Installment Sales to Intentionally Defective Grantor Trusts

With the federal estate tax exemption scheduled to drop significantly after 2025 (from $13.61 million to approximately $6-7 million), high-net-worth individuals face a critical planning window. An installment sale to an Intentionally Defective Grantor Trust (IDGT) offers one of the most powerful strategies to transfer appreciating assets out of your taxable estate while avoiding immediate income tax consequences.

According to 2025 tax law research, this strategy allows you to "freeze" the value of assets at their current worth, transferring all future appreciation to your beneficiaries tax-free. The technique has gained significant traction as estate planners recognize its unique ability to leverage both income and estate tax benefits simultaneously.

Strategy Overview

An installment sale to an IDGT involves selling appreciating assets to a specially structured trust in exchange for a promissory note. The trust is "intentionally defective" for income tax purposes, meaning you and the trust are treated as the same taxpayer, eliminating any capital gains recognition on the sale. However, the trust remains separate for estate tax purposes, removing the assets and their future growth from your taxable estate.

This dual nature creates a powerful arbitrage opportunity: you can transfer substantial wealth without triggering immediate tax consequences, while the assets you sold continue to appreciate outside your estate. The strategy is particularly effective for business interests, real estate, and other high-growth assets expected to outperform the IRS's minimum interest rates.

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Frequently Asked Questions

What makes a trust "intentionally defective" and why is that beneficial?

An Intentionally Defective Grantor Trust is structured with specific provisions that cause it to be disregarded for income tax purposes while remaining separate for estate tax purposes. This "defect" is actually a feature, not a bug.

Current Data: As of 2025, the IRS continues to respect the grantor trust rules that enable this strategy, despite previous criticisms of the "no sale" rule (Source: IRS Private Letter Rulings and Revenue Rulings)

Key Points:

• The grantor retains certain administrative powers that trigger grantor trust status
• No capital gains are recognized when selling assets to the trust
• Interest payments on the promissory note are not taxable income

Example Scenarios:

• A business owner sells a $5 million business interest to an IDGT, avoiding $1 million in immediate capital gains tax
• A real estate investor transfers properties expected to double in value over 10 years, removing $5 million of appreciation from their estate
• A family with a $15 million estate uses multiple IDGTs to maximize the current exemption before the 2026 reduction

How does the installment sale structure work and what are the requirements?

The installment sale must be structured carefully to withstand IRS scrutiny and achieve the desired tax benefits. Recent expert guidance emphasizes the importance of proper documentation and economic substance.

Expert Insight: "The note must carry at least the Applicable Federal Rate (AFR) interest to avoid being treated as a below-market loan, and the trust should be seeded with at least 10% of the intended sale value" - Estate Planning CPA recommendations

Implementation Steps:

1. Establish the IDGT with proper grantor trust provisions and fund it with a seed gift (typically 10% of sale value)
2. Obtain a qualified appraisal of assets to be sold and apply appropriate valuation discounts
3. Execute a formal sale agreement with a promissory note at or above the current AFR

What are the risks and how can they be mitigated?

While installment sales to IDGTs offer substantial benefits, they come with complexities that require careful navigation. Understanding these risks is crucial for successful implementation.

Comparison Table:

What happens if the grantor dies during the note term?

One of the most critical considerations is the treatment of the transaction if the grantor dies before the promissory note is fully paid. This edge case requires careful planning.

Advanced Techniques:

• Life Insurance: Purchase life insurance to provide liquidity for note payoff
• Note Structure: Use shorter terms or balloon payments to minimize mortality risk
• Trust Provisions: Include flexibility for trustees to manage unexpected scenarios

How can I maximize the benefits before the 2026 exemption reduction?

With the estate tax exemption set to drop after 2025, timing is critical. Advanced strategies can help maximize the current high exemptions while they last.

Red Flags to Avoid:

1. Inadequate trust funding (less than 10% seed gift) may cause IRS to disregard the sale
2. Below-market interest rates on the note could trigger gift tax consequences
3. Improper valuation or lack of appraisals invites IRS challenges

Implementation Timeline

Week 1-2: Initial Planning and Asset Selection

• Meet with estate planning attorney and CPA to assess suitability
• Identify assets for transfer (focus on high-growth potential)
• Determine optimal trust structure and beneficiaries
• Calculate potential tax savings using current exemptions

Week 3-4: Valuation and Documentation

• Engage qualified appraiser for asset valuation
• Apply for valuation discounts where applicable
• Draft trust documents with proper grantor trust provisions
• Prepare seed gift funding strategy

Week 5-8: Trust Formation and Funding

• Execute trust documents and obtain EIN
• Transfer seed gift to establish economic substance
• Document gift tax reporting requirements
• Set up trust bank accounts and record-keeping

Week 9-12: Sale Execution and Ongoing Administration

• Execute sale agreement and promissory note
• Transfer title of assets to trust
• Establish payment schedule and administration procedures
• Implement ongoing compliance and reporting systems

Optimization Strategies

Valuation Discount Maximization

• Minority Interest Discounts: Structure transfers to qualify for 20-40% discounts
• Lack of Marketability: Document restrictions that support additional 10-30% discounts
• Timing Considerations: Transfer before major liquidity events or business growth

Interest Rate Arbitrage

• AFR Selection: Use long-term AFR for maximum benefit (currently around 3.5% in 2025)
• Payment Structure: Consider interest-only payments with balloon principal
• Rate Lock: Document rates when AFRs are historically low

Multi-Generational Planning

• Dynasty Trust Features: Incorporate generation-skipping provisions
• Beneficiary Flexibility: Allow for changing family circumstances
• Asset Protection: Include spendthrift and creditor protection provisions

Advanced Strategies

Leveraged IDGT Sales

For ultra-high-net-worth families, combining installment sales with leverage can multiply the benefits. This involves the IDGT borrowing funds to make a larger down payment, reducing the note balance and accelerating wealth transfer.

Spousal Lifetime Access Trusts (SLATs) with IDGT Features

Creating reciprocal SLATs that function as IDGTs allows married couples to maximize both spouses' exemptions while maintaining indirect access to trust assets through spousal beneficiary provisions.

Charitable Lead Annuity Trust (CLAT) and IDGT Combinations

For charitably inclined families, combining a CLAT with an IDGT sale can provide immediate charitable deductions while still achieving significant estate tax savings on the remainder interest.

Ready to implement this strategy? Slim Tax can help you create a personalized implementation plan and track your progress.

Disclaimer: This strategy guide provides general tax information based on current regulations. Consult with a qualified tax professional for advice specific to your situation.