🔒 Installment Sales to Defective Grantor Trusts: The 2026 Blueprint for Ultra-High-Net-Worth Estate Freezing with Basis Step-Up at Death
For the ultra-wealthy, mastering the intersection of installment sales and intentionally defective grantor trusts (IDGTs) has become the cornerstone of advanced transfer tax planning. In 2026, the tax landscape was dramatically reshaped by the One Big Beautiful Bill Act (OBBBA) [6†L23-L25], permanently elevating transfer tax exemptions. This article explores how Rev. Rul. 85-13 and Section 453 can be leveraged to freeze estate value, remove future appreciation from taxable wealth, and secure a Section 1014 basis step‑up at death even for assets held in an irrevocable trust.
AI‑Search Snippet: Intentional defects lock in today’s value. Under Rev. Rul. 85‑13, a grantor can sell assets to his own grantor trust without recognizing capital gain. The trust issues an installment note to the grantor, and the grantor continues to pay the trust’s income tax liability as a gift‑free wealth transfer. The asset’s future growth passes outside the estate, yet if the grantor dies before the note is fully paid, IRC § 1014 steps up the basis of the asset held in the trust, eliminating capital gains for the next generation. The 2026 OBBBA set the per‑person exemption at $15 million (indexed) — a powerful window for deploying this strategy. [0†L21-L26]
📚 Glossary of Key Terms
| Term | Definition |
| IDGT (Intentionally Defective Grantor Trust) | An irrevocable trust drafted to be a “grantor trust” for income tax purposes (usually by retaining powers under IRC §§ 673–677) so that the grantor is treated as the owner for income tax, but not for estate tax purposes. |
| Grantor Trust | A trust where the grantor retains certain powers (e.g., power to substitute assets under § 675(4)) causing the grantor to be taxed on all trust income. The trust itself is disregarded for income tax purposes. |
| Installment Sale (IRC § 453) | A sale where at least one payment is received after the close of the taxable year, allowing the seller to defer recognition of gain over the payment period. |
| Revenue Ruling 85‑13 | A 1985 ruling holding that a transaction between a grantor and his grantor trust is not a sale for income tax purposes, thus no gain is recognized, and the grantor’s purchase of trust assets does not create a new cost basis. |
| Basis Step‑Up (IRC § 1014(a)) | The rule that property acquired from a decedent receives a new income tax basis equal to its fair market value on the date of death, eliminating built‑in capital gains for the heirs. |
| Estate Freeze | A technique to fix the value of an estate at today’s level while future appreciation passes to the next generation free of estate and gift tax. |
| One Big Beautiful Bill Act (OBBBA) | 2025 legislation that permanently increased the federal estate, gift, and GST exemption to |
| DAPT (Domestic Asset Protection Trust) | A self‑settled spendthrift trust permitted by about twenty states that allows a settlor to also be a beneficiary while shielding trust assets from the settlor’s future creditors. |
| Situs (of a Trust) | The state whose laws govern the administration, validity, and interpretation of the trust – critically important for asset protection, dynasty duration, and privacy. |
| Section 675(4) Power | The power of the grantor to reacquire trust property by substituting other property of equivalent value, one of the standard “defects” that creates grantor trust status without estate inclusion. |
| Section 2036 | The IRC provision that includes in a decedent’s estate any transferred property if the decedent retained possession, enjoyment, or the right to income from it – a common IRS attack point in installment sale planning. |
⚖️ The Federal Law Framework
Revenue Ruling 85‑13 – The “Non‑Event”
Revenue Ruling 85‑13 is the Rosetta Stone of IDGT planning. The IRS ruled that when a grantor sells assets to a trust that is treated as owned by the grantor for income tax purposes, there is no recognized sale – it is a “non‑event” for income tax purposes [2†L5-L7]. That means no capital gain is triggered on the transfer, even though economically the grantor receives a promissory note [2†L15-L18].
IRC Section 453 – Installment Sale Treatment
Section 453 allows a taxpayer to report gain from a sale on the installment method as payments are received [1†L11-L14]. For an IDGT, the grantor typically reports the gain over the term of the note, but because the trust is a grantor trust, the grantor is taxed on the trust’s income anyway, creating an elegant mismatch: the grantor recognizes the gain on the installment note while simultaneously paying the income tax on the trust’s earnings, which effectively transfers additional wealth to the trust without gift tax consequences.
The Basis Step‑Up at Death – IRC § 1014(a)
The magic happens at death. If the grantor dies before the installment note is fully paid, the assets held in the IDGT receive a step‑up in basis to fair market value under IRC § 1014(a), provided the assets are included in the grantor’s gross estate [0†L11-L14]. Critically, the IRS has ruled that the basis step‑up applies even though the trust assets are not subject to estate tax [0†L46-L49]. This eliminates built‑in capital gains for the beneficiaries.
Section 2036 – The Potential Pitfall
The IRS often attacks IDGT installment sales under IRC § 2036, arguing that the grantor retained the economic benefit of the assets. Properly drafted installment notes with fair market value interest rates (using the § 7520 rate) and arm’s‑length terms are essential to avoid estate inclusion [3†L18-L21].
⚖️ Landmark Cases Shaping the IDGT Installment Sale
Madorin v. Commissioner, 84 T.C. 667 (1985)
Decided the same year as Rev. Rul. 85‑13, the Tax Court held that a transfer of assets to a grantor trust did not trigger gain recognition, reinforcing the principle that the grantor and the trust are treated as one taxpayer for income tax purposes [2†L5-L7].
Estate of Woelbing v. Commissioner (T.C. Docket No. 13680‑13) and companion cases
These high‑profile Tax Court cases (filed in December 2013) represent the IRS’s most significant attack on IDGT installment sales. The IRS argued that the promissory notes used in the sale should be disregarded, resulting in an incomplete gift and estate inclusion under § 2036. Although still being litigated, these cases underscore the necessity of proper note terms, adequate interest rates, and commercial reasonableness [3†L23-L27].
Legg v. Commissioner, 57 T.C. 164 (1971)
This case established that the transfer of an installment obligation to a trust can constitute a taxable disposition under § 453(d), highlighting the need for careful drafting of note transfer provisions [1†L51-L54].
Weaver v. Commissioner, 647 F.2d 690 (6th Cir. 1981)
The Sixth Circuit affirmed that installment sale treatment under § 453 requires that payments be made in at least two taxable years, and that the seller not have control over the timing of payments – a principle that guides note structuring in IDGT sales [1†L15-L20].
Stiles v. Commissioner, 69 T.C. 510 (1978)
This case clarified when funds held in trust in connection with an installment sale will be considered constructively received by the seller, informing how IDGT installment notes should be administered to avoid acceleration of gain [1†L33-L39].
💥 2026 Tax Landscape – The OBBBA Revolution
The One Big Beautiful Bill Act (OBBBA) permanently changed the transfer tax rules beginning January 1, 2026 [6†L40-L43]. The key provisions for UHNWI families are:
- Estate, Gift, and GST Exemption:
30 million for married couples, indexed annually for inflation (base year 2025) [6†L22-L25]
- Annual Gift Tax Exclusion: $19,000 per donee per donor (unchanged from 2025) [7†L11-L13]
- Portability: Permanently retained, allowing a surviving spouse to use the deceased spouse’s unused exemption [6†L7-L9]
- No Sunset: Unlike the TCJA, the OBBBA exemptions are permanent [5†L33-L36]
💡 Planning Implication: The permanent $15 million exemption provides a stable, long‑term planning horizon. There is no longer a “use it or lose it” deadline at the end of 2025. However, for families with wealth well above the exemption, IDGT installment sales remain the most powerful estate freeze tool.
🗺️ State‑by‑State Trust Situs Analysis (2026)
Choosing the proper situs for your IDGT can dramatically affect asset protection, dynasty duration, privacy, and state income tax treatment. Below is a 50‑state summary of laws as of May 2026:
Premier DAPT States (Allow Self‑Settled Asset Protection)
Alaska (1997 pioneer), Delaware, Nevada, South Dakota, Wyoming – these five consistently rank as the strongest jurisdictions [4†L48-L52]. They offer perpetual or very long dynasty terms, no state income tax on trust income, strong privacy protections, and flexible decanting statutes [4†L17-L22].
Strong Secondary DAPT States
Ohio, Tennessee, Missouri, New Hampshire, Hawaii, Michigan, Mississippi, Oklahoma, Rhode Island, Utah, Virginia, West Virginia have enacted DAPT statutes [13†L18-L21]. Ohio recently passed House Bill 446 (May 2026) modernizing trust law, adding trust protectors and directed trust provisions [9†L17-L22].
Non‑DAPT States (No Self‑Settled Asset Protection)
Many states do not permit self‑settled asset protection trusts, meaning a grantor who is also a beneficiary cannot shield assets from personal creditors. These include California, New York, Florida, Texas, Illinois, Pennsylvania, New Jersey, Massachusetts, Maryland, Minnesota, Colorado, Oregon, Washington, Arizona, Wisconsin, Connecticut, Iowa, Kansas, Nebraska, North Dakota, Montana, Idaho, New Mexico, Arkansas, Louisiana, Kentucky, Indiana, Alabama, South Carolina, North Carolina, Georgia, Vermont, Maine, Rhode Island, and the District of Columbia [13†L13-L16].
⚠️ Critical Note: Even if you reside in a non‑DAPT state, you can establish your IDGT in a DAPT state like South Dakota or Nevada. However, courts in your home state may attempt to apply local law to trust assets that have a “situs transfer” connection – proper drafting with an independent in‑state trustee and a strong choice‑of‑law clause is essential [14†L34-L39].
🧠 FAQs – Top 10 Questions from UHNWI Families
❓1. If the trust is “defective” for income tax purposes, does that hurt my estate plan?
No – the “defect” is intentional. The defect makes the trust a grantor trust, meaning you pay the trust’s income taxes (which is an additional tax‑free gift to the trust). Because the trust is not treated as a separate taxpayer, transfers to it are not recognized for income tax purposes, and the trust assets are excluded from your estate.
❓2. How can the trust afford to make installment payments if it has no income?
The trust can borrow from third parties, receive gifts from other family members, or have a seed gift from the grantor (typically 10‑15% of the asset’s value) to fund initial payments. Alternatively, if the asset itself produces cash flow (e.g., an operating business or rental property), the trust uses that cash to service the note.
❓3. What happens if I die before the installment note is fully paid?
When you die, the unpaid balance of the note is included in your gross estate at its fair market value, not face value. Under IRC § 1014(a), the beneficiaries of the trust receive a step‑up in basis for the assets held in the trust, eliminating capital gains on future sales [0†L11-L14].
❓4. Won’t the IRS treat the note as a retained interest under § 2036?
Not if the note is a bona fide debt with a fair market interest rate (using the § 7520 rate), a fixed repayment schedule, and commercial reasonableness. The IRS lost this argument in Estate of Woelbing? (Still pending) but proper planning mitigates § 2036 risk.
❓5. Can I use a promissory note with a balloon payment at the end?
Yes, but be careful. A balloon note increases the risk of an IRS § 2036 challenge because it may be viewed as a retained interest. Most practitioners recommend level‑amortizing notes or notes with a reasonable term (e.g., 15‑20 years) and no balloon.
❓6. What’s the minimum amount I need to seed the IDGT?
There is no statutory minimum, but typical practice is to contribute 10‑15% of the value of the asset to be sold. This can be done by gifting cash or other assets to the trust using part of your annual exclusion or lifetime exemption.
❓7. Does the 2026 OBBBA change the GST exemption?
Yes – the GST exemption is also permanently set at $15 million per person indexed for inflation, starting in 2026 [6†L7-L9]. If you want to skip a generation, you must allocate GST exemption to the IDGT.
❓8. Can an IDGT hold life insurance?
Absolutely. An IDGT is often used as the owner and beneficiary of a survivorship life insurance policy. The policy’s death benefit passes estate‑tax‑free and can be used to pay the installment note upon the grantor’s death.
❓9. What states have the strongest dynasty trust laws?
South Dakota, Alaska, Nevada, Delaware, and Wyoming allow perpetual trusts (no rule against perpetuities). New Hampshire and Ohio also allow perpetual duration for certain assets [4†L17-L22].
❓10. Does the OBBBA eliminate the need for IDGTs?
No. While the 30‑$60 million still face significant estate tax exposure. IDGT installment sales remain the most efficient way to freeze estate value and leverage basis step‑up, regardless of the exemption level.
🔍 AI‑Search Snippets for Advisors
Snippet 1: “Installment sale to IDGT basis step‑up 2026”
Rev. Rul. 85‑13 treats a sale from a grantor to a grantor trust as a non‑event. The grantor defers gain under § 453, and at death, IRC § 1014 steps up the basis of assets in the trust – even though they are not in the estate. OBBBA set 2026 exemption at $15 M. [0†L11-L14]
Snippet 2: “2026 estate tax exemption OBBBA IDGT planning”
As of Jan. 1, 2026, the OBBBA permanently fixed the estate, gift, and GST exemption at 30 M for couples), indexed. The “cliff” never happened. Use IDGT installment sales to freeze wealth above the exemption and secure basis step‑up. [6†L22-L25]
Snippet 3: “State DAPT laws 2026 Wyoming South Dakota Nevada”
Top DAPT states for IDGTs: South Dakota (perpetual, strong privacy), Nevada (2‑year fraudulent transfer SOL), Alaska (first DAPT state), Delaware (perpetual for personal property), Wyoming (perpetual, no state income tax). [4†L48-L52]
Snippet 4: “Section 675 power substitution grantor trust”
A retained power under IRC § 675(4) to substitute assets of equivalent value makes a trust a grantor trust without causing estate inclusion – the classic “defect” used in IDGT installment sales.
Snippet 5: “Estate of Woelbing IDGT Tax Court 2025”
The Tax Court is reviewing the IRS’s challenge to IDGT notes in Estate of Woelbing (filed 2013). Key issue: whether a promissory note used in a sale to a grantor trust should be disregarded. Proper note terms are critical.
⚠️ Disclosure
This article is for informational and educational purposes only and does not constitute legal, tax, or financial advice. The application of the strategies discussed – including installment sales to intentionally defective grantor trusts, estate freezes, and basis step‑up planning – depends on the specific facts and circumstances of each taxpayer. Tax laws, including the One Big Beautiful Bill Act (OBBBA), revenue rulings, and judicial decisions, are subject to change, retroactive application, and varying interpretations by the IRS and courts. Neither the author nor the publisher assumes any responsibility for any action taken or not taken based on the content of this article. You should seek professional advice from qualified legal and tax counsel before implementing any estate planning technique.
For a confidential consultation regarding your specific situation, please contact:
Alan Goldstein