A defective trust is an irrevocable trust that is taken out of the grantor's estate for estate and generation-skipping transfer tax purposes, but not for income tax purposes.

Since the income is taxable to the grantor, the trust accrues income tax-free. Likewise, the grantor's payment of the income tax on the income that is earned by the trust reduces the grantor's taxable estate and consequently is the functional equivalent of a tax-free gift. In addition, the grantor can transact with the defective trust on a tax-free basis under Revenue Ruling 85-13.

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