Grantor trusts can be a great estate planning tool. Properly drafted and administered, they have the potential to shift and reduce income taxes, minimize estate taxes, and create simple tax reporting. However, proper care must be exercised to navigate the grantor trust rules to reach a desired result.
What is a Grantor Trust?
At its simplest, a grantor trust is a trust in which the trust’s grantor holds certain benefits or powers that cause the grantor to be taxed individually on the trust’s income. This is different than many other trusts, which are taxed on the income the trust’s assets produce.
The specific rules for grantor trusts are found in Internal Revenue Code Sections 671 to 679 and their related regulations. There are many trust provisions that can create grantor trust status. Common examples include when the grantor:
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- Can revoke the trust.
- Must be paid all trust income at least annually.
- Has a reversionary interest in the trust. For example, a provision that provides that the trust property returns to the grantor if the grantor dies while the trust is active.
- Controls the beneficial enjoyment of the trust, such as the ability to add a trust beneficiary.
- Has certain administrative powers, including the power to reacquire trust assets by substituting other property of equal value.
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Who is the Grantor?
The trust grantor is the person who creates and puts assets into a trust. When the grantor trust rules are implicated, this is typically the person responsible for reporting and paying the trust’s income tax on that person’s personal income tax return, Form 1040. However, the grantor trust rules can cause a person other than the grantor to be treated as a “substantial owner” of the trust or part of the trust. The portion the other person substantially owns would be reported on that person’s personal income tax return.
What Types of Trusts can be Grantor Trusts?
No trust qualifies as a grantor trust by name alone; it is the trust’s provisions that determine whether the grantor trust rules apply. However, certain trusts are generally designed to qualify for grantor trust status, including a:
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- Revocable trust.
- Qualified Personal Residence Trust (QPRT).
- Grantor Retained Annuity Trust (GRAT).
- Intentionally Defective Grantor Trust (IDGT).
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In certain situations, grantor trust status can be turned on or off. A naturally occurring event, such as the grantor’s death, can cause a once revocable trust to become irrevocable and end grantor trust status. Additionally, trust provisions can be included that allow the grantor to terminate or gain a power that implicates the grantor trust rules. For example, the grantor while alive could terminate the right to revoke a trust, which could cause the grantor trust rules to no longer apply.
What Needs to be Filed?
A grantor trust’s tax return filings can depend on, among other things, the trust’s language and the grantor’s goals. For example, a grantor that creates a revocable trust generally reports any income from the trust’s assets on the grantor’s personal income tax return without any additional filing requirements. This may be ideal if the grantor’s central goal is to avoid probate by placing assets in the trust but wishes to keep income tax reporting simple.
Other grantor trusts may either be required to or decide to file a trust income tax return, Form 1041, for a trust. This can be especially true if the goal is to remove assets from the grantor’s estate for estate tax purposes while having the grantor taxed on the income.
For grantor trusts, Form 1041 is mostly filed for informational purposes. The return reports the trust income for the year and identifies the grantor or substantial owner, creating a link between the trust’s income and the individual ultimately taxed, providing the necessary income information to be added to the personal return.
Under certain circumstances, a gift tax return, Form 709, may be required or advisable when assets are transferred to a grantor trust. The filing requirement can be triggered when a taxable gift is made. Several factors may require a return, including:
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- The trust’s terms.
- The control the grantor retains over the transferred asset.
- The transferred asset value.
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For example, a grantor transferring a brokerage account to a revocable trust will generally not file a gift tax return, as the grantor likely retains complete control over the account and therefore has not made a gift. In comparison, the transfer of the grantor’s primary residence to a QPRT usually includes giving up an interest in the property, which can create a gift requiring a gift tax return.
What Advantages can Grantor Trusts Provide?
The primary goal of grantor trusts is often to have the income taxed to the grantor or a substantial owner. Both situations can provide numerous potential benefits, including:
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- Simplified trust administration.
- Simplified tax filings.
- Larger growth of trust assets as the grantor or substantial owner pays income tax on the trust income with personal assets instead of trust assets.
- Removing assets from the grantor’s estate for estate tax purposes.
- Reducing the value of taxable gifts.
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What are Some Disadvantages to Grantor Trusts?
Like all estate planning tools, grantor trusts are not a one size fits all document. A grantor trust may not be best if the grantor or substantial owner:
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- Does not want to be taxed on the income the trust produces.
- Does not have assets to pay the created tax burden or will be unduly burden by the increased burden.
- Will be unable to qualify for certain programs due to a higher income.
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Additionally, a grantor trust may be unnecessary if the trust:
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- Is unlikely to produce significant income.
- Is intended to distribute all its income to the named beneficiaries.
- Goals can be accomplished with other estate planning tools.
- Maintenance becomes undesirable due to a change in circumstances.
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Let us Help
Whether you are interested in creating a grantor trust or need help with an already existing trust, Boulay estate and trust planning advisors can assist you and your family with finding the best solutions for you. Learn more by contacting a Boulay advisor at 952-893-9320 or learnmore@boulaygroup.com and asking about our estate and trust planning services.
Legal services provided by Andrew Kremer Law.