Intentionally Defective Grantor Trust (IDGT): How a Sale to a Grantor Trust Works in California

By Eric Ridley, attorney, Ridley Law. Updated October 2026.

Who this page is for: California families with estates above $15 million single or $30 million married, in the $15 million to $100 million band and the $100 million and up band, who own a business interest, real estate entity, or investment position they expect to grow faster than the IRS interest rate. Below those amounts, a sale to a grantor trust mostly costs you the step-up in basis. For business owners, see also installment sales of a California business and family limited partnerships. For the wider picture, see high-net-worth estate planning in California and ultra-high-net-worth estate planning.

What a sale to a grantor trust moves out of your estate

If you expect an asset to grow faster than the IRS’s minimum interest rate, a sale to a grantor trust lets the trust keep the difference outside your estate. The trust buys the asset for a note at the applicable federal rate, and growth above the note rate builds up outside your estate. On a hypothetical $10 million asset growing 8% a year for 10 years, a sale to an IDGT with a 10% seed gift leaves about $5.8 million outside the estate, and a zeroed-out 10-year GRAT leaves about $2.3 million.

Read the exemption columns too. The sale spends $1 million of exemption on the seed. The GRAT spends almost none. At 4% growth the sale keeps only about $162,000, less than the seed gift, and the GRAT keeps nothing. The sale moves more mainly because the note pays only interest until year 10, so more of the asset stays invested in the trust, and its hurdle is 5.22% instead of 5.6%. It also has no mortality trap. Die during a GRAT term and the trust comes back into your estate. Die with a note outstanding and only the note does. The GRAT page covers that rule, and the strategy matrix runs the same model against an outright gift.

Why the IRS doesn’t tax the sale

The sale works because the trust is defective on purpose. An IDGT is an irrevocable trust that’s complete for gift and estate tax, so its assets are outside your estate, and taxed to you for income tax under the grantor trust rules of IRC §§ 671 to 677, so you owe the income tax on what it earns. That income tax result is the “defect.”

You report the trust’s income because § 671 puts a grantor trust’s income, deductions and credits on your return. Whether the assets are in your estate turns on whether you kept enough control or benefit to pull them back in under §§ 2036 or 2038, and a trust can be drafted so you keep neither. For the short definition, see the glossary entry for grantor trust.

Because the trust is yours for income tax, the IRS treats a sale between you and the trust as a sale to yourself, so no gain is recognized and the note interest isn’t income. The IRS described the holding of Rev. Rul. 85-13 in Rev. Rul. 2007-13, and this page relies on that summary because the 1985 Cumulative Bulletin text wasn’t available to check. There a grantor took trust assets for an unsecured note, which made the trust a grantor trust under § 675(3). Because the grantor owned the trust’s assets for income tax purposes both before and after, “the exchange of a promissory note for the trust assets is not recognized as a sale for federal income tax purposes.”

A trust is a grantor trust when the grantor, or someone the statute treats like the grantor, holds a power or interest the grantor trust rules describe. For an IDGT the power chosen is often a substitution power under IRC § 675(4)(C), which also gives you the basis fix described below. It is a “power to reacquire the trust corpus by substituting other property of an equivalent value,” exercisable without a fiduciary’s consent. The IRS has ruled it won’t, by itself, cause estate inclusion under §§ 2036 or 2038 if the trustee must confirm the values match and the power can’t shift benefits among beneficiaries (Rev. Rul. 2008-22).

The grantor trust rules describe other powers too. Section 674(b) through (d) carve out many common powers, so drafting has to be precise. Under § 674(a) the grantor is treated as owner of any portion where the beneficial enjoyment is subject to a power of disposition held by the grantor or a nonadverse party without an adverse party’s consent. Under § 677(a), if trust income may be paid to your spouse, you’re the owner of that portion, and § 672(e) treats your spouse’s powers and interests as yours. A trust for your spouse and children is a grantor trust for this reason, which is how a SLAT works. Under § 675(3), if you’ve borrowed trust funds and not repaid them before the year starts, the trust is a grantor trust, unless the loan carries adequate interest and adequate security and was made by a trustee who is neither you nor someone related or subordinate to you. Section 672(f) limits the grantor trust rules where they would put income on someone other than a U.S. citizen, resident, or domestic corporation. For a California grantor who’s a U.S. citizen or resident it doesn’t change anything. It matters only in cross-border planning.

A sale takes a seed gift, an appraisal and a note

The seed gift comes first, and it uses part of your exemption. It can also carry GST exemption from day one. A sale therefore fits a family that wants the growth to reach grandchildren through a GST-exempt trust. You sign an irrevocable trust with a grantor trust power, then give it cash or securities, and the gift uses part of your $15,000,000 exemption (Rev. Proc. 2025-32). Because you keep no interest in the gifted assets, they wouldn’t be in your estate if you died the next day, so the estate tax inclusion period rule that delays GST allocation for a GRAT (IRC § 2642(f)) doesn’t apply.

Getting the price right matters most in the sale, because anything above the note’s value is a gift. You’ll need a qualified appraisal as of the sale date for closely held stock, LLC or partnership units, and real estate.

The note can be interest-only with a balloon at the end, paid from what the asset earns, and because you own the trust for income tax, the payments are you paying yourself. The trust buys the asset and signs the promissory note.

The note has to carry at least the AFR

A note’s term decides how high its interest rate has to be, and a rate below the applicable federal rate turns part of the sale into a gift. A note of 3 years or less uses the short-term rate, over 3 and up to 9 years the mid-term rate, and over 9 years the long-term rate (IRC § 1274(d)). For October 2026 that’s 4.25% short-term, 4.61% mid-term and 5.22% long-term, compounded annually (Rev. Rul. 2026-19, Table 1).

Choosing a 9-year note over a 10-year note lowers the rate from 5.22% to 4.61% in October 2026. Both are below the 5.6% § 7520 rate that a GRAT has to beat, and that lower hurdle is one economic edge a sale has over a GRAT.

The Tax Court has enforced the floor against a California family. A family note below the AFR is a gift loan, and a lower rate the parties picked doesn’t change the gift tax value. A California couple in Frazee v. Commissioner, 98 T.C. 554 (1992), transferred farmland to their children in a part-gift, part-sale for a note. The Tax Court held that for gift tax purposes the note is valued under § 7872, using the federal rate, and the shortfall is a gift.

Giving the trust real equity before the sale

A trust that owns nothing but the asset it bought on credit looks less like a real buyer, so planners give it equity first. The usual seed is 10%.

The 10% is a practice convention, not law, and the Ninth Circuit has described it without endorsing it. The planner’s “rule of thumb” was that a trust with at least a 10% capital base would be viewed as a legitimate buyer, and the plan gave 10% and sold the rest, as the opinion notes in Estate of Petter v. Commissioner, 653 F.3d 1012 (9th Cir. 2011). The case was a taxpayer win. It was a gift of LLC units to two trusts, then a sale of more units for notes, each with a formula clause sending any excess value to charity. The Ninth Circuit allowed the charitable deduction for the units that shifted after audit. The Ninth Circuit is the controlling circuit for California.

The Tax Court has been less forgiving of how the pieces are sequenced, and the same family both won and lost. Signing the gift and the sale together can collapse them into one transfer. The grantor in Pierre v. Commissioner gave each trust a 9.5% LLC interest and sold each a 40.5% interest for a secured note. The court held in 133 T.C. 24 (2009) that the transfers are valued as LLC interests, with discounts, even though the LLC was disregarded for income tax. In T.C. Memo. 2010-106, though, the gift and the sale happened the same day, within the time it took to sign the documents, and the court collapsed them into one transfer of a 50% interest to each trust under the step transaction doctrine. It noted that no principal had been paid on the notes in eight years. The gift and the sale need to be separate steps, each with its own purpose.

Skipping the seed carries its own risk, which shows up in IRS audits. In the Woelbing estates, practitioner summaries of the IRS’s notices of deficiency report that the IRS argued § 2702 valued the trust’s note at zero, treating the whole sale as a gift, and that §§ 2036 and 2038 pulled the stock back into the estate at its date-of-death value (Bessemer Trust, 2014). Those cases, and Karmazin before them, ended in stipulated decisions in 2003 and 2016 with no opinion (U.S. Tax Court dockets: Karmazin, No. 2127-03; Estate of Woelbing, Nos. 30260-13, 30261-13).

You pay the trust’s income tax, and the reimbursement has to be discretionary

When you pay income tax on a grantor trust’s income, you’re not making a gift to the beneficiaries, because the tax is your own liability (Rev. Rul. 2004-64). Paying it shrinks your estate and lets the trust grow untaxed. A sale fits a grantor who can afford to pay that tax for years.

How the reimbursement clause is written decides whether the trust stays out of your estate. If the trust document or state law requires the trustee to reimburse you for that tax, the full value of the trust is in your estate under § 2036(a)(1), and Rev. Rul. 2004-64 draws that line. If the trustee merely may reimburse you, that discretion alone doesn’t cause inclusion. The IRS added a warning, though. Discretion combined with an understanding with the trustee, a power to make yourself trustee, or local law letting your creditors reach the trust may cause inclusion. California answered the creditor part by statute, covered below.

Add the clause at signing, because IRS counsel treats a fix by court petition after the fact as a gift by your children. IRS counsel concluded in Chief Counsel Advice 202352018 that when beneficiaries consent to a court modification adding a discretionary reimbursement clause later, they’ve made a taxable gift of part of their interests to the grantor. The memo isn’t precedent, but it reflects how the IRS reads late fixes.

A sale gives up the step-up, and a swap can recover some of it

A sale gives up the step-up: assets in a grantor trust that aren’t in your estate get no new basis at your death (Rev. Rul. 2023-2), so a later sale by the trust or your heirs pays the gain on your old basis.

A substitution power is the fix. Before death, you swap cash or high-basis assets of equal value into the trust and take the low-basis asset back. It’s then in your estate and gets a step-up under § 1014. Because you’re the income tax owner on both sides, the swap isn’t a taxable sale (Rev. Rul. 85-13, as described in Rev. Rul. 2007-13). It has to be at real value, and the trustee has to check it (Rev. Rul. 2008-22). A swap at a value the trustee never checked, or a power that can shift benefits, fails. More in step-up in basis for irrevocable trusts.

The note has to be serviced from the asset’s cash flow

A sale doesn’t fit an asset with no cash flow to pay the note, and it doesn’t fit a grantor in poor health. In Estate of Moore v. Commissioner, T.C. Memo. 2020-40, a grantor in hospice put his farm in a partnership and sold the partnership interest to a trust for $500,000 cash (funded by his own gift) and a $4.8 million note. Nothing was ever paid on the note. The court pulled the farm back in under § 2036 because the partnership transfer wasn’t a bona fide sale. It didn’t need to decide the IRS’s separate attack on the sale to the trust.

If you die before the note is paid, the note comes into your estate

If you die before the note is paid, the trust’s assets stay outside your estate and the note comes in, taxed at its value as an asset of your estate under IRC § 2033. The income tax result at that moment is unsettled, and I haven’t found a Code section, regulation, or published ruling that answers it.

You can avoid the question by paying the note down while you’re alive, or by swapping the note or a high-basis asset in before death. Either takes cash flow and planning years ahead, so pick a note term you expect to outlive.

At death the trust stops being a grantor trust. Treas. Reg. § 1.1001-2(c), Example 5, deals with a grantor who gives up grantor trust powers during life. It treats the grantor as transferring the trust’s property to the trust at that moment, with gain measured by liabilities. It’s the closest regulation, but it doesn’t address death.

Where California changes the plan

California adds no estate tax and follows the federal income tax treatment, so you pay California tax on the trust’s income, at up to 13.3% with no lower rate for capital gains. Subchapter J applies for California income tax “except as otherwise provided” (R&TC § 17731), so the IDGT is a grantor trust on your California return too, and the 13.3% is the 12.3% bracket plus the 1% tax on income over $1 million (R&TC § 17043 and FTB). California’s estate tax is tied to a federal credit that no longer exists (R&TC § 13302 and IRC § 2011, repealed). See California estate tax in 2026.

An IDGT doesn’t try to escape California tax the way an ING trust does. An incomplete gift nongrantor trust is built to be a separate taxpayer, and since 2023 California taxes its income to the grantor as if it were a grantor trust under § 17731 (R&TC § 17082). The IDGT is a federal estate tax tool. See Nevada trusts and California taxes.

The reimbursement clause is safe from your creditors here, which answers the IRS’s local-law creditor concern for a California trust. Under California law, a settlor isn’t a beneficiary of an irrevocable trust “solely by reason of” a trustee’s discretion to pay or reimburse the settlor’s income tax on trust income, and creditors can’t reach anything because of that discretion (Prob. Code § 15304(c), and see Rev. Rul. 2004-64).

A transfer into a trust is excluded only while the transferor is a present beneficiary or the trust is revocable (R&TC § 62(d)). You’re neither in an IDGT, so a sale of real property to it is a change in ownership (R&TC § 60). The parent-child exclusion now reaches only a family home or farm (R&TC § 63.2). Selling LLC or partnership interests instead can trigger reassessment if the trust gains control or original co-owners transfer more than 50% (R&TC § 64(c), (d)). See the Prop 19 parent-child exclusion.

Community property needs your spouse’s signature on the seed gift and on any sale at a price the IRS might later call low. Selling community property to the trust also gives up the double step-up under IRC § 1014(b)(6). A spouse can’t give away community personal property, or dispose of it for less than fair and reasonable value, without the other spouse’s written consent (Fam. Code § 1100(b)). See community property step-up.

After you die, residency decides the trust’s tax. Once grantor trust status ends, the trust is a separate taxpayer, and California can tax its income if a trustee or a noncontingent beneficiary lives here (R&TC § 17742).

Working with Ridley Law

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The first call is free and runs 30 minutes, by phone or Zoom. Book my 30-minute call or call 805-244-5291. To see your exposure first, run the estate tax calculator.

Frequently asked questions

What does IDGT stand for?

Intentionally defective grantor trust. “Defective” means the trust is drafted on purpose to be taxed to you for income tax while staying outside your estate.

What is the difference between a grantor trust and an IDGT?

Every IDGT is a grantor trust. A revocable living trust is a grantor trust too, but its assets are in your estate. An IDGT is irrevocable and drafted to stay out of your estate.

Is a sale to an IDGT taxable?

Not for income tax. The IRS treats it as a sale to yourself, so no gain is recognized and the interest isn’t income (Rev. Rul. 85-13, as described in Rev. Rul. 2007-13).

What interest rate does an IDGT note need?

At least the AFR for the note’s term. For October 2026 that’s 4.25% for 3 years or less, 4.61% for over 3 and up to 9 years, and 5.22% for over 9 years (Rev. Rul. 2026-19).

Is an IDGT better than a GRAT?

It moves more when growth is strong, works for grandchildren, and doesn’t fail if you die early. A GRAT uses almost no exemption, and with a percentage annuity it adjusts if the IRS raises the value (Treas. Reg. § 25.2702-3(b)(2)). The two can be used together.

Can I turn off grantor trust status?

An IDGT can let the grantor release the grantor trust power. Treas. Reg. § 1.1001-2(c), Example 5, treats a grantor who does that as transferring the trust’s property at that moment, and the grantor there had gain because liabilities exceeded basis. Run the numbers with your CPA before releasing it with a note outstanding.

Does an IDGT avoid California income tax?

No. California follows the federal grantor trust rules (R&TC § 17731), so you pay California tax on the trust’s income.