A defective grantor trust is a type of an irrevocable trust where the grantor retains control over the trust’s assets. A defective grantor trust is a wonderful tool to protect an individual’s family home as well as a stock portfolio, and is used by estate planners to protect businesses and families. Assets are moved outside of the control of the creator of the taxable estate of the trust. Those assets are no longer owned by the creator of the trust for the purposes of asset protection. Thus, all the future growth and appreciation of the assets takes place outside of the taxable estate of the grantor and beyond the reach of creditors. In essence, this trust is used for freezing the estate of the trust creator.
A defective grantor trust freezes the value of some assets, at least for the purposes of gift tax and federal estate tax. The shares are either sold or given away by the grantor. Business assets are transferred or given away to the trust by the grantor at a price that is discounted, using the strategies of acceptable discount valuation. In exchange, the trust grants a promissory note to the grantor. This means that an appreciating asset is traded to the trust by the grantor for an asset that is non-appreciating. Even when all or most of the shares have been bought by the trust, the grantor still has the power of controlling the business. Upon the grantor’s death the appreciated value of the company passes over to the beneficiaries without estate tax. Tax is paid by the estate on the unappreciated value of the promissory note.