What Is a Defective Irrevocable Trust?
If your lawyer proposes a defective irrevocable trust for your asset planning goals, he's not suggesting he'll commit malpractice. An intentionally defective irrevocable trust is a way to exploit a sort of loophole in the tax code that gives you the benefits of both grantor-type and complex trusts.
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Irrevocable Trusts
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An irrevocable trust is one which, under the laws of the state in which it is created, cannot be revoked or altered by the person who created the trust, called the grantor. Under state law, and for most legal purposes, the trust is a separate and distinct entity from the grantor. But for federal tax purposes, the Internal Revenue Service (IRS) looks beyond the revocability or irrevocability of the trust to the powers retained by the grantor. Only if the grantor forgoes virtually any use or control of the trust and its assets will the IRS treat the trust as a separate taxable entity.
Grantor Trust
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Grantor trust is one that, under IRS rules, is treated as a disregarded entity for income tax purposes. This means the income of the trust is taxable to the grantor. Sections 671 to 679 of the Internal Revenue Code (26 U.S.C. §§ 671--79) describe the rules for grantor trusts. Generally, grantor trusts are those in which the grantor retains a reversionary interest, beneficial use or some other form of control over the trust or its assets. A defective irrevocable trust is termed "defective" because it intentionally fails to satisfy IRS rules that would prevent taxation as a grantor trust.
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Sales to Grantor Trust
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The benefit of a grantor trust is that a sale of assets from the grantor to the grantor trust does not trigger an income tax liability in the grantor, even if the sales price reflects significant legitimate appreciation in value. A defective irrevocable trust intentionally seeks to be taxed as a grantor trust to take advantage of this benefit. If the grantor first makes a gift to the trust at the time of its creation, this seed money can be used to secure a promissory note for the purchase price of additional assets from the grantor.
Estate Tax
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The second aspect of a defective irrevocable trust is that it removes property that is properly transferred to the trust from the grantor's gross estate, which makes it exempt from the estate tax. Sections 2031 to 2046 of the Internal Revenue Code (26 U.S.C. §§ 2036--38) describe the types of transfers that are nonetheless included in a decedent's gross estate after death. If a transfer to the trust is outside of those described in the statutes, it is completed for estate tax purposes. Thus, a defective grantor trust allows the grantor to reduce estate taxes while leveraging the value of the assets in the trust for your beneficiaries.
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