Business owners ask me about these two trusts often. They are powerful, and also complex, irrevocable and expensive to do properly. My goal is to explain them plainly so you know whether the attorney conversation is worth having.
What is an intentionally defective grantor trust, in plain English?
Start with the word “defective.” Nothing is broken. The trust is drafted on purpose so that two different parts of the tax code treat it two different ways.
- For estate and gift tax, the transfer to the trust is a completed gift. The assets are no longer in your estate, and future growth happens outside it.
- For income tax, the trust is a “grantor trust.” The grantor is the person who creates and funds the trust. The IRS ignores the trust as a separate taxpayer and treats you as the owner of its assets (Internal Revenue Code sections 671 to 679). Every dollar of trust income, gain and deduction shows up on your personal return.
That mismatch is the “defect,” and it is the whole point. The attorney creates it by giving you, or someone else, a power listed in the grantor trust rules. The most common one is a “swap power” under section 675(4)(C): the right to take assets out of the trust by putting in other assets of equal value.
How does an IDGT actually move wealth?
An IDGT is a container. The planning is in how you fill it.
Option 1: a straight gift
You give assets to the trust and use part of your lifetime gift and estate tax exemption ($15,000,000 per person in 2026). Growth after the gift is outside your estate, but the amount you can move is capped by the exemption you use.
Option 2: the seed gift plus installment sale
This is the technique most people mean when they say “IDGT.” It has three steps.
- Seed gift. You give the trust some cash or other assets, typically using part of your exemption. Many practitioners use a rule of thumb that the trust should hold equity of roughly 10% of the value it will buy, so the trust looks like a real buyer with something at stake. That 10% figure is a planning convention, not a number in the tax code, and your attorney may recommend more.
- Sale for a note. You sell a larger asset to the trust, such as nonvoting shares of your company, at fair market value set by a qualified appraiser. The trust pays you with a promissory note instead of cash.
- Interest at the AFR. The note charges interest at no less than the applicable federal rate (AFR), the minimum rate the IRS publishes each month for loans between related parties. For November 2026, the mid-term AFR (for notes longer than 3 years and up to 9 years) is 5.08% compounded annually, according to IRS Revenue Ruling 2026-21.
Because you are selling to a trust you are treated as owning for income tax purposes, the IRS has long taken the position that the sale is a transaction with yourself, so you generally recognize no capital gain on the sale and the interest payments are not taxable income to you (Revenue Ruling 85-13). Your attorney and CPA should confirm this treatment for your facts.
The result is an “estate freeze.” Your estate holds a note with a fixed value. Growth above the AFR belongs to the trust, outside your estate. Growth below it means little is gained.
The tax-free bonus: you keep paying the trust’s income tax
Why pay tax on income you cannot spend? Because it works like a gift that does not count as one. In Revenue Ruling 2004-64, the IRS concluded that a grantor’s payment of income tax on grantor trust income is not a gift to the trust’s beneficiaries, because the tax is the grantor’s own legal obligation.
In practice this means:
- Your estate shrinks by the amount of tax you pay.
- The trust grows without paying any income tax at all.
- None of it uses your gift or GST exemption.
Over 10 or 20 years, this “tax burn” can move a great deal of value. It can also strain your cash flow.
Pennsylvania now matches this. Under Act 64 of 2023, for tax years beginning after December 31, 2024, grantor trust income is generally taxed to the grantor on the Pennsylvania return too. Before that, Pennsylvania taxed most irrevocable grantor trusts as separate taxpayers.
What is a generation-skipping trust?
A generation-skipping trust benefits people two or more generations below you, usually grandchildren. When it is meant to last for many generations, it is often called a dynasty trust. It exists because of a second federal transfer tax most people have never heard of.
The GST tax in plain English
Without the GST tax, a family could leave everything to grandchildren and skip a whole round of estate tax at the children’s level. Congress closed that door. The GST tax applies, in addition to any estate or gift tax, when wealth passes to a “skip person” (a grandchild, a great-grandchild, or an unrelated person more than 37½ years younger than you, or a trust for only those people). It can apply to a direct gift or bequest to a grandchild, a trust distribution to a grandchild, or the point when the last child-generation beneficiary’s interest in a trust ends.
- Rate. The GST tax rate equals the top federal estate tax rate, which is 40% (sections 2641 and 2001(c)).
- Exemption. Each person gets a GST exemption equal to the basic exclusion amount for estate tax (section 2631(c)). For 2026, that is $15,000,000 per person, or $30,000,000 for a married couple who each use their own. Starting in 2027, it is indexed for inflation.
How the exemption makes a trust “GST-exempt”
When you fund a trust, you (or your CPA, on a gift tax return) allocate GST exemption to it. If you allocate exemption equal to the full value of the gift, the trust has an “inclusion ratio” of zero. That means it is fully exempt: every future dollar of growth and every future distribution to grandchildren is free of GST tax, for as long as the trust lasts.
That is the leverage. If you allocate $2 million of exemption to a trust that grows to $20 million over 40 years, the whole $20 million stays GST-exempt.
Default rules (section 2632) allocate some exemption automatically, and they do not always match what a family intends. Your CPA and attorney should handle allocation deliberately on Form 709.
How long can a dynasty trust last in Pennsylvania?
Longer than in many states. Pennsylvania effectively abolished the traditional rule against perpetuities for interests created after December 31, 2006 (20 Pa.C.S. § 6107.1). A trust created today can, in general, continue for generations. There is a 360-year limit on certain interests created by exercising a power of appointment, which your attorney will address in drafting.
Do the children get anything?
Yes, if you want them to. Children can be beneficiaries for life, with the trustee able to distribute for health, education and support. Because the children do not own the assets, they generally are not in the children’s taxable estates, and the trust then continues for grandchildren. It may also protect against a beneficiary’s creditors or divorce, depending on state law and drafting.
How do an IDGT and a generation-skipping trust work together?
They are not competing choices. The attorney drafts a single irrevocable trust that is (1) a grantor trust for income tax, (2) outside your estate for estate tax, and (3) GST-exempt because you allocate GST exemption to your seed gift. Then you sell assets to it on a note.
Why this is efficient: you allocate GST exemption only to what you give, not to what you sell for full value. If the inclusion ratio is zero after the seed gift, growth on the purchased assets stays inside an exempt trust. If the assets perform, a modest seed gift can shelter many times its value at your generation, your children’s and beyond.
| Feature | IDGT (on its own) | GST / dynasty trust (on its own) | Combined: GST-exempt IDGT |
|---|---|---|---|
| Who pays income tax | You (the grantor) | Depends on drafting: you, or the trust | You, for your lifetime (unless grantor status is turned off) |
| Out of your estate? | Yes, if properly structured | Yes | Yes |
| Out of your children’s estates? | Not necessarily | Yes, if designed that way | Yes |
| Uses GST exemption | Optional | Yes, on gifts to it | Yes, on the seed gift and any other gifts |
| Typical funding | Gift, or seed gift plus sale | Gifts | Seed gift plus sale |
| Step-up in basis at your death | Generally no | Generally no | Generally no |
| Can you undo it? | No | No | No |
A worked example: selling a business interest to an IDGT
This example is illustrative only. The numbers are simplified and the growth rates are assumptions, not predictions.
The setup. Dana, 60, owns a profitable manufacturing company in Montgomery County. Her estate is about $40 million, well above the $15 million exemption. Her attorney recapitalizes the company into voting and nonvoting shares so Dana keeps control. A qualified appraiser values the nonvoting shares Dana will sell at $8,000,000. (Valuation discounts for nonvoting interests are fact-specific and a frequent IRS audit target, so I assume none here. Our business valuation calculator gives a rough starting point, not a formal appraisal.)
The steps.
- Dana gives $800,000 of cash to a new GST-exempt grantor trust for her children and grandchildren. She uses $800,000 of her $15,000,000 gift and estate exemption and allocates $800,000 of GST exemption, giving the trust a zero inclusion ratio. Her CPA reports this on Form 709.
- Dana sells the $8,000,000 of nonvoting shares to the trust for a 9-year note at the November 2026 mid-term AFR of 5.08%, with interest paid annually and principal due at the end.
- The trust pays Dana $406,400 of interest each year from company distributions, then repays the $8,000,000 principal in year 9.
- Every year, Dana pays the income tax on the company’s earnings that flow to the trust, from her own pocket.
What is left in the trust after the note is repaid depends almost entirely on how the trust’s assets ($8.8 million to start) grow:
| Assumed annual growth of trust assets | Trust value after 9 years, after repaying the $8,000,000 note | What happened |
|---|---|---|
| 3% | About $646,700 short | The trust cannot fully repay; the seed gift is consumed and the plan likely fails to move value |
| 5.08% (equal to the AFR) | About $1,250,000 | Roughly the seed gift plus growth at the AFR; little gained |
| 8% | About $4,516,000 | About $3.7 million more than the seed gift is now outside Dana’s estate |
| 12% | About $10,398,000 | The freeze works hard: over $10 million is outside the estate |
At 8% growth, the trust holds about $4.5 million that never touches Dana’s taxable estate, and because the trust is GST-exempt, it may also stay out of her children’s estates. If Dana’s estate is above the exemption at her death, keeping that $4.5 million out of it could avoid roughly $1.8 million of federal estate tax at the 40% rate. That ignores the income tax Dana paid for the trust, which also shrank her estate without using exemption.
Notice the 3% row. An IDGT sale is a bet that the asset will outgrow the AFR, and with the mid-term AFR above 5%, that bet is harder to win than when rates were near 1%. If the business is sold later, I usually want to see the sale proceeds modeled with the real tax rate on a business sale in mind, since Dana, not the trust, would owe the capital gains tax on a later sale while the trust is still a grantor trust.
Who still benefits from these trusts after the 2026 exemption change?
The One Big Beautiful Bill Act (Public Law 119-21, signed July 4, 2025) set the basic exclusion amount at $15,000,000 per person for 2026, indexed for inflation after that, with no scheduled sunset. I wrote about what that means for most families in the 2026 estate exemption article. The short version: most families no longer face federal estate tax, and for them, an IDGT can be all cost and no benefit.
I think these trusts still deserve a serious look in a few situations:
- Estates already above $15 million per person ($30 million per couple), or close to it.
- Fast-growing assets. A company growing at 15% a year can double in about five years. An estate of $12 million today may not be under the line in ten.
- A business interest before a sale. Moving shares to a trust before any buyer is in the picture can shift future sale value out of the estate. Once a deal is underway, the valuation and income tax analysis gets much harder. Our business advisory work often starts years before a sale for exactly this reason.
- Families who want multi-generation protection. Even without estate tax, a dynasty trust may protect inherited wealth from a child’s divorce, creditors or poor decisions. That reason can stand on its own.
- Owners of qualified small business stock (QSBS). The 2025 law expanded the section 1202 exclusion for stock issued after July 4, 2025, and how QSBS interacts with trusts is technical. Our QSBS exclusion calculator shows the basic math.
And who probably should skip them: families comfortably under the exemption, anyone who may need the money back, and anyone whose main assets have very low basis and would benefit more from a step-up at death.
The basis tradeoff: no step-up for assets in the trust
When you die owning an appreciated asset, your heirs generally get a “stepped-up” basis equal to its value at your death, so the gain during your life is never taxed (section 1014). Assets in an IDGT are not in your estate, so they do not get that step-up. In Revenue Ruling 2023-2, the IRS confirmed that assets in an irrevocable grantor trust that are not included in the grantor’s gross estate do not receive a basis adjustment at the grantor’s death.
Because the sale to the trust is ignored for income tax, the trust generally keeps Dana’s original basis in the shares, not the $8 million price. If her basis was $500,000 and the shares are worth $20 million at her death, a later sale by the trust could face tax on about $19.5 million of gain. So the trade is: avoid up to 40% estate tax on the growth, but keep capital gains tax on it. When the family is well above the exemption, that trade often favors the trust. When the family is near or below it, the trade can run the other way.
Swap powers can help
The same swap power that makes the trust “defective” can soften this. Before death, you may be able to take low-basis assets back out of the trust and put in high-basis assets (like cash) of equal value. The low-basis assets are then back in your estate and may get a step-up at death, and the trust holds cash with no built-in gain. In Revenue Ruling 2008-22, the IRS concluded that holding this power does not, by itself, pull the trust into your estate, as long as the trustee has a duty to make sure the swapped assets are truly of equal value.
A swap needs enough high-basis assets to put in and current valuations. Review it with your attorney and CPA every few years, not on a deathbed.
Pennsylvania notes
Pennsylvania has no gift tax and no separate state GST tax. Its main death tax is an inheritance tax on what passes at death. According to the Pennsylvania Department of Revenue, the rates are:
| Beneficiary | PA inheritance tax rate |
|---|---|
| Surviving spouse; parent inheriting from a child aged 21 or younger | 0% |
| Children, grandchildren and other lineal descendants | 4.5% |
| Siblings | 12% |
| Other heirs | 15% |
| Qualifying charities and government entities | Exempt |
How this interacts with these trusts:
- Lifetime transfers may avoid it. Pennsylvania generally taxes gifts made within one year of death, above a $3,000 exclusion per recipient per calendar year. Assets transferred to an irrevocable trust more than a year before death, without retained interests, generally are not subject to the inheritance tax. Your attorney should confirm this for your trust’s terms.
- The note stays in your estate. In an IDGT sale, the unpaid note balance and any cash you received are still yours, so they may be subject to Pennsylvania inheritance tax at your death.
- Grandchildren pay the lineal rate. Pennsylvania taxes a bequest to a grandchild at the same 4.5% as one to a child. The skip-generation benefit here is federal.
What are the risks and costs?
This is not easy money. Here is what can go wrong.
- Valuation challenges. If the IRS argues the shares were worth more than the appraisal, the difference may be a taxable gift.
- The note must be real. The trust needs real equity and should pay on schedule. If the sale looks like a disguised retained interest, the IRS may argue the assets belong in your estate.
- Underperformance. As the 3% row showed, if the assets grow slower than the AFR, the plan can fail and waste the seed gift’s exemption.
- Death during the note term. The unpaid note is in your estate, and its income tax treatment at the grantor’s death is not fully settled.
- The tax burn can bite. Paying the trust’s tax every year helps your heirs and strains your cash flow. Some trusts let an independent trustee reimburse you, but adding that clause later, or an understanding that you will be reimbursed, can create gift or estate tax problems. Some trusts let you “toggle off” grantor status, but then the trust pays tax at compressed trust brackets that reach the top rate at a far lower income.
- S corporation stock. A grantor trust can generally hold S corporation shares during your life, but after your death the trust typically needs a timely QSST or ESBT election to protect the S election.
- It is irrevocable. Unwinding is difficult and sometimes impossible.
- Legislative risk. Proposals to curb grantor trust techniques have surfaced in recent years and could return.
- Cost. Attorney fees, a formal appraisal, gift tax returns and annual administration. Some of these recur every year.
Who drafts these trusts?
An experienced estate planning attorney drafts the trust, the sale agreement and the note. A qualified appraiser values the business interest. A CPA files the gift tax return and allocates GST exemption. I do not draft legal documents or prepare tax returns. My role is the financial side: modeling whether the numbers justify the cost and stress-testing the cash flow needed to keep paying the trust’s tax, which is part of our tax planning work.
How Modern Wealth can help
If your estate may be above the 2026 exemption, or your business is growing fast, I can help you judge whether an IDGT or dynasty trust is worth raising with an attorney, model what it might move, and work alongside your attorney and CPA. You can learn more about how I approach estate planning for families and business owners.
Frequently asked questions
What is the downside of an intentionally defective grantor trust?
It is irrevocable, its assets generally get no step-up in basis at your death, you pay its income tax every year, and it is costly to set up and run. If the assets grow slower than the AFR, a sale may move little or nothing.
Who pays the taxes on an IDGT?
You, the grantor, pay the income tax on the trust’s income for as long as it is a grantor trust. The IRS has ruled that this payment is not a gift to the beneficiaries (Revenue Ruling 2004-64). Pennsylvania now generally follows the same treatment for state income tax.
What is the GST exemption for 2026?
$15,000,000 per person, matching the federal basic exclusion amount, under the One Big Beautiful Bill Act. A married couple can protect up to $30,000,000 if each spouse uses their own exemption. It is indexed for inflation after 2026.
Is a generation-skipping trust a good idea?
It can be for families whose wealth is likely to face estate tax at the children’s level, or who want long-term protection for heirs. Well under the exemption, the costs may outweigh the benefits.
Do assets in an IDGT get a step-up in basis?
Generally no. Under Revenue Ruling 2023-2, assets in an irrevocable grantor trust that are not included in your estate do not get a basis adjustment at death. A swap power may let you move low-basis assets back into your estate before death so they can receive a step-up.
What is the difference between a grantor trust and an IDGT?
Every IDGT is a grantor trust, but not every grantor trust is an IDGT. A revocable living trust is also a grantor trust, but its assets stay in your estate. An IDGT is irrevocable and is drafted so the assets are out of your estate while you still pay the income tax.
This article is for general education and is not tax, legal or investment advice for your situation. Talk with your tax and legal advisors before acting.
Sources
- IRS, “What’s new: Estate and gift tax” (2026 basic exclusion amount of $15,000,000; Public Law 119-21): https://www.irs.gov/businesses/small-businesses-self-employed/whats-new-estate-and-gift-tax
- IRS, “IRS releases tax inflation adjustments for tax year 2026, including amendments from the One, Big, Beautiful Bill” (2026 basic exclusion; $19,000 annual exclusion): https://www.irs.gov/newsroom/irs-releases-tax-inflation-adjustments-for-tax-year-2026-including-amendments-from-the-one-big-beautiful-bill
- IRS, Revenue Ruling 2026-21, applicable federal rates for November 2026: https://www.irs.gov/pub/irs-drop/rr-26-21.pdf
- IRS, Revenue Ruling 2023-2 (no basis adjustment for grantor trust assets outside the gross estate): https://www.irs.gov/pub/irs-drop/rr-23-02.pdf
- IRS, Internal Revenue Bulletin 2004-27, Revenue Ruling 2004-64 (grantor’s payment of trust income tax): https://www.irs.gov/irb/2004-27_IRB
- IRS, Internal Revenue Bulletin 2008-16, Revenue Ruling 2008-22 (power to substitute assets): https://www.irs.gov/irb/2008-16_IRB
- 26 U.S.C. § 2631 (GST exemption equal to the basic exclusion amount): https://www.law.cornell.edu/uscode/text/26/2631
- 26 U.S.C. § 2641 (GST tax rate equal to the maximum estate tax rate): https://www.law.cornell.edu/uscode/text/26/2641
- 26 U.S.C. § 2001 (estate tax rates): https://www.law.cornell.edu/uscode/text/26/2001
- 26 U.S.C. § 675 (grantor trust administrative powers, including the power to substitute assets): https://www.law.cornell.edu/uscode/text/26/675
- 26 U.S.C. § 1014 (basis of property acquired from a decedent): https://www.law.cornell.edu/uscode/text/26/1014
- Pennsylvania Department of Revenue, Inheritance Tax (rates): https://www.pa.gov/en/agencies/revenue/resources/tax-types-and-information/inheritance-tax.html
- Pennsylvania Department of Revenue, REV-1510 Schedule G instructions (transfers within one year of death, $3,000 exclusion): https://www.pa.gov/content/dam/copapwp-pagov/en/revenue/documents/formsandpublications/formsforindividuals/inheritancetax/documents/rev-1510.pdf
- Pennsylvania Department of Revenue, PA Personal Income Tax Guide, Estates, Trusts and Decedents (grantor trust income taxable to the grantor): https://www.pa.gov/en/agencies/revenue/forms-and-publications/pa-personal-income-tax-guide/estates,-trusts-and-decedents.html
- 20 Pa.C.S. § 6107.1 (rule against perpetuities for interests created after December 31, 2006): https://www.legis.state.pa.us/WU01/LI/LI/CT/HTM/20/00.061.007.001..HTM