Grantor trusts can provide substantial estate and income tax savings to those who establish them. The grantor of a “grantor trust” is treated as the owner of the trust assets for federal income tax purposes. The grantor continues to pay the income tax generated by the assets contributed to the trust and receives the benefit of all deductions and credits. Whether the grantor trust property is excluded from the estate of the grantor, and thus escapes estate tax, is dependent on the drafting of the trust. The rules regarding grantor trusts can be found in Sections 671 through 679 of the Internal Revenue Code. [1]
It is beneficial for the grantor to be treated as the income tax owner of a trust because trusts have more compressed tax brackets than do individuals. For example, in 2022, individuals were taxed at the highest marginal rate of 37% on income over $539,900, or $647,850 for married taxpayers.[2] Trusts, however, reached the top marginal rate of 37% at income above $13,450.[3]
In general, the following provisions in a trust will create a “grantor trust.”
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- The grantor holds power to cause trust assets to revert to the grantor. [4]
- The grantor or non-adverse party retains the power to affect the interests of the beneficiaries. [5]
- The grantor, spouse of the grantor, or a non-adverse party, has the power to deal with the trust assets for less than full and adequate consideration. [6]
- There is a specific power in a non-adverse party to lend to the grantor or grantor’s spouse from the trust without adequate security or interest.[7]
- The grantor borrows from the trust without repayment before the beginning of the next tax year.[8]
- The grantor or a non-fiduciary has the power to vote closely held stock or control investments, unless consent of a fiduciary is required.[9]
- The grantor or a non-fiduciary has the power to re-acquire assets by substituting assets of equivalent value.[10]
- The trust allows the distribution of income for the benefit of the grantor or the grantor’s spouse.[11]
Grantor trusts allow for income tax free growth in the trust because the grantor pays the tax without being considered to have made further gifts to the trust, thus preserving the grantor’s estate and gift tax exemption to shelter other gifts. A grantor trust may allow for the exchange of low basis assets for higher basis assets, thereby providing for those assets a step-up in basis at the grantor’s death.
Many different types of trusts are considered “grantor trusts.” Revocable trusts are always grantor trusts. In addition, several types of irrevocable trusts can be considered grantor trusts. For example:
- An Irrevocable Life Insurance Trust (“ILIT”) is designed to hold life insurance policies in order to keep the policy proceeds out of a grantor’s taxable estate.
- A Grantor Retained Annuity Trust (“GRAT”) allows a grantor to transfer property to a trust and retain the right to an annuity payable for a term of years. The appreciation on the assets contributed is removed from the grantor’s estate for federal estate tax purposes.
- A Spousal Lifetime Access Trust (“SLAT”), to which assets are transferred during a grantor’s life, secures the current federal estate and gift tax exemption of $12,920,000.
- A Beneficiary Deemed Owner Trust (“BDOT”) allows the beneficiary to be treated as the owner of the trust for income tax purposes.
The advantages of grantor trusts are numerous, and we urge you to reach out to your estate planning attorney if you believe you might benefit from grantor trust planning.
[1] Rev. Proc. 2021-45.
[2] Id.
[3] IRC §§ 671–679.
[4] IRC § 673.
[5] IRC § 674.
[6] IRC §675(1).
[7] IRC §675(2).
[8] IRC §675(3).
[9] IRC §675(4).
[10] IRC §675(4).
[11] IRC §677.