A defective trust is an irrevocable trust built so the IRS taxes its income to the person who created it, while the assets inside it stay out of that person’s taxable estate. The word “defective” makes it sound like something broke. Nothing did. The defect is deliberate, written into the trust on purpose, and the mismatch between how the trust is treated for income tax and how it is treated for estate tax is the entire reason estate planners use it. The full name most practitioners use is Intentionally Defective Grantor Trust, or IDGT.
Why “Defective” Is a Feature, Not a Flaw
In trust law, “defective” refers to a specific flaw for income tax purposes only. The IRS looks at the trust, sees that the grantor kept certain powers, and decides the trust is not a separate taxpayer. All the income, deductions, and credits flow through to the grantor’s personal Form 1040 as if the trust did not exist.1Office of the Law Revision Counsel. 26 U.S. Code 671 – Trust Income, Deductions, and Credits Attributable to Grantors and Others as Substantial Owners
The IRS calls any trust with this feature a “grantor trust.”2Internal Revenue Service. Abusive Trust Tax Evasion Schemes – Questions and Answers A revocable living trust is a grantor trust automatically. The planning value, though, comes from irrevocable trusts that are engineered to trigger grantor trust status while still succeeding at removing assets from the grantor’s estate. Those are the intentionally defective ones.
The Powers That Make a Trust Defective
The Internal Revenue Code lists several retained powers that will cause a trust to be treated as a grantor trust. The drafter chooses one carefully, because the goal is to trigger grantor trust status for income tax purposes without also causing the trust assets to be pulled back into the estate for estate tax purposes. Those two questions are governed by different sections of the Code and do not move together.
The workhorse is the substitution power under IRC Section 675: the grantor keeps the right to swap assets in and out of the trust for other property of equivalent value, held in a nonfiduciary capacity. Other triggers include the power to borrow from the trust without adequate interest or security.3Office of the Law Revision Counsel. 26 U.S. Code 675 – Administrative Powers Sections 673, 674, 676, and 677 list additional powers, from retained reversionary interests to the ability to revoke to income used for the grantor’s benefit, but most of those either pull the trust into the estate or defeat the estate planning purpose in some other way. The substitution power avoids both problems, which is why it is the standard choice.
How the Tax Treatment Actually Works
Because the IRS treats the trust as invisible for income tax purposes, the grantor reports all trust income on their personal return using their own Social Security number. The trust itself files no separate income tax return, or files an informational return only.2Internal Revenue Service. Abusive Trust Tax Evasion Schemes – Questions and Answers
That produces two benefits. The first is bracket relief. Trusts that file their own returns hit the top federal income tax rate at very low income levels, far lower than an individual would. Taxing the income to the grantor at individual rates avoids that compression.
The second benefit is the strategic one, and it is where the real wealth transfer happens. When the grantor pays the income tax on trust earnings from personal funds, the trust keeps every dollar it earns. Those tax payments are not treated as additional gifts to the trust, yet they have the same practical effect: the grantor’s estate shrinks by the tax paid, and the trust’s assets compound untouched.1Office of the Law Revision Counsel. 26 U.S. Code 671 – Trust Income, Deductions, and Credits Attributable to Grantors and Others as Substantial Owners Over years, on a trust holding income-producing assets, that can move a large amount of wealth to beneficiaries without triggering any additional gift or estate tax.
Selling Assets to a Defective Trust
A common IDGT strategy goes further than gifting. The grantor sells appreciated assets to the trust in exchange for a promissory note. Under Revenue Ruling 85-13, a transaction between a grantor and their own grantor trust is not recognized as a sale for federal income tax purposes. The grantor is treated as both buyer and seller, so no capital gains tax is triggered on the transfer, no matter how much the assets have appreciated.
The note must charge interest at least equal to the Applicable Federal Rate the IRS publishes each month.4Internal Revenue Service. Revenue Ruling 2026-2 – Applicable Federal Rates That rate is typically below commercial lending rates. If the assets inside the trust grow faster than the AFR the note charges, the excess growth belongs to the trust beneficiaries and passes free of transfer tax.
What the Grantor’s Death Changes
The grantor’s death ends the defective status. The trust becomes a separate taxpayer going forward, obtains its own Employer Identification Number, and files its own income tax returns. Any outstanding promissory note from an installment sale is handled according to the trust’s terms.
The most important consequence involves cost basis. Property included in a decedent’s estate normally receives a stepped-up basis to fair market value at the date of death, which can wipe out decades of built-in capital gain.5Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent IDGT assets do not get that step-up. In Revenue Ruling 2023-2, the IRS confirmed that because IDGT assets are not included in the grantor’s gross estate, they are not considered property acquired from a decedent and do not qualify for a basis adjustment.6Internal Revenue Service. Revenue Ruling 2023-2
That is a real trade-off. Beneficiaries inherit the grantor’s original basis, so a later sale of appreciated assets can bring a substantial capital gains bill. Whether the IDGT still comes out ahead depends on whether the estate tax that was avoided would have been larger than the capital gains tax the beneficiaries eventually pay.
Risks and Limitations
The income tax obligation does not turn off just because it becomes inconvenient. As long as the trust remains defective, the grantor covers the tax bill on the trust’s earnings out of personal funds every year. For a trust holding significant income-producing assets, that can be a large recurring cost, and it does not adjust to changes in the grantor’s cash flow.
Estate tax inclusion is the drafting risk. Section 675’s substitution power is generally safe, but if the grantor keeps other powers that look like retained enjoyment of the property, the IRS can argue the assets belong back in the estate under IRC Section 2036. That would erase the estate tax benefit entirely. The line between a power that triggers grantor trust status and one that triggers estate inclusion is not intuitive, and precise drafting is what keeps a trust on the right side of it.
The trust is irrevocable. Assets that go in cannot come back out because the grantor changed their mind. The substitution power allows swapping for property of equal value, not withdrawing wealth.
Some IDGTs include a mechanism to turn off grantor trust status later by releasing the triggering power. The IRS has scrutinized these toggling arrangements, and a poorly structured toggle can invite challenge.
Defective Is Not the Same as Invalid
A defective trust is legally valid, properly executed, and fully enforceable. It holds assets, has beneficiaries, and operates as intended. The only defect is a deliberate design choice that affects how the IRS taxes its income.
An invalid trust does not function as a trust at all. It may fail because the person who created it lacked capacity, because it was never funded, or because it was created for an illegal purpose. An invalid trust cannot hold property or distribute assets. A defective trust does all of those things without difficulty; it simply happens to be invisible to the IRS for income tax purposes, which is precisely what the grantor wanted.