The use of the word “defective” makes it seem like an IDGT might not be legal, but that’s not the case. The “defective” refers to this type of trust not being valid for income tax purposes.
Because it’s a Grantor Trust, all of the income, deductions, and credits are reported on the individual income tax return of the person creating the IDGT, who is called the Grantor or Settlor. This is explained in detail in The Nevada Appeal’s “What is an ‘IDGT?’”
An IDGT is valid for gift or estate tax purposes. The Grantor is also called the “deemed owner” and is separate from the trust. A big benefit of the IDGT is that significant wealth can be transferred by the Grantor without transfer taxes. This is due to the lack of coordination between the regulations for income tax and those concerning gift and estate (transfer) taxes that apply to grantor trusts.
A grantor trust—which is also known as a “living trust”—is revocable. The owner or grantor is allowed to modify the terms, add assets and remove assets from the trust. Income is reported on the individual income tax return, and the grantor trust isn’t required to file Form 1041, an income tax return for estates and trusts.
A typical transaction involves the grantor selling an asset that is expected to grow in value to the IDGT, in exchange for a promissory note for the fair market value of the item, with interest at the applicable federal rate (AFR). Since the transaction is a sale for gift tax purposes, the gift tax doesn’t apply. It’s also a sale for estate tax purposes.
The grantor owns only the promissory note, and when he or she dies, only the value of the note is included in the grantor’s estate. The appreciation passes to the beneficiaries of the trust without any gift or estate tax liability.
Bear in mind that the trust does not pay income taxes. The grantor must report and pay taxes on trust income, whatever form that income takes. However, the grantor pays income taxes from other assets, which serves to reduce the assets of the estate. Payment of these income taxes cannot be reported as a gift. This is useful for high net worth individuals who wish to reduce their estate tax liability.
Reference: Nevada Appeal (January 23, 2017) “What is an ‘IDGT?’”