What is a grantor trust?
A grantor trust is a trust in which either the grantor or another person possesses sufficient specific rights or interests over the trust is considered to be the "owner" of the trust. Under the grantor trust rules a "grantor" includes any person to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer of property to a trust. Reg. 1.671-2(e)(1) of the Internal Revenue Code. The retention or possession of these rights gives the grantor control over the trust property and the trust income. The basic issue for the grantor trust is who is going to be taxed when the grantor has retained a certain degree of control--the trust, the beneficiary or the grantor. Once a trust is characterized as a grantor trust, the grantor is determined to have taxable income which includes all of the income, deductions and credits available at the trust level. A person who creates a trust but makes no gratuitous transfer to the trust is not treated as an owner of any portion of the trust under Code Sections 671-677.
In order to determine whether a grantor possesses the specifically enumerated rights and interests in the governing trust instrument to require classification of the trust as a grantor trust, Internal Revenue Code Section 673 and 677 must be examined. These Sections define the circumstances (enumerated below) under which income of a trust is taxed to the grantor. Reg. 1.67-1(a). A person who is not a transferor of property to the trust, but who, as a beneficiary of the trust possesses certain rights, such as power of withdrawal over the trust income or principal, may be deemed a grantor of the trust and considered to be an owner of the entire trust or a portion of the trust for income tax purposes. Code Section 678.
If the grantor retains certain benefits or control over the trust, the normal rules governing taxation of nongrantor trusts contained in Subparts A - D of Part 1 of Subchapter J of the Internal Revenue Code. (26 US Code Subchapter J, Estates, Trusts, Beneficiaries and Decedents) applies. Trusts treated as grantor trusts are "ignored" for income tax purposes with the grantor being viewed as the taxpayer. The goal of probate avoidance in many states, the compressed income tax rates on complex trusts, and the desire of many taxpayers to accomplish sophisticated tax planning have led to the use of grantor trusts.
The current grantor trust rules arose from Supreme Court cases that addressed issues involving attempted assignments of income by the high bracket taxpayer to shift the tax consequences of income receipts to the lowest bracket taxpayer. In Lucas v. Earl, 281 U.S. 112 (1930) the Supreme Court held that income must be taxed to the one who earns it, a theme seen later in the enactment of the grantor trust rules. However, where property rights were transferred, and the donor gave away his entire interest, the assignees of the property were recognized as valid donees, and the income was taxed to them. Blair v. Commissioner, 300 U.S. 5 (1937). Congress then enacted rules based on the cases in the 1954 Internal Revenue Code. At the time, individual taxpayers were faced with extremely progressive and high tax rates. At one time, there were twenty separate tax brackets under the Internal Revenue Code, reaching from 19.2 percent on the first $2,000 to 89 percent on taxable income over $200,000. After 1953 the lowest bracket was due to decline to 17 percent, and the top bracket to 88 percent. The 50 percent tax rate was reached at $200,000. As a planning technique, wealthy taxpayers did whatever they could to shift income to persons, typically family members, in lower income tax brackets. Multiple trusts were created with the intent that each rtust would be recognized as an independent taxpayer to be taxed beginning at the lower end of the progressive rate structure. However, the creator of the trust tried to maintain as much control over the trust as they possibly could.
Enter the grantor trust rules. By including Section 671-678 of the 1954 Internal Revenue Code, Congress forced trust grantors to make a choice--either transfer property into a trust for another person and relinquish control over the income and principal of the trust, and relinquish much of the administration of the trust, and shift the income taxation to the trust beneficiary--or retain one of more elements of control or administrative power and be taxed on the trust income despite having created the trust arrangement for the benefit of another person.
The regulations provide that since the principle is that income of a trust over which the grantor has retained substantial control should be taxed to the grantor rather than to the trust, it is ordinarily immaterial whether the income involved is income or principal for trust accounting purposes.
General Tax Rules.
A grantor can be taxed on the income or principal of a trust, or both. If the grantor is treated as the owner of only part of the trust, the grantor will be taxed on the income from that part of the trust, and the rest of the income will be taxed according to the regular rules regarding the income taxation of trusts and estates. Reg. 1.671-2(d). A trust can have multiple grantors. For example, assume Cindy creates and funds a trust for the benefit of her children, Andy and Belyn. Thereafter, Dylan makes a gift to the same trust. Both Cindy and Dylan will be considered grantors of the trust. Reg. 1.671-2(e)(6).
A person will be treated as a grantor of a trust if "certain circumstances" are present. These "circumstances" refer to the retention of broad powers over and interests in a trust that constitute the basis of the remaining provisions of the grantor trust rules in Regulation Section 1.671-1(a):
- If the grantor has retained a reversionary interest in the trust of a certain amount, within specified time limits (Code Section 673);
- If the grantor or a nonadverse party has certain powers of the beneficial interests in the trust (Code Section 674);
- If certain administrative powers over the trust exist under which the grantor can or does benefit (Code Section 675);
- If the grantor or a nonadverse party has a power to revoke the trust or return the trust principal to the grantor (Code Section 676);
- If the grantor or a nonadverse party has the power to distribute income to or for the benefit of the grantor or the grantor's spouse (Code Section 677);
- If a person other than the grantor has the sole power to vest income or principal in himself or herself so as to be treated in the same manner as would be a grantor of the trust (Code Section 678).
To re-emphasize the key distinction among trusts: to the extent there are other portions of a trust which are not treated as owned by the grantor or by another person with a grantor-like power over income or principal, these portions of the trust are taxed in accordance with the "normal" rules addressing the taxation of trusts and their beneficiaries as found in Subchapter J, Subparts A through D, Code Sections 641 and following.
The operative theory of the grantor trust is that the trust is not a separate taxpayer with respect to the various items of income, deductions and credits which the trust itself may generate. Instead, those items are taxed directly to the grantor. An item of income, deduction or credit is treated as if it had been received directly by the grantor. The existence of the trust does not "filter" or otherwise alter the character of income. For example, items of tax exempt income pass through the trust to the grantor, as do capital gain items.
Taxpayers who created grantor trusts in the years prior to the passage of the 2017 Tax Cuts and Jobs Act may, due to the significant increase in the lifetime exemption amount, now find they have little estate tax exposure but substantial income tax exposure. The effects of that Act are beyond the scope of this article. Because of that, making a trust now may include relinquishing the powers that make the trust a grantor trust and allow the trust, or more likely the trust beneficiaries, to be the income payors. There may be a rush to establish nongrantor trusts for families with multiple members to create eligibility for Code Section deductions that were not available to the grantor acting alone as the only income tax payor.
As with so many tax planning issues, your circumstances must be evaluated separately because there is no "one size fits all" for the tax planning aspect of creating a trust.
And, while I don't usually take this deep a dive into the technical and tax aspects of trust, it is important to have this baseline knowledge of a grantor trust and the tax implications of a grantor trust, because many trusts are created as grantor trusts because of the amount of control afforded the maker of the trust. This article is the beginning of a series on the types of trusts, their tax treatment and the benefits and alternatives to each.
If you would like to discuss your current trust, whether you need a trust or the planning aspects of your trust, please call 307.200.1914 for a free telephone or video conference.