A grantor trust is a revocable living trust that is taxed as a “disregarded individual.” It does not collect taxes or file tax returns. Instead, its profits and deductions are registered and claimed on the grantor’s personal tax return—the individual who established and financed the trust and usually manages its properties. So let’s see the rules of this grantor’s trust and compare it with other non-grantors trusts like the irrevocable trust.
What is a Grantor Trust?
A Grantor trust is a trust in which the trust’s creator, holds one or more rights over the trust and the trust’s income is taxable to the creator.
In some cases, a trust can be considered a grantor trust if a third party who is not opposed to the trustor has an interest or control over the trust that can be attributed to the trustor (for example, the spouse). Although a trust may be considered a grantor trust for income tax purposes, it may be excluded from the trustors’ estate for estate tax purposes (depending on the powers retained by the trusts’ creator).
Powers that Constitute the Trust
The following are examples of powers that, if held by the trustor, would cause a trust to be classified as a Grantor Trust for income tax purposes:
- a reversionary stake in either the trust’s corpus or its revenue
- if the beneficial enjoyment of the corpus of the trust income is subject to the trustors’ power of disposition without the permission or consent of any adverse party
- Certain administrative powers exercisable by the creator of the trusts’ benefit rather than the trust beneficiaries, as well as powers exercisable in a nonfiduciary capacity, such as:
- the authority to deal with trust assets in exchange for less than full and adequate consideration
- the ability to borrow trust assets without providing adequate interest and security
- other powers exercised in a nonfiduciary capacity by any person without the approval or consent of a fiduciary, including:
- The grantor (or the grantors’ spouse) has the authority to revoke the grant.
- the ability to substitute assets of equal value
- the ability to add charitable beneficiaries
- if they use trust income to pay the premiums on a life insurance policy on the trustors’ (or the spouse’s) life, at least to the extent of such income, without the consent of an adverse person.
Examples of Grantors Trust
The following are some examples of Grantor Trusts:
- Retained Interest Trusts
- Revocable Grantors Trust (also known as a Living Trust)
- Grantor Retained Annuity Trust (GRAT)
- Qualified Personal Residence Trust (QPRT)
- Intentionally Defective Grantor Trust (IDGT)
An IDGT is a completed transfer to a trust for tax purposes, but an incomplete, “defective” transfer for income tax purposes.
If the trustor has not retained any powers that would cause estate tax inclusion, the trust can be excluded from the trustors’ estate for estate and gift tax purposes. So, on the date the trust is funded, the future value of the assets transferred is deducted from the gross estate. Because the trustor retains one of the above powers, the trust is classified as a Grantor Trust for income tax purposes. Even though he or she is not a beneficiary, the trustor is taxed on all of the trust’s income. This is despite that he or she is not entitled to any trust distributions.
Read Also; IDGT Explained!!! (Understanding Intentionally Defective Trust)
How does this Trust Work?
Assume you’ve established this trust and funded it with interest-bearing assets—that is, you’ve transferred ownership of these assets into the trust’s name. During the course of the year, they earn $10,000. The trust has spent $1,000 in tax-deductible expenses to retain and administer them.
This income and deductions will be registered and claimed on your personal Form 1040 tax return under your own Social Security number. The trust does not have to file its own tax return.
Claim the revenue from your trust on your personal tax return to raise your taxable income. This will eventually drive you into a higher marginal tax bracket.
Grantor trusts automatically convert to non-grantor trusts when the trustor dies and is no longer alive to file a tax return. Any distributions made by the trust at that time will be taxable to the recipients.
Other Irrevocable Trusts vs. Grantor Trusts
The grantor of an irrevocable trust that does not qualify as a disregarded tax agency permanently relinquishes possession and control of the properties placed in it. Hence, the trust now owns the land, not the creator of the trust. Grantors of irrevocable trusts cannot serve as trustees of their own trusts. They must delegate control of the operation to someone else.
| Grantors Trust | Irrevocable Trusts |
| 1. The trustor has the right to recover assets from the trust. | The grantor relinquishes all properties for all time. |
| 2. As a trustee, the trustor controls trust properties. | A trustee must be appointed by a third party. |
| 3. The grantor’s income is taxed on his or her personal return. | The trust is responsible for filing its own tax returns and paying any related taxes. |
| 4. The properties of the trust are subject to estate tax. | Estate tax does not apply to trust properties. |
The revocability or irrevocability of trust is a result of state laws and the trust’s establishment documents. Many states would deem the grantor’s trust revocable if the trust deed does not say that it is irrevocable.
What are Grantor Trust Rules?
Grantor trust rules are Internal Revenue Code (IRC) guidelines that detail the tax consequences of a grantor trust. So, for income and estate tax purposes, the person who forms a grantor trust is the owner of the assets and property held within the trust under these laws.
Benefits of Grantor Trust Rules
Grantor trusts have several characteristics. So, this allows the trust’s owners to use them for their specific tax and income purposes.
#1. Trust Earnings
The income of the trust is taxed at the trustors’ income tax rate rather than at the trust’s. In this regard, trust rules provide individuals with some tax protection. This is because individual tax rates are generally lower than those for trusts.
#2. Beneficiaries
Trustors can also change the trust’s beneficiaries, as well as its investments and assets. They may even guide a trustee to make changes. Individuals or financial institutions that hold and manage assets for the benefit of a trust and its beneficiaries are the trustees.
#3. Revocable
The trustors may also revoke the trust at any time if they are mentally competent at the time they are making the decision. Because of this distinction, a grantor trust is a form of the revocable living trust. A revocable trust is one that the creator, originator, or grantor may alter or cancel.
#4. Changing the Trust
However, the grantor is free to relinquish ownership of the trust, converting it into an irrevocable trust that cannot be revised or revoked without the consent of the trust’s beneficiaries. In this scenario, the trust will pay taxes on its own revenue, and it will need its own tax identification number (TIN).
Special Considerations
Trusts are for a variety of reasons, including the storage of the owner’s properties in a separate legal body. As a result, trust owners should be mindful of the possibility that the trust will be converted into a grantor trust.
The Internal Revenue Service (IRS) specifies eight exceptions to the trusts’ status. For example, if the trust only has one beneficiary who receives the trust’s principal and profits. So alternatively, if the trust has several beneficiaries, each of whom receives the trust’s principal and revenue in proportion to their shareholding in the trust.
How these rules affect different trusts
Grantor trust rules also outline some conditions under which an irrevocable trust can be treated by the IRS in the same way as a revocable trust. These circumstances may often result in the formation of so-called “intentionally defective grantor trusts.”
In these cases, the trustor is responsible for paying taxes on the trust’s revenue, but trust assets are not included in the owner’s properties. However, such assets will refer to a trustors’ estate if the person operates a revocable trust. This is because the individual effectively owns property owned by the trust.
One can move out properties effectively from the grantor’s estate, and into an irrevocable trust. Individuals also do this to ensure that their property goes on to family members when they die. In this scenario, a gift tax will be imposed on the value of the property at the time it is passed. However, no estate tax is due upon the grantor’s death.
The rules also state that trust becomes a grantor trust if the trust’s creator has a reversionary interest in more than 5% of the trust’s assets at the time they move the assets to the trust.
A trust arrangement specifies how to handle and transfer properties after the death of the trustor. Finally, state law decides whether a trust is revocable or irrevocable, as well as the consequences of each.
Grantor Trust Rule
The IRS has outlined the following grantor confidence rules:
- The authority to incorporate or remove a trust’s beneficiaries.
- The ability to borrow from a trust fund without sufficient protection
- The authority to use trust income to pay life insurance premiums
- The authority to alter the trust’s composition by substituting assets of equivalent value.
Non-grantors Trust
Any trust that is not a grantor trust is referred to as a non-grantor trust. The manner in which they are taxed;
- A non-grantor trust must have its own TIN since it is a distinct tax body.
- A non-grantor trust pays income tax on all taxable income held by the trust at the trust level.
- non-grantor trusts must pay income taxes, which are normally much higher than for persons.
If a trust makes a distribution to a beneficiary, the taxable ordinary income (but not capital gains) will go on to the beneficiary. So, the tax will be on the beneficiary’s personal income tax return. The trustee must complete Form 1041 and provide the beneficiary with a Schedule K-1 detailing the sum and type of income from the trust. Also, the beneficiary will make the report on his or her individual tax return.
They are taxed differently than non-grantor trusts. Non-grantor trusts are distinct legal entities (like a C-Corporation). However, the trustors of trustors trusts retain substantial rights to the trust’s assets and income. As a result, they treat it as direct owners of the trust assets (like a sole proprietorship).
Who controls a grantor trust?
A grantor trust, as defined by the IRS, is one in which the grantor (the person who created the trust) keeps ownership of its assets and profits. With this kind of setup, the grantor and not the trust itself is responsible for paying taxes on the trust’s revenue.
What is the opposite of a grantor trust?
Any trust that is not a grantor trust is referred to as a non grantor trust. The grantor has no authority or control over this type of trust. That implies that they are unable to terminate the trust, alter its provisions, or alter the trust’s beneficiaries.
Can you take money out of a grantor trust?
Since they are the owners of the trust and the trust property and keep an interest in it until they pass away, the grantor-trustee can often take money from the trust as they see fit.
Is a grantor also a trustee?
The individual who establishes and funds the Trust is known as the Grantor. They may also serve in this capacity, but it’s not always the case and it’s not necessary. There are no restrictions on this, and a Trust need not be set up in this manner for the Grantor to occasionally designate themself as beneficiary.
Can anyone gift to a grantor trust?
Gift taxes will apply to all transfers made to the grantor trust unless the grantor receives anything of comparable value in return. A grantor trust will often be funded with an initial gift that is taxable but is usually protected by the lifetime exclusion amount.
Can a grantor trust make distributions?
Asset transfers made between a grantor trust and its grantor are not considered sales for income tax purposes, allowing transfers to take place without resulting in capital gains taxes. Grantor trusts permit distributions to trust beneficiaries without incurring any gift tax obligations.
Final Thoughts
Generally, these trusts are an important estate planning tool. The revocable trusts are by far the most common and can provide significant estate or gift tax savings. Hence, clients should think about the value of these trusts in their estate plans.
Grantors Trust FAQs
What is the purpose of a grantor trust?
The typical purpose of the trust is to create a vehicle allowing the grantor to preserve the wealth he/she has accumulated in a trust that provides assets protection for their beneficiaries, minimizes the ultimate tax burden to the beneficiaries, and keeps the assets out of the grantor’s taxable estate at death
Who pays taxes on a grantor trust?
If the trust is a grantor trust, the income is taxed to the grantor even if the income and other distributions actually go to someone else. A nongrantor trust, by comparison, is taxed as its own separate taxpaying entity. The trustee of the trust has the trust file its own tax return, Form 1041
Are irrevocable trusts a good idea?
Irrevocable trusts are an important tool in many people’s estate plans. They can be used to lock in your estate tax exemption before it drops, keep appreciation on assets from inflating your taxable estate, protect assets from creditors, and even make you eligible for benefit programs like Medicaid.
What happens to a trust when the grantor dies?
Death of the Grantor of a Trust
When the grantor of an individual living trust dies, the trust becomes irrevocable. This means no changes can be made to the trust. If the grantor was also the trustee, it is at this point that the successor trustee steps in. There is one exception to this rule.
