Intentionally Defective Grantor Trust (IDGT): The Installment Sale Freeze
An intentionally defective grantor trust (IDGT) is an irrevocable trust built to sit outside your taxable estate while you are still treated as its owner for income tax. That mismatch lets you sell an appreciating asset to the trust for an installment note with no income tax on the sale, freeze the asset's value in your estate at the note amount, and let future growth pass to your heirs. It is an estate tax tool, not an income tax deferral tool, and it only pays off if your estate is large enough to face estate tax and the asset outgrows the note's interest rate.
This page explains how the sale works, runs a labeled simple example, and lists the risks. For the general rules on selling to relatives on terms, see related-party installment sales.
What "intentionally defective" means
Two tax systems look at the same trust differently:
| System | How it sees the IDGT | Why |
|---|---|---|
| Estate and gift tax | A separate owner. Assets you transfer are out of your estate. | You gave up control in a completed gift or sold at full value. |
| Income tax | You are still the owner. The trust is ignored. | The trust document includes a power listed in the grantor trust rules, §§671-677. |
The grantor trust rules treat you as owner if you keep certain powers or benefits. Common drafting choices include a power to reacquire trust property by substituting other property of equal value (§675(4)(C)) or giving your spouse a right to trust income (§677(a)). The trust is "defective" only for income tax, and that is the point.
Why the sale to an IDGT is not a taxable sale
The IRS said in Rev. Rul. 85-13 that when you are treated as owning a trust, a transfer between you and that trust is not a sale for federal income tax. The IRS repeated that reading in Rev. Rul. 2007-13: "the exchange of a promissory note for the trust assets is not recognized as a sale for federal income tax purposes."
So when the trust buys your asset for a note:
- You report no gain on the sale, no Form 6252 and no gross profit percentage calculation.
- Interest the trust pays you is not interest income to you. You are paying yourself.
- The trust's income (rent, dividends, business profits) is taxed on your personal return.
That last point is a feature. Rev. Rul. 2004-64 holds that when the grantor pays the income tax on grantor trust income, the grantor is not making a gift to the beneficiaries. Every dollar of tax you pay shrinks your estate and leaves the trust's assets growing untaxed. The same ruling warns that a mandatory tax reimbursement clause pulls the whole trust into your estate under §2036(a)(1). A purely discretionary reimbursement power, by itself, does not.
How a sale to an IDGT works, step by step
- Create the trust. An irrevocable trust for children or grandchildren, with a grantor trust power.
- Seed the trust. You make a gift, often cash, so the trust has its own equity. Practitioners often use about 10% of the total value. That ratio is custom, not law. No Code section or regulation sets it.
- Sell the asset. The trust buys a business interest, real estate or stock at appraised fair market value for an installment note.
- Set the interest rate. Commonly at least the applicable federal rate for the note's term, so the note is worth its face value for gift tax purposes. See seller financing interest rates and the AFR and the AFR guide.
- Collect payments. Often interest only with a balloon, paid from the asset's cash flow.
- Growth stays in the trust. Anything the asset earns above the note rate belongs to the trust, outside your estate.
Discounts matter here. A minority, non-voting interest in a family company or LLC is often appraised below a pro rata share of the whole. That lowers the price, and the note. Appraisal quality is where many IRS challenges start. See installment sales of stock and partnership interests for the income tax side of selling entity interests.
Simple example: the estate freeze math
Simple example. Assumptions: a $10,000,000 business interest; you gift $1,000,000 cash to the IDGT (the seed), and the trust buys a $9,000,000 interest for a 9-year, interest-only note at an assumed 4.5%. The trust's assets earn an assumed 8% a year in total return. The estate tax rate is the 40% top rate in §2001(c), assuming your estate is already above the $15,000,000 basic exclusion amount for 2026 (§2010(c)(3)). Round numbers, no discounts.
| Item | Keep the asset | Sell to IDGT |
|---|---|---|
| Value after 9 years | $19,990,046 in your estate | Trust holds $14,932,585 before the balloon |
| Paid back to you | n/a | $405,000 interest a year plus $9,000,000 balloon |
| Left in the trust after the note is paid | n/a | $5,932,585, outside your estate |
| Growth moved out beyond the $1,000,000 seed | $0 | $4,932,585 |
| Estate tax at 40% on that shifted growth | n/a | about $1,973,034 not owed |
The note payments come back into your estate, so the freeze does not shrink what you already have. It caps it. Growth above the 4.5% note rate lands in the trust. The seed gift used $1,000,000 of your lifetime exclusion. On top of this, you paid the trust's income tax each year, which is a further tax-free transfer under Rev. Rul. 2004-64.
If the asset had grown at only 4.5%, the trust would end with roughly the seed and nothing more. The strategy is a bet that growth beats the note rate.
The step-up trade-off
The biggest income tax cost of an IDGT is basis. Assets you keep until death generally get a §1014 step-up to fair market value, which can erase the built-in gain. Assets in an IDGT that are not in your gross estate do not. Rev. Rul. 2023-2 says so directly: the §1014 basis adjustment "generally does not apply to the assets of an irrevocable grantor trust not included in the deceased grantor's gross estate."
| Situation | Estate tax | Beneficiaries' basis |
|---|---|---|
| Keep the asset until death | Full value taxed if above the exclusion | Stepped up |
| Asset in IDGT | Growth out of the estate | Your carryover basis |
That is why many IDGTs include a substitution power. Late in life, you can swap high-basis assets, such as cash or a note, back into the trust in exchange for low-basis assets, so the low-basis assets are in your estate at death and get the step-up. It works only if you have assets of equal value to swap. For estates below the exclusion, this trade-off often means an IDGT costs more in income tax than it saves in estate tax. Compare what happens to an installment note at death.
Risks and open questions
- Valuation. If the IRS says the asset was worth more than the price, the difference can be a gift. Formula clauses and qualified appraisals are the usual defenses.
- Note respected as debt. A trust with no equity and no realistic way to pay may see the note treated as a retained interest, which risks pulling the asset back into your estate under §2036. The seed gift and a real payment history help.
- Death with the note outstanding. Grantor trust status ends at death. Whether that triggers income tax on the unpaid note is not settled by statute, regulation or ruling. Plan for it.
- Turning off grantor status. If you release the grantor trust power while the note is outstanding, the trust starts being a separate taxpayer. Get advice before you do it.
- Paying the trust's tax forever. The income tax burden is a benefit for estate tax but a real cash drain. Model it.
- Legislation. Grantor trust rules have been the subject of past reform proposals. Current law is what is described here. See what could change.
IDGT vs a regular installment sale to family
| Feature | Installment sale to a family member | Sale to an IDGT |
|---|---|---|
| Income tax on the sale | Gain reported as payments arrive (§453) | None while the trust is a grantor trust |
| Interest on the note | Taxable interest income to you | Ignored |
| Resale within 2 years | Can accelerate your gain (§453(e)) | Not a concern for income tax while grantor trust |
| Depreciable property | §453(g) can deny installment reporting | Not a concern while grantor trust |
| Estate tax | Note stays in your estate; growth goes to buyer | Note stays in your estate; growth goes to trust |
| Basis at your death | Buyer has cost basis | Trust has your carryover basis |
If you are selling to a family member outright, the related-party rules apply. For a sale to an unrelated buyer, run a normal installment sale in the calculator.
Bottom line
An IDGT turns an installment note into an estate freeze. The sale is ignored for income tax, you pay the trust's taxes, and growth above the note rate leaves your estate. It fits large estates with assets expected to grow fast and owners willing to give up the step-up on what they sell. It does not defer or reduce income tax on a sale to an outside buyer.
Questions to ask your CPA
- Is my estate large enough, after the $15,000,000 exclusion, to justify an IDGT?
- Which grantor trust power should the trust use, and can I turn it off later?
- How big should the seed gift be, and how will we document the note as real debt?
- What is the lost step-up worth to my heirs versus the estate tax saved?
- What happens to income tax if I die with the note outstanding, and how do we plan for it?
- Can I afford to pay the trust's income tax every year?
Run your own numbers. Compare a cash sale, seller financing and a structured installment sale side by side, free.
Educational only, not tax, legal or investment advice. Examples are illustrative. Have your CPA or tax attorney review your facts before you act. Hans Goldstein is a licensed insurance agent (CA Insurance License #4273294) and is not a CPA or attorney. He is paid a commission only if a structured installment sale is funded; seller financing pays him nothing. Disclosures.