What Is A Grantor Trust?

According to the IRS, a grantor trust is one in which the grantor, i.e. the settlor establishing the trust, retains control over trust’s income and assets. It’s usually used by families for estate planning purposes. 

What Is A Grantor?

Identifying The Grantor

The grantor of a trust is the person (settlor) who provides property or other funds to the trust that forms part of the trust corpus (assets).

Multiple Grantors

A trust can have more than one grantor. For instance, if more than one person funded the trust, they will each be treated as grantor in proportion to the value of the cash or property that they transferred to the trust. 

Foreign Grantors

If a foreign person is treated as the owner of the trust under the grantor trust rules, and the trust has a U.S. person as a beneficiary, the beneficiary will be treated as the grantor of the trust to the extent that the beneficiary made gifts (directly or indirectly) to the foreign person irrespective of gift tax applying. 

Powers Held By Grantor’s Spouse

In terms of the grantor rules, the grantor of a trust is treated as owning any powers or interests held by their spouse.

Who Is The Grantor Of A Trust?

The trust grantor will usually be regarded by the IRS as the person who funds the trust.

Grantor Vs Grantee

A grantor differs from a grantee. While the grantor is the person who owns the trust and transfers assets to the trust, the grantee is the person who receives the assets. 

Grantor Vs Trustee

Trustees are individuals or companies that hold and manage the assets for the benefit of a trust and its beneficiaries (while a grantor is the owner).

Examples Of A Grantor Trust

A common example is a revocable living trust

Who Needs A Grantor Trust?

There is no one-shoe-fits-all answer to who needs a grantor trust. It will depend on your financial situation and estate planning needs, as they are generally used for asset protection purposes. It is best to talk with the trusted advisors at Asena to guide you on your specific needs and how the IRS reporting requirements work. 

How A Grantor Trust Works

For federal income tax purposes, a grantor trust is considered a disregarded entity by the IRS. Any taxable income or deduction earned by the trust, will be included in the grantor’s income tax return. The IRS allows a grantor trust to use the grantor’s Social Security Number (SSN) instead of having a separate Tax Income Number (TIN).

Pros And Cons Of Grantor Trusts

The primary advantage for estate planning is the potential to preserve wealth and minimize taxes for your heirs.

One of the major concerns however is that the assumption is you have the financial resources to pay income tax obligations on trust assets during your lifetime.

Types Of Grantor Trusts

Revocable Living Trust

In a revocable living trust you name yourself or someone else as trustee. You then transfer the assets to the trustee’s ownership to manage. Due to the trust being a revocable living trust, you can change the terms at any time or terminate the trust altogether. 

Retained Interest Trusts

This is a trust where a grantor makes an irrevocable transfer of assets but reserves the right to receive income or enjoyment of those assets for a period of time. When the trust then subsequently terminates, the assets are passed on to others. 

Grantor Retained Annuity Trust (GRAT)

This is a type of irrevocable trust that allows you to draw income from the assets you transferred to the trust. You will receive annuity payments from the trust for a set number of years. Once the annuitization period ends, any remaining assets in the trust would be passed on to the beneficiaries. 

Qualified Personal Residence Trust (QPRT)

This trust allows you to transfer ownership of your primary home or secondary home to it and exclude that value from your taxable income.

Intentionally Defective Grantor Trust (IDGT)

Intentionally defective grantor trusts (IDGT) are another type of irrevocable trust. It treats you as the owner of the assets transferred to the trust for income tax purposes, but not for estate tax purposes. Intentionally defective grantor trusts (IDGT) are useful in helping to reduce your estate and gift tax liabilities. 

What Are Grantor Trust Rules?

These rules are guidelines in the Internal Revenue Code (IRC), which outlines certain tax implications of a grantor trust. In terms of these rules, the individual who creates a trust that is a grantor is regarded as the owner of the assets transferred to the trust for income and estate tax purposes. 

With this type of structure, the income from the trust is taxed to the grantor, not the trust itself. The IRS grantor trust rules stipulate that all revocable trusts are grantor trusts

Benefits Of Grantor Trust Rules

Trust Income

The income generated by the trust is included in the grantor’s income tax return rather than to the trust. This provides individuals with a certain degree of tax protection as individual tax rates are generally more favorable than trust tax rates. 

Beneficiaries

Grantors have the discretion to change the beneficiaries of the trust.

Revocable

As long as a grantor is deemed mentally competent, they can change or terminate the trust if needed. 

Changing The Trust

The grantor is also free to relinquish control of the trust and make it an irrevocable trust.

How Grantor Trust Rules Apply To Different Trusts?

The rules outline certain conditions when an irrevocable trust can receive some of the same treatment as a revocable trust for federal income tax purposes. These situations sometimes lead to the creation of IDGTs (intentionally defective grantor trusts) as discussed earlier and the income generated by the trust assets is taxable to the grantor but excluded from the grantor’s estate. 

Examples Of Grantor Trust Rules

Two examples of where grantor status can be triggered, include, where:

  1. the grantor (or the grantor’s spouse) has the power to vest the title to the trust assets in the grantor, including, any power ‘to revoke, to terminate, to alter or amend, or to appoint’; or
  2. the grantor has the power to control trust distributions by paying principal to the grantor instead of to the beneficiaries.

Powers That Make A Trust A Grantor Trust

The power to:

  1. add or change the beneficiary of a trust;
  2. borrow from the trust without adequate security;
  3. use the income from the trust to pay life insurance premiums
  4. make changes to the trust’s composition by substituting assets of equal value

Grantor Trusts Vs. Other Irrevocable Trusts

Grantor Trusts

Irrevocable Trusts

Grantor can reclaim assets from the trust Grantor gives up assets i.e. separation of ownership
Grantor manages trust assets or dictates trustee how to manage assets A 3rd party must act as a trustee
Income is taxed on the grantor’s personal return Trust files its own return and pays taxes. 
Trust assets are included for estate tax purposes.  Trust assets are not subject to estate tax

When An Irrevocable Trust Can Be A Grantor Trust

The Grantor Maintains A Reversionary Interest

If the grantor as stipulated in IRC § 673(a) holds a ‘reversionary interest’ in a trust which is greater than 5% of the trust principal or income. 

The Grantor Has The Power To Control Beneficial Enjoyment

If the grantor in terms of IRC § 674 can control the ‘beneficial enjoyment’ of trust income or assets.

The Grantor Maintains Administrative Control

In terms of IRC § 675, if the grantor maintains administrative control over the trust that can be exercised for his own benefit.

The Grantor Maintains Revocation Powers

In terms of IRC § 676, the trust allows the grantor to revoke any part of the trust and then reclaim or take back the trust’s assets. 

The Trust Distributes Income To The Grantor

If the trust distributes income to the grantor, the trust may in terms of IRC § 677(a) be regarded as a grantor trust.

What’s The Difference Between A Grantor And Non-Grantor Trust?

Grantor Trust – As discussed above, this is any trust in which the grantor is treated as owner of any portion of the trust. This is determined by a list of powers. A grantor only needs one of these powers for the trust to be regarded as a grantor trust. 

Non-Grantor Trust – A non-grantor trust is any trust that is not a grantor trust and is required to have its own TIN due to it being a separate tax entity. 

Non-grantor trusts pay taxes on income received, which is typically higher than individual rates.

What Happens To A Grantor Trust When The Grantor Dies?

The grantor status of the trust terminates with the death of the grantor. The trust deed must be reviewed to determine what happens to the trust property after the death of the grantor. 

Provisions Triggering Grantor Trust Status

Grantor Trust Powers Generally (IRC §671)

671 lays out the basic foundation on which the more specific grantor rules are premised. IRC §671 sets forth the general principle that if the grantor (or another person) is treated as the owner of any part of a trust, then the grantor (or such other person) must include the trust’s income, deductions and credits in calculating is or her own personal taxable income.

Definitions And Rules (IRC §672)

To understand how the rules are applied, it is necessary to understand the meaning of certain terms and rules that are defined in IRC §672. Such as – “Adverse Party.”, “Non-adverse Party.”, and “Related or Subordinate Party.” 

Reversionary Interests (IRC §673)

Under IRC §673(a), a grantor is treated as the owner of trust assets if:

  1. The grantor (or the grantor’s spouse) retains a reversionary interest in those assets; and if
  2. The value of the reversionary interest exceeds five percent (5%) of the value of those assets over which the reversionary interest is held.

Power To Control Beneficial Enjoyment (IRC §674)

IRC §674(a) sets forth the general rule that a grantor is treated as the owner of a trust and taxed on its income if the grantor or a non-adverse party (or both) have the power to affect the beneficial enjoyment of the trust corpus or income without the approval or consent of an adverse party.

Administrative Powers (IRC §675)

The grantor is treated as the owner of a trust if he possesses certain administrative powers which are exercisable for his benefit rather than the beneficiaries

Power To Revoke (IRC §676)

The grantor will be treated as the owner of any part of a trust in which the grantor (or a non-adverse) party has the power to revest title to trust assets in the grantor. 

Income For The Benefit Of The Grantor (IRC §677)

The grantor will be treated as the owner of any portion of a trust if the income from the trust is or may, in the discretion of the grantor (or a non-adverse party) be:

  1. Distributed to the grantor or the grantor’s spouse;
  2. Accumulated for future distribution to the grantor or the grantor’s spouse; or
  3. Applied to the payment of insurance policies on the life of the grantor or the grantor’s spouse.

Persons Other Than The Grantor Treated As Owner (IRC §678)

Under IRC §678, a person other than the grantor of a trust (such as, for example, a trust beneficiary) will be treated as owning the trust assets if that person holds one or more of the following powers:

The right to unilaterally withdraw the trust corpus or income;

Retention of a grantor trust-type power (under IRC §§673-677) over trust assets after having released a power to withdraw trust corpus or income; or

The actual use of trust income to discharge the holder’s legal support obligation.

Drafting Tips

Obtaining Stepped-Up Tax Basis

If a grantor wants their estate planning to have a trust asset’s tax basis ‘stepped-up’ at their death, it will be necessary to trigger grantor status in a way that causes the asset to be treated as part of the grantor’s estate. This will ensure that the asset’s tax basis will be stepped up at the grantor’s death. A way to achieve this is for the grantor to retain a power of revocation over the trust assets or retain an ongoing right to trust income. 

Preserving The Home Sale Exemption 

If a trust is created for the purpose of protecting the grantor’s home from long-term care creditors, it will be advantageous to structure the trust as a grantor trust in order to preserve the grantor’s exemption from a gain on the sale of a personal residence. Any grantor trust power should suffice when including this into your estate planning. 

Avoiding Estate Tax Inclusion

In order to avoid estate tax inclusion, grantors will most likely want to utilize grantor trust powers that causes the trust to be disregarded for income tax purposes, but will also not cause the assets to be included in the grantor’s gross estates for federal tax purposes. 

So, for example, the grantor might be inclined to incorporate into the trust deed, a power on the part of a non-adverse party (other than the grantor) to borrow against corpus or income without adequate interest or without adequate security.

Avoiding Realty Transfer Tax

An issue that will frequently arise when real estate is used to fund a trust is the issue of realty transfer tax. It makes sense to authorize the trustee to distribute the trust assets to persons other than the grantor and those persons are persons who could be counted to provide for the grantor’s needs if required. However, the drafting of such a trust deed necessitates a working knowledge of the applicable Realty Transfer Tax laws applicable to different states. 

Tax Reporting

Income Tax Reporting Methods

There are basically three reporting methods available: 

Traditional Reporting Method

Alternate Reporting Method #1

Alternate Reporting Method #2

Filing Deadline (Under The Traditional Method)

The fiduciary tax return for the trust (under the traditional reporting method) is due by the 15th of April following the end of the trust’s tax year.

Tax Reporting In Year Of Grantor’s Death

The trust continues to report in the same manner as before the grantor died. Under the traditional method of tax reporting, the trustee is required to file a fiduciary tax return for the trust tax year that ends with the decedent’s date of death. The filing deadline for the fiduciary return would be the fifteenth day of the fourth month that began with the first day of the decedent’s taxable year.

Tax Years After The Year Of Grantor’s Death

For tax years beginning after the year of the grantor’s death, the trust is no longer a grantor trust. The trust must therefore obtain an entirely new Employment Identification Number (EIN). The trustee must report the trust’s income, deduction and credits on a fiduciary return under the rules normally applicable to a trust under Subchapter J of the Internal Revenue Code, 

Quick Q & A:

What is the purpose of a grantor trust?

The are various reason for setting up a grantor trust, but the following reasons are common: 

Asset protection and wealth preservation;

Credit protection;

Avoiding probate;

Reduce or eliminate estate taxes; and 

To gain some tax benefits or tax deferral benefits.

Who pays tax on grantor trust?

If a trust is a grantor trust, then the grantor is treated as the owner of the assets, the trust is disregarded as a separate tax entity, and all income is taxed to the grantor

Is a family trust a grantor trust?

Not automatically. Only if it falls within the grantor trust rules. 

What makes an irrevocable trust a grantor trust?

An irrevocable trust can become a grantor trust if the trust meets any one of the requirements as set out in IRC § 673-679. 

For more information on Grantor Trusts, please contact one of our specialists at Asena Advisors. We make sure that your specific needs are catered for.
Check out our vlog series on Grantor Trusts on our YouTube Page.

Shaun Eastman