What is an Intentionally Defective Grantor Trust (IDGT)?

A Strategic Tool for Early-Stage Founders

Quick Overview

An Intentionally Defective Grantor Trust (IDGT) offers early-stage founders a powerful combination of flexibility and future tax benefits. Unlike standard non-grantor trusts, IDGTs allow founders to maintain significant control over their shares while building their company, with the strategic option to convert to non-grantor status before a liquidity event to maximize QSBS stacking benefits. This article explains how IDGTs work, why they're particularly valuable for founders early in their journey, the conversion process to non-grantor status, and how this flexible approach can preserve founder control while still enabling significant tax savings at exit.

Understanding the "Intentionally Defective" Structure

The term "intentionally defective" often causes confusion – it sounds like something's wrong with the trust. In reality, this unusual name refers to a deliberate structural choice that creates different treatment for income tax purposes versus estate tax purposes.

An IDGT is:

• "Defective" for income tax purposes: The grantor (founder) remains responsible for paying income taxes on trust assets

• Effective for estate tax purposes: The assets are removed from the founder's estate for estate tax purposes

This split treatment creates unique advantages, particularly for founders building early-stage companies.

How IDGTs Differ from Non-Grantor Trusts

To understand IDGTs, it helps to contrast them with the non-grantor trusts (like SLANTs) discussed in previous articles:

Who pays income taxes:

• IDGT: Grantor (founder)

• Non-Grantor Trust: The trust itself

Separate taxpayer for QSBS:

• IDGT: No (initially)

• Non-Grantor Trust: Yes

Founder control:

• IDGT: High

• Non-Grantor Trust: Limited

Flexibility:

• IDGT: High

• Non-Grantor Trust: Limited

Best timing:

• IDGT: Early company stage

• Non-Grantor Trust: Closer to exit

Complexity:

• IDGT: Moderate

• Non-Grantor Trust: Moderate

The key difference is that with an IDGT, the founder initially maintains more control and flexibility with the ability to transition to non-grantor status later.

Why IDGTs Are Ideal for Early-Stage Founders

At Promissory, IDGTs are common for founders who are early in their company-building journey for several strategic reasons:

1. Maintained Control During Critical Growth Phases

Early-stage founders need maximum flexibility and control as they build their company. IDGTs allow you to:

• Retain significant control over trust assets

• Make key decisions about your equity

• Adapt to changing business circumstances

• Maintain certain powers that would disqualify a non-grantor trust

2. Simplified Tax Reporting Initially

With an IDGT:

• The founder pays income taxes on trust assets

• This simplifies early tax compliance

• There's no need for separate trust tax returns initially, although your trust will have an EIN

• The founder can cover tax obligations while the company grows

• Your trust is unlikely to have any income or tax obligations while your shares are illiquid

3. Future Conversion Flexibility

The strategic advantage of IDGTs is the ability to:

• Start with grantor trust status during company building

• Convert to non-grantor status as you approach exit

• Transition to full QSBS stacking benefits when they matter most

• Make this conversion without creating an entirely new trust

4. Earlier Asset Transfer at Lower Valuations

By establishing an IDGT early:

• You can transfer shares when company valuation is low

• This minimizes gift tax implications

• You can get more shares into the trust structure

• The appreciation occurs outside your estate

The Conversion Strategy: From IDGT to Non-Grantor Status

One of the most powerful aspects of IDGTs for QSBS planning is the ability to convert from grantor to non-grantor status as you approach a liquidity event. At Promissory, we check in with founders on a regular cadence to help them through this transition when they're approximately 12 months from a potential exit.

How the Conversion Works

Converting an IDGT to non-grantor status involves:

1. Removing grantor trust triggers: Eliminating the specific provisions that created grantor trust status

2. Documenting the conversion: Formal documentation with the trustee

3. Filing appropriate notices: Ensuring proper reporting to tax authorities

4. Maintaining proper records: Documenting the transition for future QSBS claims

The beauty of this approach is that it doesn't require creating a new trust or transferring assets again. All trust assets remain in place, but the tax treatment changes.

Timing Considerations for Conversion

The conversion timing is strategic:

• Too early: You lose the control benefits of the IDGT structure prematurely

• Too late: You might not establish non-grantor status long enough before exit

• Optimal timing: Typically 12-18 months before anticipated liquidity

At Promissory, we work closely with founders to monitor their company trajectory and identify the optimal conversion window.

IDGT Creation and Design for Founders

When establishing an IDGT for eventual QSBS stacking, several design elements are particularly important:

1. Intentional Grantor Trust Provisions

The trust needs specific provisions that trigger grantor trust status under IRC Sections 671-679, such as:

• Power to substitute assets of equivalent value

• Power to borrow without adequate security

• Administrative powers that fall under Section 675

• Specific beneficial interests under Section 677

These provisions are what make the trust "defective" for income tax purposes, while still removing assets from your estate.

2. Conversion Mechanisms

For maximum flexibility, the trust should include:

• Clear mechanisms for removing grantor trust provisions

• Documentation requirements for conversion

• Procedures for transitioning to non-grantor status

• Preservation of underlying trust assets during conversion

3. Trustee Selection

Choosing the right trustee is crucial:

• Someone who understands startup equity

• Experience with both IDGTs and non-grantor trusts

• Capability to handle the conversion process

• Understanding of QSBS requirements

Our trustee is well versed in IDGTs and conversion to a non-grantor trust.

4. Jurisdiction Considerations

Even though the trust begins as an IDGT, jurisdiction still matters:

• Nevada remains optimal for eventual non-grantor status

• No state income tax for when the trust converts

• Strong asset protection laws

• Dynasty trust provisions for long-term planning

Real-World Example: IDGT to Non-Grantor Conversion

A founder I spoke with established an IDGT when his company was at seed stage, with a valuation of approximately $5 million. He transferred 40% of his founder shares (worth about $500,000) to the IDGT.

For three years, he maintained grantor trust status, which allowed him to:

• Make key decisions about his equity during pivotal growth phases

• Cover income tax obligations from the trust (which were none)

• Maintain flexibility as the company evolved

• Secure significant control during fundraising rounds

As the company approached Series B and a potential acquisition became possible within 18 months, he converted the IDGT to non-grantor status. By this time:

• The company valuation had grown to $50 million

• His shares in the trust were worth approximately $6 million

• The 5-year QSBS holding period was approaching completion

• Conversion timing aligned perfectly with potential exit timelines

When the company was acquired the following year, the now non-grantor trust was able to claim its own $10 million QSBS exclusion, saving approximately $1.4 million in capital gains taxes that would have been due had he maintained grantor trust status.

The key to this strategy was establishing the trust early when share values were low, maintaining control during critical growth phases, and converting to non-grantor status at the optimal time before exit.

Comparing IDGT Strategy to Direct Non-Grantor Approach

For founders considering their options, here's how the IDGT with conversion strategy compares to starting directly with a non-grantor trust:

IDGT with Conversion Strategy (Early-Stage Founders)

Advantages:

• Greater control during company building

• Flexibility to adapt to business changes

• Same eventual tax benefits at exit

• Simpler initial administration

Disadvantages:

• Requires conversion step

• Slightly more complex documentation

• Timing of conversion is critical

Direct Non-Grantor Trust (Later-Stage Founders)

Advantages:

• Immediate separate taxpayer status

• No conversion required

• Cleaner for founders closer to exit

• Potentially simpler QSBS qualification

Disadvantages:

• Less control for founder

• Less flexibility during business growth

• Immediate separation of assets

• Separate tax filings from day one

At Promissory, we typically guide founders based on their company stage and anticipated timeline to exit:

• Early-stage founders (exit 3+ years away): IDGT with conversion strategy

• Later-stage founders (exit within 12-18 months): Direct non-grantor trust or SLANT

Potential Pitfalls and How to Avoid Them

Pitfall #1: Incomplete Conversion

Failing to properly remove all grantor trust provisions can result in continued grantor trust status, potentially disqualifying separate QSBS treatment.

Solution: Work with experienced trust professionals who understand the specific provisions that trigger grantor trust status and can document their complete removal.

Pitfall #2: Poor Conversion Timing

Converting too close to a liquidity event might appear to be a last-minute tax avoidance strategy rather than legitimate planning.

Solution: Aim for conversion at least 12 months before any anticipated liquidity event, with proper ongoing administration after conversion. Promissory will check in periodically to ensure proper timing.

Pitfall #3: Inadequate Documentation

Insufficient documentation of the conversion could create challenges when claiming QSBS benefits.

Solution: Maintain meticulous records of the original trust creation, the conversion process, and all subsequent administration. This comes standard with Promissory.

Pitfall #4: Continuing Grantor Behaviors

Continuing to treat trust assets as your own after conversion could undermine non-grantor status.

Solution: Follow strict protocols for trust administration after conversion, with clear separation between personal and trust assets.

Key Takeaways

• IDGTs provide early-stage founders with control and flexibility while building their companies

• The strategic conversion to non-grantor status preserves QSBS stacking benefits

• Timing the conversion properly (typically 12-18 months before exit) is critical

• This approach allows for asset transfers when company valuations are lower

• Proper documentation of both the original trust and the conversion is essential

• Jurisdiction matters even for IDGTs – Nevada remains optimal for eventual non-grantor status

• At Promissory, we tailor the trust strategy to your company stage and exit timeline

Disclaimer

Tax laws are complex and constantly evolving. While this article provides general information about IDGTs for QSBS planning, it should not be considered legal or tax advice. Each situation is unique, and tax treatment can vary based on individual circumstances. Always consult with qualified tax and legal professionals before making decisions based on the information provided here.

Ready to explore how an IDGT could fit into your early-stage QSBS strategy? Promissory streamlines the entire process from trust creation to conversion timing and Nevada trust custody—all in one platform for a fraction of the cost of traditional attorney services. Create an account today and start building your tax-optimized founder journey.