excess financial burden.
To set up a defective trust, a grantor must first loan the trust some of his funds. In return for this loan, the IDGT must yield periodic interest payments to the grantor at a rate determined by tax officials. The trust then uses the funds gained from the loan to buy an asset or multiple assets from the grantor's estate. These assets often include real estate or investment securities, which can appreciate in value over time.
By doing this, the defective trust removes value from the estate, thereby lessening the estate tax burden when the grantor dies. In addition, the grantor continues paying income tax for any gains accumulated by the assets, further lessening the value of the estate. The inheritors of the trust then are allowed access to these assets or the funds generated from them as stipulated by the trust.
One of the problems with a defective trust is that its efforts to avoid taxes can put it on the radar of tax officials. Should the trust not hold up to tax laws, the trust may ending up costing heirs more than they might expect. In addition, should the assets depreciate in value, the grantor could take twice the hit. He or she would still be liable to pay income taxes, and the trust would still have to pay back the loan.