Defective Grantor Trusts
This type of trust gives the grantor the ability to limit the impact of future asset appreciation or depreciation on his or her estate by substituting trust assets of equivalent value. The trust is irrevocable for estate and gift purposes because the grantor has not retained any powers that would cause any estate tax.
Defective grantor trusts are considered complete for transfer tax purposes but incomplete (or “defective”) for income tax purposes. In practice, this means that grantors can transfer assets out of their estate without being subject to the gift tax, thereby reducing future taxable estate value. Since the grantor retains limited powers over the trust, though, he or she is subject to income tax on the full amount generated by the income-producing assets―even though he or she is not entitled to any trust distributions.
- Because the grantor is allowed to substitute equivalent assets, possible losses from future depreciation can be minimized.
- By satisfying the requirement to pay income tax on trust income, the grantor is able to reduce the size of his or her estate while making a gift to the beneficiaries without incurring gift or estate taxes.