An intentionally defective grantor trust is deliberately drafted to fail the income tax rules while passing the estate tax rules. The assets are outside the grantor's taxable estate, but the grantor still pays the trust's income tax, which the Service has ruled is not a gift, so the trust grows without tax drag while the grantor's estate shrinks by the tax paid. Sales between the grantor and the trust are ignored for income tax, so the grantor can sell an appreciating business interest or real estate to the trust for a note at the applicable federal rate and recognize no gain.
Everything the asset earns above the note rate accrues to the beneficiaries free of transfer tax, and valuation discounts on entity interests lower the price. The cost is the loss of a basis step-up at death, which the Service confirmed in 2023 applies to grantor trusts, so the usual answer is a swap power that lets the grantor exchange cash for the low basis assets late in life. The technique fits someone with a taxable estate, an asset likely to appreciate faster than the federal rate, the liquidity to pay the trust's tax for years, and no need to get the asset back.
The full piece is at turnipseed.law.
