A trust is a convenient tool in one’s estate plan that allows the “Grantor,” or the person establishing and funding the trust, to provide for the distribution of his or her assets outside of probate. Not only do trusts allow for confidentiality, but the trust can assist the Grantor in avoiding unfavorable tax consequences resulting from transfers outside of trust and during the Grantor’s life, as well as after he or she passes. While trusts can come in many different forms, this article describes the attributes of the Grantor Trust.
What Makes a Trust a Grantor Trust?
A Grantor Trust is simply a trust in which the Grantor has retained certain powers set out by the Internal Revenue Code causing it to be treated as such for tax purposes. These powers may allow the Grantor to retain the ability to revoke the trust, to swap assets from the trust with assets owned by the grantor of like value (“swap power”), or change trust beneficiaries, for example.
What Are the Tax Consequences of a Grantor Trust?
Income generated from a Grantor Trust is taxed to the Grantor, even if the income is distributed to a different beneficiary. The reason for this treatment is based on the Grantor’s reservation of powers in the trust agreement. The IRS essentially treats the Grantor Trust as an extension of the Grantor, because the Grantor is able to make certain changes to the trust agreement, retain certain benefits of the trust, and control the trust assets. Income is reported on the Grantor’s own tax return, using the Grantor’s social security number.
Grantor Trust has several benefits including, but not limited to, the following: First, if the Grantor sells an asset to the trust, it does result in recognizable gain to the Grantor. Second, the Grantor’s payment of income tax is not considered an additional gift to the trust, allowing the trust assets to grow without income tax liability. Third, income earned by the trust is taxed at the Grantor’s tax rate, rather than the trust’s, which is subject to higher tax brackets much quicker than at the individual level. Finally, the Grantor can loan money to the trust, and any accrued interest does not result in interest income taxable to the Grantor.
Standard Grantor Trusts will require the trust assets to be included in the Grantor’s estate at death, due to the fact that the Grantor retained certain powers, described above, up until his or her death. Usually, Grantor Trusts are revocable, but they don’t have to be. For example, a unique variation of the Grantor Trust is used to avoid this result, and it is called the Intentionally Defective Grantor Trust. An Intentionally Defective Grantor Trust (IDGT) is an irrevocable trust and allows the Grantor to transfer assets outside of the Grantor’s estate and avoid paying estate and gift taxes. The trust is “defective” because the Grantor is still required to pay income taxes on trust income.
With an IDGT, if the Grantor reserves the “swap power,” described above, the Grantor can swap low appreciated assets owned by the Grantor into the trust for high appreciated assets. By doing so, the Grantor is able to obtain a “step-up” in basis for the high appreciated assets, since they will be owned by the Grantor at his death, which results in the tax basis of the assets increasing to current-day fair market value.
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