Installment Sale to an Intentionally Defective Grantor Trust (IDGT)

How it works, in plain English

An intentionally defective grantor trust is an irrevocable trust drafted so that you are treated as its owner for income tax under the grantor trust rules (Sections 671 to 679), while its assets are not in your estate for estate tax. The "defect" is deliberate.

1. You make a gift to the trust so it has its own equity, using part of your lifetime exclusion ($15,000,000 per person in 2026).
2. You sell assets to the trust, often discounted business or partnership interests, for a promissory note at no less than the applicable federal rate.
3. The trust pays the note from the assets' cash flow. Growth above the note rate stays in the trust for your heirs.

Because you and the trust are one taxpayer, the IRS does not treat the sale as a sale. Rev. Rul. 85-13, summarized in Rev. Rul. 2007-13, holds that the grantor is the owner of the trust assets and the exchange of a note for them is not recognized as a sale. There is no gain, and the note interest is neither income to you nor deductible by the trust.

What it does not do: defer tax on a real sale

An IDGT is an estate tool, not an income tax deferral. If the trust later sells the business to an outside buyer for cash, the whole gain is reported on your return, because you are still the owner for income tax. If the trust sells on an installment note, Section 453 applies to you as the owner. Paying that tax yourself is part of the design: under Rev. Rul. 2004-64, your payment of tax on trust income is not a gift to the trust, so every dollar of tax you pay shrinks your estate while the trust keeps growing.

Timing matters. Transferring an interest after a sale is effectively agreed can be attacked as an assignment of income; the sale to the trust should come well before a deal is in hand.

Who it fits, and who it does not

• Fits: owners whose estates exceed the exclusion, holding assets likely to grow faster than the federal rate, who can afford to keep paying the trust's income tax.
• Fits: families planning a sale years out who want future growth outside the estate.
• Does not fit: estates under the exclusion, where the lost step-up usually costs more than the estate tax saved.
• Does not fit: a seller looking to cut tax on a sale already under contract.

Worked example (engine-computed note terms)

Assumptions: you sell interests worth $4,000,000 to your IDGT for a 9-year interest-only note with a balloon. Assume a mid-term applicable federal rate of 4.00% (the IRS rate is published monthly and is quoted with semiannual compounding).

At 4.04% annual the trust pays $5,454,400 over nine years including the $4,000,000 balloon. None of it is income to you. If the assets grow faster than the note rate, the excess stays in the trust, outside your estate. If they grow slower, the trust can end up owing more than it owns, and value flows back to you.

IRS stance and audit risk

Sales to grantor trusts are widely used and are not listed transactions or transactions of interest. The IRS attacks on several fronts:

• Valuation. If the assets are undervalued, the excess is a gift. Use a qualified appraisal and consider a formula clause with counsel.
• Section 2036. If the note is not real debt, for example payments tied to the assets' income, a trust with little equity of its own, or missed payments, the IRS argues you kept an income interest and the assets are back in your estate.
• No step-up. Rev. Rul. 2023-2 holds that assets of an irrevocable grantor trust not included in the grantor's estate get no basis adjustment under Section 1014 at the grantor's death.
• Death with the note unpaid. The income tax result when grantor trust status ends with a note outstanding is not settled by published guidance; plan for it with counsel.

Costs and fees

Expect estate-planning attorney fees for the trust and sale documents, qualified appraisals of the interests sold, a gift tax return for the seed gift, and ongoing trust administration. The largest ongoing cost is the income tax you pay on trust income, which is intended. The largest hidden cost is the lost step-up on appreciated assets the trust holds at your death.

How it compares with a Section 453 installment sale

A third-party Section 453 installment sale spreads income tax on a real sale; it does nothing for estate tax beyond the cash you spend. An IDGT sale moves future growth out of the estate but defers no income tax, because the sale to your own trust is ignored and any later outside sale is taxed to you. Families often use both: the IDGT years before an exit, and a seller-financed or cash sale at the exit. Related tools: self-cancelling installment note, gifting shares before a sale, family limited partnership.

Hans studies the tax side of exits. The $5,000 Big Sale Tax Analysis models the income tax of the eventual sale under each path; estate counsel designs and drafts the trust.

Frequently asked questions