Small and medium sized business owners who have grown their business into a successful company begin to run into tax issues. A significant tax issue is many in this situation deals with is the value of the business will someday be subject to estate taxes. To further compound the problem as the business continues to grow and be successful the estate tax price tag grows as well.
In recent years many small business owners have managed this issue with an Intentionally Defective Grantor Trust (IDGT). The structure of the IDGT means the business still pays the owner the income but removes the value of the business from the owner’s estate for estate tax purposes. Hence the IDGT gets its name because the trust is “effective” for estate taxes but “defective” for income tax purposes.
Intentionally Defective Grantor Trust (IDGT) specifically excludes the value and growth of the trust, and therefore the value of the business, from the grantor’s estate. The fact the IDGT is defective for income means the business owner can pay the trust’s tax bill without using any of their estate and gift tax exclusion.
For the IDGT to work, the business owner sells the business to the IDGT in exchange for an interest-only note. This does not trigger capital gains tax; the business owner is basically selling themselves the business. The net effect is the business owner has essentially traded the growth of business for a low-yield bond (hint: interest rates are low right now).
In the long run this can possibly save thousands if not millions in estate taxes to the extent the business, which is now part of the Intentionally Defective Grantor Trust, continues to grow in value by leaps and bounds above the interest paid on the note.