I agree that the 10% funding threshold is a safe harbor. The transaction has to be commercially reasonable. Although I have seen IDGTs funded with less, with security agreements, etc., the safer approach is to fund the trust with 10% initial equity. The IDIT sale has to be characterized as an independent, arms-length financial transaction with proper valuations, etc.

What Is An Intentionally Defective Grantor Trust? A “Grantor Trust” is a trust that runs “afoul” of the rules contained in Sections 671 through 679 of the Internal Revenue Code (the “Grantor Trust Rules”). Traditionally, running afoul of Gra ntor Trust Rules was viewed negatively in that the Grantor (the Trustor or creator) of the trust was, for income tax purposes, the owner of the trust assets, and therefore personally responsible for all items of income (ordina ry income and ca pital gains) attribu table to the asse ts held in the trust. This personal responsibility existed whether the income and/or principal was d istributed to the Grantor or not. Even though the Grantor is treated as the owner of a Grantor Trust for income tax purposes, he or she is not necessarily treated as the owner for estate tax purposes. The estate tax inclusion rules are applied separately to make the latter determination. In some cases, a beneficiary can be treated as a Grantor (and therefore, the owner, for income tax purposes) of a Grantor Trust, thus allowing the beneficiary to utilize an y tax bene fits (or detriments) that would otherwise be attribu table to the Grantor Trust. An “Intentionally Defective Grantor Trust” (“IDGT”) is a term used for a trust that is purposely drafted to invoke the Grantor Trust Rules. How Do You Make A Trust An IDGT? An IDGT can be created in one or more of the following ways: 1. The Trustor or his or her spo use retains the power to recover the trust assets (e.g., the Trustor retains the right to reac quire pro perty out of the trust in exchange for prop erty of equal value); 2. The Trustor or his or her spouse can or does benefit from the trust income (e.g., the Trustor and/or a nonadverse Trustee can sprinkle income for the benefit of the Trustor’s spouse); 3. The Trustor or his or her spouse possesses a reversionary interest worth more than 5% of the value of the trust upon its creation; 4. The Trustor o r his or her spouse controls to whom and when trust income and principal is to be distributed, or possesses certain administrative powers that may benefit the Trustor or his or her spouse (e.g., a nonadverse Trustee may add beneficiaries of the trust income and/or principal); 5. The Beneficiary has a po wer to withdraw the tru st income or principal to himself or herse lf (e.g., a Crummey power); and/or Copyright ©Miller, Monson, Peshel, Polacek & Hoshaw, 2002 2 6. The Trustor and/or a nonadverse Trustee has the power to apply trust income to the payment of premiums for insurance on the life of the Trustor or the Trustor’s spouse. Why Would You Want An IDGT? An IDGT is an essential component for many estate planning techniques. For example, the most basic plan includes a revocable living trust (to avoid probate and allow for full use of the Applicable Exclusion Amount fo r estate tax), which is an IDGT. Irrevocable trusts, held for the benefit of the Trustor’s/Grantor’s beneficiaries, can be IDGTs also. Because the Trustor/Grantor pays the income taxes incurred by the IDGT, the assets held in the IDGT can grow unreduced by such income taxes. This, in turn, increases the value of the assets available for the trust beneficiaries. In essence, the payment of taxes by a Trustor/Grantor is a gift to the trust beneficiaries that is not subject to transfer tax. Payment by the Grantor of the income taxes will also work to reduce the assets held in the Grantor’s estate, another very basic strategy for reducing estate taxes. Certain insurance trusts, GRATs, GRUTs, charitable lead trusts, and QPRTs, all very valuable estate planning tools, are IDGTs as well. (These trusts are all discussed in other articles on th is website.) As mentioned above, the Trustor need not be the “Grantor” of an IDGT. Instead, if the beneficiaries have a right to withdraw assets from the trust, ev en if such right lasts for just a brief period (i.e., a Crummey power to withdraw), such beneficiaries will be the “Gra ntors” with respect to such assets held in the IDGT, for purposes of the Grantor Trust Rules. Setting up IDGTs where the beneficiaries are the “Grantors,” however, may cause creditor protection issues for the beneficiaries. The status of the law on this issue in California is not yet clear. Also, because the Grantor is treated as the owner of the assets in an IDGT for income tax purposes, th e sale of an asset by a Grantor to his IDGT will not trigger gain. Further, the interest paid by the IDGT and received by the Grantor will likewise not be subject to income tax treatment. If such an asset is sold on an installment basis (due to, for example, limited other assets in the IDGT), and the Grantor dies before all payments are made, all payments subsequent to the Grantor’s death will be subject to income tax treatment, because the Grantor will no longer be treated as the owner of the IDGT, for income tax purposes. (Such income tax consequences may be mitigated by any estate taxes that are paid on the above-described right to receive payments after de ath.)