An intentionally defective grantor trust is an extremely effective tool that accomplishes multiple objectives. First, it helps to minimize gift or transfer tax liability that a person may have to pay if the asset passed through normal probate process or it were gifted to the intended recipient. Second, it helps to step up the cost basis, which can be extremely valuable if the asset grew in value and then stabilized. It is often an effective tool for a small business owner who seeks to pass his/her business on to children or grandchildren. It is even more fitting if the same small business grew in size but then stabilized in value.
But, the question has to be asked. What’s with the reference “defective” in its name? It certainly is not a name conducive to marketing its rather impressive abilities. The term does not refer to something being broken (or busted). The term defective has a simple explanation, it is defective as to income tax liability. To state it in the inverse may help to explain it better; the trust is effective for estate tax purposes. In other words, the trust does not eliminate all taxes in that the grantor still pays the income taxes generated by the asset that is the corpus of the trust, but it does eliminate estate tax liability. Furthermore, it is a “grantor trust”, as defined at 26 U.S.C. § 675, meaning that it satisfies the legal definition of a grantor trust.
WHAT ABOUT GIFT TAX LIABILITY?