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?
Certain powers reserved by the Grantor in the trust agreement will cause a trust to be treated as a Grantor Trust for tax purposes. Internal Revenue Code Sections 673-678 set forth the rules for determining when the grantor and, in some cases, another person is treated as the owner of any portion of the trust. Examples of powers that will cause a trust to be treated as a Grantor Trust include some of the following:
- A Grantor’s reversionary interest in either the corpus or the income of the trust.
- Distribution of income to the grantor or the grantor’s spouse without approval or consent of an adverse party.
- The beneficial enjoyment of the corpus or the income from the trust is subject to a power of disposition by the Grantor without the approval or consent of any adverse party, such as a beneficiary.
- Administrative powers exercisable by the Grantor for the benefit of the Grantor rather than for the trust beneficiaries, including, for example, the power to substitute assets for equal value, the power to add charitable beneficiaries, and the power to revoke by the grantor (or the grantor’s spouse).
What Are the Tax Consequences of a Grantor Trust?
Because a Grantor Trust results where a Grantor has retained sufficient control over trust corpus or income, the Grantor is taxed on the income generated by the trust regardless of whether the Grantor actually receives the income. In this sense, the Grantor Trust is treated as a disregarded entity for income tax purposes, requiring any taxable income or deduction earned by the trust to be reported on the Grantor’s tax return. Thus, even if the Grantor designates his or her children as income beneficiaries during his or her life, for example, the Grantor will still be required to report the income on his or her personal tax return. Further, because of the disregarded entity status of the trust, a transaction between the Grantor and the trust are ignored or treated as income tax nonevents.
A trust may be treated as a Grantor Trust for income tax purposes, even if the trust is irrevocable. This result occurs with an Intentionally Defective Grantor Trust, or “IDGT.” An IDGT is a completed transfer to a trust for estate tax purposes but an incomplete, “defective” transfer for income tax purposes. As with other Grantor Trusts, the Grantor is taxed on the income of the Trust, even though he or she is not entitled to any distributions. If the Grantor retains powers such as the right to income from transferred property to the trust for the Grantor’s life, the right to reside in the property for the Grantor’s life, or the right change beneficiaries by way of a limited testamentary power of appointment, such powers will cause the assets subject to those powers to be included in Grantor’s estate. Pursuant to Internal Revenue Code Section 1014, when an appreciated asset is included in the Grantor’s taxable estate upon his or her death, it receives a step-up in basis equal to the date-of-death fair market value of the property. Thus, such assets held in an IDGT will receive a step up in tax basis upon the Grantor’s death. Thus, these types of trusts can be very useful in shielding a beneficiary from capital gains on highly appreciated property.
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