IDGT + Installment Sale: The Intentionally Defective Grantor Trust Strategy

A founder holds $25 million of pre-IPO stock, basis $100K. She wants to transfer as much as possible outside her estate while preserving liquidity and not burning her full lifetime exemption.

She sets up an IDGT (Intentionally Defective Grantor Trust) for her children, gifts a “seed” amount of $2.5M using a portion of her lifetime exemption, then sells $22.5M of stock to the IDGT in exchange for a 9-year installment note at the applicable mid-term federal rate (AFR, ~4.2% in April 2026). The trust pays her $2.5M of principal and interest each year.

Over 9 years, the stock appreciates to $75M. She has received back the $22.5M principal plus $4.4M of interest (installment payments). The remaining $48M+ of trust value passes to her children estate-tax-free. Total gift exemption used: $2.5M (the seed). Lifetime exemption remaining: $11.49M (2025) minus what was used.

This is the IDGT-sale strategy. For founders with large expected appreciation, it moves much more value than pure gifting because the note repays the value back to the estate while the appreciation stays in the trust.

What “intentionally defective” means

An IDGT is a trust that is:

Complete for gift and estate tax purposes (assets are out of the grantor’s estate).
Incomplete (defective) for income tax purposes (the grantor is treated as the owner of the trust’s income and assets for income tax).

“Defective” is a historical term; the structure is intentional. The grantor trust status is triggered by including specific powers (often the power to substitute assets of equivalent value under IRC §675(4)(C)) that make the grantor the income-tax owner but don’t cause estate inclusion.

Benefits of the grantor trust status:

The sale of assets to the IDGT is not a taxable event (grantor selling to grantor for income tax purposes).
Trust income is taxed to the grantor, not the trust. Grantor’s payment of tax is an additional de facto gift (not additional gift for gift tax purposes under Rev. Rul. 2004-64).
Assets compound inside trust without income tax drag.

The installment sale mechanics

Grantor gifts a “seed” amount to the IDGT. Common sizing: 10% of the expected installment principal. For a $22.5M sale, gift $2.5M of seed.
Trust now has sufficient net worth to support the installment note (standard rule-of-thumb: equity position at least 10% of sale price; some practitioners advocate higher).
Grantor sells additional assets to the IDGT in exchange for an installment note. Note terms:
- Principal: value of assets sold.
- Interest rate: applicable federal rate (AFR). The AFR is published monthly by IRS. Mid-term AFR (3-9 years) is the most common.
- Term: typically 9 years (to stay within mid-term AFR) or longer.
- Security: the note can be unsecured or secured by the sold assets.
The IDGT pays interest (or interest + principal) annually from trust income and assets.
Over the note term, the installment payments return principal and interest to the grantor. Appreciation above the AFR stays in the trust.

The grantor trust status is critical

If the trust were a non-grantor trust:

The sale would be a taxable event. Grantor recognizes gain on the $22.5M sale immediately.
For a $22.5M sale with $100K basis, federal LTCG tax: $22.4M × 23.8% = $5.3M, plus state.

With grantor trust status:

No gain recognition on sale.
The note’s interest payments to the grantor are not taxable income (grantor is paying interest to themselves in tax terms).
The grantor pays tax on trust income going forward.

The grantor trust status makes the strategy economically workable. A non-grantor IDGT sale of low-basis stock would trigger unacceptable current-year tax.

The seed gift

The seed gift is the only portion that uses lifetime exemption. For a $22.5M sale with $2.5M seed, total exemption used is $2.5M plus any additional amounts that might be recharacterized if the sale is challenged (rare with proper structure).

The seed should be large enough that the trust is a “real” entity with real equity, not just a conduit. IRS has challenged IDGT sales where seeds were too small (under 10% of the sale) as being collapsed with the sale.

The remaining exemption ($11.49M in 2025 less the seed) stays available for other gifts.

Comparison: IDGT sale vs alternatives

Scenario: transfer $25M of expected-to-be-$75M value over 9 years.

Strategy	Exemption used	Transfer achieved	Grantor tax exposure
Outright gift of $25M	$25M (exceeds exemption, pays gift tax)	Full $75M eventual	Gift tax now, none later
Zeroed-out GRAT	None	$50M if stock performs	None on GRAT
IDGT sale with $2.5M seed	$2.5M	~$50M	Annual income tax on trust
SLAT	$13.99M (2025 exemption)	Value transferred = gift value	Annual income tax on trust
Sale at FMV for cash	None	None	None on sale, full value in estate

IDGT sale shines when:

Stock has large expected appreciation.
Exemption is valuable; don’t want to burn it.
Grantor is willing to pay trust’s income tax.
Asset can support the installment payments (needs liquidity or ability to pay in-kind).

The “Karmazin risk” and note structuring

Karmazin v. Commissioner (2003) is a Tax Court case that challenged an IDGT installment sale, arguing the note was a disguised gift (not arm’s-length). The court rejected the argument in that case, but practitioners learned specific rules:

Note interest rate at or above AFR.
Payment terms are reasonable and enforceable.
Seed is substantial (at least 10% of sale).
Trust has other income and assets beyond the sold stock.
Documentation is real.

An IDGT sale that follows these rules has been successfully defended in numerous rulings and cases.

What if the IRS challenges?

The primary IRS argument would be that the sale was a disguised gift with the note being without real value. Defenses:

Real seed gift supports the trust’s ability to pay.
Market-rate interest on the note.
Consistent payment behavior over the note term.
Arm’s-length note terms (security, default provisions, etc.).

If the IRS successfully recharacterizes the sale as a gift, the grantor would owe gift tax on the full value at sale date (not a sale). Lifetime exemption could be exceeded, triggering gift tax.

Paying the installment

The trust must pay the installment payments. If the trust holds illiquid private stock, payments can be:

In-kind: trust delivers stock back to grantor, valued at current FMV. Reduces trust’s holdings.
From income: trust generates income (dividends, rent if real estate) sufficient to pay.
Borrow: trust takes a loan against its assets to pay (if allowable under trust instrument).
Defer with negative amortization: some notes allow interest-only or deferred payments; riskier and more subject to IRS challenge.

For pre-IPO stock IDGT sales, in-kind payments are common until liquidity events. Post-IPO or post-acquisition, cash payments become feasible.

The grantor’s death during note term

If the grantor dies during the installment note term:

The unpaid note principal is in the grantor’s estate.
But the trust’s asset value (the stock sold in) is not in the estate.
Net estate inclusion: just the remaining note principal.

Compared to owning the stock directly at death (full FMV in estate), the IDGT sale has significantly reduced estate inclusion once the note is paid down or the stock has appreciated materially.

Frequently asked

What AFR applies? Mid-term AFR is published monthly by IRS. For April 2026, mid-term AFR is approximately 4.2% (verify current). The rate in effect at the month of the sale is used for the note.

Can I use an IDGT without the spouse as beneficiary? Yes. IDGTs can have any beneficiaries. The benefit of spousal access (as in SLATs) is separate.

Do I pay income tax on the note interest? No. The grantor trust status means interest paid to grantor is tax-free to grantor (it’s payment to yourself for income tax).

What happens at the end of the note? If the trust has paid the full note, the trust still holds whatever appreciation occurred above the AFR. The note is satisfied and the trust continues.

Can I modify the note during the term? Yes, but modifications can be challenged. Some flexibility exists (prepayment, refinancing), but wholesale changes to rate or term are riskier.

Next step

If you have substantial appreciating assets and are interested in wealth transfer, consider an IDGT sale. Engage estate planning counsel and valuation counsel. Key steps: draft the IDGT trust document, fund the seed gift, obtain a qualified appraisal of the sale assets, execute the installment sale documents. Time the sale to a favorable AFR month. Plan for annual installment payments from trust.