IDGT Sale: Selling Shares to an Intentionally Defective Grantor Trust

How an IDGT Sale Works

The transaction has four steps, and each one carries weight.

The trust. The owner creates an irrevocable trust for children or grandchildren, sometimes with a spouse as a beneficiary as well. The trust is drafted so the owner keeps no interest and no control that would pull it into the estate, while one or more provisions make it a grantor trust for income tax. The most common is a power, held by the owner in a nonfiduciary capacity, to reacquire trust assets by substituting other property of equal value; another is a power to borrow from the trust without adequate interest or security. The “defect” in the name is deliberate: the trust is effective for estate tax and ignored for income tax. The owner does not serve as trustee. A family member or an independent trustee does, and an independent trustee also strengthens the arm’s-length character of the sale that follows.

The seed gift. The owner gives the trust cash or other assets before the sale, commonly about 10% of the planned purchase price. The gift uses some of the owner’s lifetime exemption and is reported on a gift tax return. Its job is to make the trust a credible buyer: a trust with nothing but a promise to pay invites the argument that the sale was not really a sale. The 10% figure is a practitioner convention, not a rule for these sales; it is usually traced to an analogy with a separate gift tax rule that, in certain family company transfers, values the common equity at no less than 10% of the company’s total equity plus what it owes the owner and certain family members. Some plans add guarantees of the note from the trust’s beneficiaries for further support, which raise gift tax questions of their own.

The sale. The trust buys business interests from the owner at their appraised fair market value, paying with a promissory note. The note carries at least the applicable federal rate for its term, published monthly; in October 2026 that is 4.25% for notes of three years or less, 4.61% for notes over three years and up to nine, and 5.22% for longer notes. Many notes pay interest only, with the principal due at the end, and allow prepayment. The note is usually secured by the shares the trust bought.

The payments. The trust pays the interest, and eventually the principal, from what the shares produce: distributions from the company, or the proceeds when the business is sold. Those payments return to the owner’s estate. Everything above them stays in the trust.

The owner in a sale like this keeps something a gift does not: a stream of payments and, at the end, the value that was sold. What leaves the estate is the growth and income above the note’s interest rate. That is why the transaction is called an estate freeze. Practitioners also call it an installment sale to a grantor trust, though, as the next section explains, the income tax rules for installment sales do not apply to it.

Why the Tax Code Lets It Work

The structure rests on the gap between two sets of rules that were never designed to line up.

For income tax, the owner of a grantor trust is treated as owning its assets. The IRS concluded in Revenue Ruling 85-13 that a transaction between a grantor and a grantor trust is not a sale for income tax purposes, because, in its view, you cannot sell to yourself. Three results follow. The sale of the shares produces no capital gain. The interest the trust pays on the note is not income to the owner, and not a deduction to the trust. And the trust’s own income, including its share of the company’s profits and any gain when the business is later sold, is reported on the owner’s return and paid from the owner’s other assets. The IRS confirmed in Revenue Ruling 2004-64 that the owner’s payment of that tax is not a gift, so every dollar of it leaves the estate without using any exemption.

For estate and gift tax, the trust is a separate owner. A sale for full value is not a gift, so the only exemption the transaction uses is the seed gift. If the owner allocates generation-skipping transfer tax (GST) exemption to that seed gift, the whole trust can be exempt from that tax as well, because the shares bought for full value add nothing that needs exemption.

The result is leverage. A gift of the same shares would use exemption equal to their appraised value. A sale uses exemption equal to the seed gift, and moves the same growth out of the estate, less the interest the note pays back.

The rules for sales to outsiders do not apply. An installment sale to anyone else is taxed under the installment method, with gain recognized as payments arrive, an interest charge on the deferred tax when more than $5,000,000 of notes are outstanding at year end, and special rules for related buyers who resell within two years, as our article on installment sales and earnouts explains. A sale to a grantor trust is not recognized at all. When the trust later sells the business, that sale is treated as the owner’s: the owner reports the gain, and if the buyer pays over time, any note the trust takes is counted as the owner’s for that $5,000,000 test.

The same logic governs C corporation stock that qualifies for the qualified small business stock exclusion. A sale to a grantor trust is generally treated as changing nothing for income tax, so the owner keeps the exclusion, under the same per-issuer cap as before, and claims it when the trust sells. A grantor trust does not get a cap of its own; that takes a gift of the stock to a separate trust that pays its own tax, a strategy we treat as aggressive.

The Pieces That Make It Hold Up

Nothing in the tax code mentions an IDGT sale. It works because each piece is respected on its own, and the IRS has challenged transactions where the pieces were thin.

A real appraisal. The price has to be fair market value, supported by a qualified appraisal as of the sale date. A minority, nonvoting interest in a private company is worth less than its proportionate share of the whole, because the buyer cannot control the company or sell the interest easily, and those discounts are legitimate when the appraisal supports them. Our article on how a business is valued for sale explains why a gift or trust-sale appraisal can come in well below a later deal price. The appraisal has to be completed before a buyer names a number, the timing our article on estate planning before a business sale describes.

Nonvoting shares. Owners of S corporations usually recapitalize into voting and nonvoting shares first, which an S corporation can do without creating a second class of stock. Selling nonvoting shares keeps control with the owner and supports the discount. The company’s shareholder or buy-sell agreement also has to permit the transfer, and its terms will govern the trust’s shares from then on.

A formula for the price. Because the IRS can later argue the shares were worth more than the appraisal said, many sales define what is sold by a formula: shares with a fair market value of a stated amount, as finally determined for federal gift tax purposes. Clauses that send any excess to a charity have appellate support, including from the Fifth Circuit, whose rulings govern Texas, in McCord (2006). Clauses that instead adjust the number of shares so the excess stays with the owner rest mainly on a 2012 Tax Court decision, Wandry, that the IRS has said it does not accept. The Fifth Circuit showed how much the wording matters in Nelson (2021). There, the documents transferred partnership interests worth $20,000,000, as determined by a qualified appraiser within 180 days, as part of a sale to a trust for a note. The court read that, under Texas contract law, as a sale of a fixed percentage set by the appraiser, not a formula, so when the Tax Court found the interests were worth more, the excess was a taxable gift. A formula clause is drafted by the estate attorney, and the wording is the whole point.

A note that behaves like a note. The trust should make its payments on time, from its own assets, under terms an unrelated lender would recognize. If the payments simply equal whatever the shares happen to pay out, or are skipped, the IRS can argue the owner kept the income from the shares and never really sold them. That argument has teeth: in the Woelbing estate cases, the IRS asserted that a note received in a sale to a grantor trust was a retained interest worth nothing for gift tax and that the trust belonged in the estate. The cases settled in 2016, with stipulated decisions showing no additional gift or estate tax in those cases, so there is no ruling either way, and the seed gift, a fixed payment schedule, and a payment history are the usual defense.

Full disclosure. The sale is reported on the owner’s gift tax return as a transaction for full value, with the appraisal and enough detail to meet the IRS’s adequate disclosure standard. That starts the three-year clock on any challenge to the value, which otherwise never runs.

A Worked Example: A Dallas Distributor’s Sale to a Trust

A couple in their early sixties lives in Dallas. The husband founded a distribution company before they married, organized as an S corporation, and the shares are his separate property. The company is worth about $20,000,000. With their other assets, their projection shows the estate well above the $30,000,000 combined exemption at the second death, and growing; our article on the $15 million exemption explains who is still in that position.

The setup. The company recapitalizes into voting and nonvoting shares. He creates a trust for their children, gives it $700,000 in cash from his separate property, allocating GST exemption to the gift, and sells it nonvoting shares equal to half the company. Half the company’s value is $10,000,000; as a minority, nonvoting interest, the shares appraise at $7,000,000. The trust signs a nine-year note for $7,000,000 at the October 2026 mid-term rate of 4.61%, interest only, with the principal due at the end. The interest is $322,700 a year. His basis in the shares sold is $500,000.

The cash flow. The company distributes $1,000,000 a year to its shareholders, so the trust receives $500,000. Because the trust is a grantor trust, the husband pays the income tax on the trust’s share of the company’s profits, so the trust keeps every dollar: $500,000 in, $322,700 of interest out, $177,300 left each year. (The example ignores investment growth on the trust’s cash and assumes the company’s taxable profit equals its distributions, so the basis of the shares sold stays at $500,000.)

The sale. Four years later, a buyer purchases the whole company for $34,000,000. The trust’s shares bring $17,000,000: four years of growth, plus the discount disappearing in a sale of the whole company. Because the trust is a grantor trust, the $16,500,000 gain is reported on his return, and he pays about $3,300,000 of tax at an illustrative 20% federal rate. (He works in the business, so the 3.8% net investment income tax generally does not apply.) The trust repays the $7,000,000 note in full.

What it moved. After repaying the note, the trust holds $11,409,200: the $17,000,000 of proceeds plus $1,409,200 of cash (the $700,000 seed gift and four years of $177,300 in net distributions), less the $7,000,000 it repaid. Of that, $700,000 was the seed gift, which counts against his exemption; the other $10,709,200 left the estate without using any. If the estate is above the exemption at the second death, that is about $4.3 million of estate tax at 40%, before any growth after the sale. About $1,320,000 of that saving comes from his paying the $3,300,000 of tax on the trust’s gain from his own assets, and more from the tax he paid each year on its share of the profits; had the trust paid the tax on the gain, it would hold about $8.1 million. His estate received back the $7,000,000 of principal and $1,290,800 of interest.

What a gift would have done. Giving the same shares to the trust would have used $7,000,000 of his exemption, and the trust would have kept every distribution, holding $19,000,000 after the sale. Measured beyond the exemption each one uses, the gift moves $12,000,000 and the sale $10,709,200; the $1,290,800 difference is the interest the note paid back. So the sale does not beat a gift on estate tax. What it buys is the note: $8,290,800 of principal and interest returned to him, with the $6,300,000 of exemption he did not use still available to shelter most of it at death. The sale’s other advantage appears at larger sizes. A gift beyond the exemption owes gift tax at 40%, while a sale needs exemption only for the seed gift, so it can reach a stake far larger than the exemption could cover as a gift.

The other ways it can go. A freeze transfers only what the shares earn or gain above the note’s rate, so the outcome depends on the business:

• If the company is never sold and its value stays flat, the trust still keeps the distributions above the interest. After nine years it holds $2,295,700 in cash, having paid $2,904,300 of interest, and repays the note by returning shares appraised at $7,000,000. Under current law that return of shares triggers no gain; under the pending Senate bill described below, it would.
• If the company falls to $12,000,000 by year four, the trust’s shares appraise at about $4,200,000. With $1,409,200 of cash, the trust holds $5,609,200 against a $7,000,000 note, and it hands everything back, about $1,390,800 short of the note. Whether that balance stays owed or is forgiven, which can itself be treated as a gift, is a question for the estate attorney. The family ends roughly where it started, less the $700,000 of exemption the seed gift used and the professional fees.
• If he dies in year two, before any sale, with the company worth $24,000,000, the trust holds shares appraised at about $8,400,000 and $1,054,600 of cash. The $7,000,000 note is in his estate; the trust’s other $2,454,600 is not. How his death affects the income tax on the gain built into the shares the trust bought is unsettled, as the risks section below explains.

IDGT Sale, Gift, or GRAT

The same goal, moving a business’s growth out of an estate, has three common vehicles, and the choice turns on exemption, timing, and risk.

A gift in trust. A gift to a trust, such as a spousal lifetime access trust, moves the asset and all of its future growth, but uses exemption equal to the full appraised value and gives the owner nothing back. Our article on how a SLAT works walks through that version. For an owner who can spare the value outright and has exemption to use, it is simpler, and it moves more, by the interest a note would have paid back. For an owner whose stake is larger than the exemption can cover, or who wants to keep today’s value and move only the growth, the sale fits better.

A sale to a SLAT. The two can be combined: an existing spousal lifetime access trust is itself a grantor trust, and its assets can serve as the seed for a sale. The household keeps indirect access through the spouse, and the sale adds leverage the gift alone does not.

A GRAT. A grantor retained annuity trust pays the owner a fixed annuity for a set term, and whatever is left above an IRS hurdle rate, the Section 7520 rate (5.6% in October 2026), passes to the beneficiaries with little or no gift. A GRAT’s annuity can be set so the gift is close to zero, which a sale cannot match. But its hurdle is higher than the mid-term rate a nine-year note carries (4.61% in October 2026); if the owner dies during the term, much or all of the assets come back into the estate; and GST exemption cannot be allocated to a GRAT until its term ends, which makes it a poor fit for trusts meant to last for generations. A GRAT’s real advantage is certainty: its rules are written into the statute and its regulations, while a sale to a grantor trust rests on rulings, cases, and practice. GRATs tend to suit short, volatile bets on a single asset; sales to grantor trusts tend to suit longer holds and families planning across generations.

The Risks: Death, a Falling Value, and a Change in the Law

Every freeze is a bet that the asset will outgrow the note’s rate. The risks around that bet are where planning effort belongs.

The business does not grow. If the shares earn and gain less than the note’s rate, the trust gives value back rather than keeping it, and the worst case, shown in the example, returns roughly to the starting point, less the seed gift’s exemption and the fees. The asymmetry is the attraction: the downside is modest, the upside is not.

The owner dies before the note is paid. The note, and any interest owed, is part of the estate. The trust’s assets above the note are not. What the tax code does not answer is the income tax: whether the owner’s death, which ends the trust’s grantor status with the note outstanding, causes the owner to recognize the gain built into the shares the trust bought. There is no statute, regulation, or ruling on point, and the commentators disagree. Planners respond by keeping note terms short enough to be paid during the owner’s life where they can, and by modeling the early-death case before the sale rather than after. A variation, the self-canceling installment note, ends at the owner’s death so the unpaid balance stays out of the estate; the trust pays for that feature with a higher price or interest rate, and the IRS has challenged these notes, especially where the owner’s health made an early death likely.

Grantor status ends during life. Releasing the power that makes a trust a grantor trust while the note is still outstanding may cause the owner to recognize gain, as if the shares had been sold for the note at that moment. How the rules apply to a note owed to the owner is contested, which is reason enough to make turning off grantor status a decision for after the note is paid, or one made with the consequences priced.

No step-up. The shares in the trust keep the owner’s original basis. Assets in a grantor trust that are excluded from the estate do not receive a step-up at death, the IRS confirmed in Revenue Ruling 2023-2, so shares the trust still holds when the owner dies carry their built-in gain to the heirs. Our article on the step-up in basis explains what that is worth. In the example, the company was sold during life and its gain was taxed then either way, so nothing was lost; for a business the family expects to hold forever, the swap power is the usual repair, letting the owner exchange cash or high-basis assets for the trust’s low-basis shares before death.

S corporation eligibility after death. A grantor trust can hold S corporation shares while the owner is alive, and for two years after the owner’s death. After that, the trust must qualify through one of two trust elections, or the company loses its S election, so the trust’s terms need to allow for one. A qualified subchapter S trust has a single beneficiary, must pay out its income, and passes the tax on the company’s income to that beneficiary. An electing small business trust can keep income and have several beneficiaries, which suits a trust meant to last for generations, but it pays the top federal rates on all of its share of the company’s income. Other income the trust keeps reaches the top 37% bracket above $16,000 in 2026, and the 3.8% net investment income tax reaches the investment income it keeps once its income passes that same threshold.

A change in the law. In April 2026, Senators Wyden and King introduced S. 4287, the GRATS Act, which would treat a transfer of property for consideration between a grantor trust and its owner as a sale for income tax purposes, for transfers after enactment. A new sale to an IDGT would then be taxed like a sale to a related buyer, with the gain reported at the sale or as the note is paid, repaying an existing note with shares rather than cash would recognize gain on those shares, and so would a swap made to recover basis, even in a trust created before enactment. The bill would also require new GRATs to run at least 15 years and to leave a remainder worth at least the greater of 25% of the property or $500,000, which would end both the short GRAT and the near-zero gift. The same bill would treat the owner’s payment of a grantor trust’s income tax as a gift unless reimbursed in the same year, for trusts created on or after enactment. It has been referred to the Senate Finance Committee and has not become law. Similar proposals have appeared before, and none has become law. A trust that can pay its note in cash, and a plan that does not depend on future in-kind transfers, holds up better if one does.

Texas Considerations

Texas has no estate or inheritance tax, so for Texas residents the question is the federal one, plus any estate tax another state can levy on property the family owns there. Four Texas points shape the structure.

Community property. In Texas, most of what a couple acquires during marriage belongs to both spouses equally. If the business shares are community property, both spouses own half of what is being sold. Some couples have both spouses join as sellers and as grantors of the trust; others first convert the shares into each spouse’s separate property with a written partition agreement. The seed gift raises the same question on a smaller scale: a gift of community cash is treated as made half by each spouse, so the seed comes from the selling spouse’s separate property, from cash partitioned for the purpose, or from both spouses as grantors. Separate cash is often scarcer than it looks: in Texas, income from separate property, including distributions on separate property shares, is community property unless the spouses have agreed otherwise in writing. If the trust will benefit a spouse, the partition route is the usual one, for the reasons our SLAT article gives. Which path fits, and what a partition costs in step-up at the first death, is a question for the estate attorney before the appraisal is ordered.

Texas contract law reads the documents. Nelson was decided under Texas contract law, and the court would not look past the words of the transfer documents to the family’s intent. In Texas, the formula clause and the sale agreement are read as written.

Tax reimbursement. Under Texas law, an owner is not treated as a beneficiary of a trust solely because a trustee other than the owner may reimburse the owner for income tax on the trust’s income. That matters because Revenue Ruling 2004-64, which says the owner’s tax payment is not a gift, also says a discretionary power to reimburse it does not, by itself, pull the trust into the estate, provided there is no prearranged understanding and state law does not let the owner’s creditors reach the trust because of the power. With that statute in place, a Texas trust can carry a reimbursement power as a release valve if the tax bills grow larger than the owner wants to keep paying, though every dollar reimbursed moves back into the estate.

Trusts can last for generations. Texas allows trusts created on or after September 1, 2021 to last up to 300 years, so a trust that buys a business interest can be written to hold it, or its proceeds, for grandchildren and beyond, with GST exemption allocated to the seed gift.

How We Think About It

We lean toward a sale to a grantor trust for households whose projection shows the estate well above the combined federal exemption at the second death, or above the exemption of a state that can tax it, and only after the owner’s own lifetime needs are secured by assets outside the trust and the note. The asset matters as much as the estate: the sale pays off only when what the trust buys grows faster than the note’s rate for long enough to matter, which usually means an operating business with years of growth ahead. It works only with assets that can be sold during life; a retirement account cannot be. Below the exemption, holding a growing business for the step-up usually beats moving it, the same conclusion our SLAT and step-up articles reach. In between, where the projection crosses the line only modestly or only in some scenarios, the answer is usually partial and staged, and a possible future cut in the exemption is a reason to keep the plan flexible rather than, on its own, a reason to give up the step-up.

Above the line, we lean toward a sale over a gift in two situations: when the stake is larger than the exemption can cover, because a sale needs exemption only for the seed gift, and when the owner wants to keep today’s value, because the note’s payments come back to live on. On the same shares, a sale moves the same growth a gift would, less the interest the note pays back, so where the exemption covers a gift and the owner does not need the value, the simpler gift moves more. We also run the case with no discount and no sale: in the worked example, part of the trust’s gain came from the discount disappearing when the company sold, and a plan that works only if both happen is a bet on the deal rather than on the business.

We lean toward treating the sale as a real loan in every detail: an appraisal as of the sale date, a seed gift that makes the trust a credible buyer, a payment schedule the trust can meet from its own assets, payments made on time, full disclosure on the gift tax return, and a formula clause drafted to the standard courts have upheld rather than one that only sounds like it. The transactions that fail usually fail on the paperwork, not the strategy.

We lean toward planning the note’s end before it begins: modeling what happens if the business does not grow, if the owner dies before the note is paid, and if the law changes. We treat the note’s term as a trade to model rather than a default: a longer note fixes the hurdle rate for longer, while a shorter one, paid in cash during the owner’s life, avoids the unsettled income tax question at death and does not depend on returning shares, which the pending bill would tax. Basis belongs in the same plan, with the swap written down at the start for any asset the family expects to keep. These are decisions we make alongside the family’s estate attorney, appraiser, and CPA, who draft the documents, value the shares, and file the returns.

Common Questions

What is an intentionally defective grantor trust?

It is an irrevocable trust drafted to be outside its creator’s estate for estate tax while still treated as owned by its creator for income tax. The “defect” is intentional: because the creator and the trust are the same taxpayer, the creator can sell assets to the trust without recognizing gain, the trust’s interest payments are not taxable income, and the creator pays the trust’s income tax, which moves more value out of the estate without using exemption.

How much seed money does an IDGT sale need?

Practitioners commonly give the trust cash or other assets worth about 10% of the purchase price before the sale, so the trust has real equity behind its note. The tax code sets no minimum; the seed exists to support the argument that the sale was a genuine sale for full value. The seed gift uses lifetime exemption and is reported on a gift tax return, usually with generation-skipping transfer tax exemption allocated to it.

What happens if the owner dies before the IDGT note is paid off?

The note and any interest owed are included in the owner’s estate, while the trust’s assets above the note stay out of it. Whether the death also causes income tax on the gain built into the shares the trust bought is unsettled, with no statute, regulation, or ruling on point. Many plans use note terms short enough to be paid during the owner’s life and model the early-death case before the sale.

Is an IDGT sale better than a GRAT?

Neither is better in general; each fits different situations. A GRAT can be set up with almost no gift and rests on rules written into the statute and regulations, but its hurdle rate (5.6% in October 2026) is higher than the mid-term rate a nine-year sale note carries (4.61%), much or all of its assets return to the estate if the owner dies during the term, and generation-skipping transfer tax exemption cannot be allocated to it until the term ends. A sale to a grantor trust uses a seed gift, rests on rulings and case law rather than regulations, and carries the risk of a note that outlasts the owner, but suits longer holds and planning across generations.