Grantor trusts--an introduction
“Grantor trust” is a shorthand term of art for a trust that is not a separate taxpayer for federal income tax purposes. The taxation of grantor trusts is governed by Sections 671-679 of the Internal Revenue Code. While other trusts are treated as separate taxable entities which must file their own income tax returns on Form 1041 and pay income tax according to a special rate schedule, a “grantor trust” is one for which the settlor (or another person) is treated as the “owner” and reports income, deductions, and credits against tax on his or her own income tax return. This treatment has potential implications for the rate of income tax paid on the assets in the trust. Grantor trusts also interact with the transfer tax system in interesting ways that give rise to estate planning opportunities.
The tax code and grantor trusts
Sections 671-679 of the Internal Revenue Code are commonly called the “grantor trust rules.” Section 671 establishes the basic principle that where the grantor trust rules apply, the owner of the trust for federal income tax purposes reports its income, deductions, and credits on his or her own income tax return. Section 672 contains important definitions. Sections 673-677 describe types of trusts for which the settlor is treated as the owner. Section 678 describes trusts for which a party other than the settlor is treated as the owner because of certain powers over the trust assets. Section 679 deals with foreign trusts and is beyond the scope of this introduction.
Perhaps the most important estate planning concept to grasp about grantor trusts is that the grantor trust rules and the estate and gift tax inclusion rules do not always give the same results. These inconsistencies create tax planning opportunities with grantor trusts.
Also relevant to understanding the uses of grantor trusts is Internal Revenue Code § 1014, which generally provides a step-up in basis for assets in a decedent’s estate as of his or her date of death. By carefully using advanced estate planning methods, a client can potentially save lifetime income taxes but also obtain a basis step-up at the client’s death.
A two-minute history of the grantor trust rules
A bit of history is helpful to understanding where the grantor trust rules come from and why they can produce tax savings. When the rules were first enacted in 1954 (based on earlier regulations), it made sense for taxpayers to move income-producing assets into a trust, which would be taxed at a lower marginal rate. The grantor trust rules were thus usually a net revenue generator for the IRS, and it sought to push income out of the trust to the deemed “owner” when possible. Conversely, a common tax planning goal was to avoid grantor trust status so that a trust’s assets could be taxed at a lower marginal rate.
The Tax Reform Act of 1986 fundamentally changed these incentives in two ways: (1) it flattened the progressivity of the individual income tax brackets, and (2) it compressed the trust income tax brackets such that a trust reaches the highest marginal tax rate at a far lower income level than does an individual. Any income tax savings which might be achieved by conveying assets to a nongrantor trust are now almost always more than offset by the planning and administration expenses of the trust. Conversely, clients who are not in the highest marginal tax bracket will often save overall income tax if trust assets are taxed to them as the owner.
When the income tax avoidance incentives of nongrantor trusts were removed, tax planners focused their efforts on avoiding transfer taxes using trusts, and found that grantor trust status is often a good thing from an estate and gift tax perspective. Because grantor trust status traditionally was not desirable, these trusts became known, among other names, as “intentionally defective grantor trusts” or IDGTs. Despite the name, when used properly today there is nothing “defective” about these trusts.
How to use grantor trusts in estate planning
Creative estate planners have devised many innovative strategies using intentional grantor trusts for their clients. The most common of these can be put into three main categories:
- Transfer tax leveraging for income taxes paid. Suppose a client with a potentially taxable estate sets up a grantor trust, contributions to which are treated as completed gifts and not includible in his gross estate. Importantly, each dollar contributed to the trust potentially incurs gift tax (or at least uses up the client’s unified credit). The trust’s assets grow income tax-free once paid in, from the perspective of the trust itself, so long as the client is paying the income tax. Because the client can make the income tax payments the trust would otherwise make without making a taxable gift to the trust to pay them, the overall effect is to save the client the gift tax consequences of a gift to the trust in the amount of the trust’s income tax liability each year. This allows the client to transfer more net wealth to beneficiaries free of gift tax.
- Tax-free sale. For income tax purposes, a transaction between an owner and his or her grantor trust is disregarded. By selling, instead of gifting, assets to a grantor trust (in return for cash, securities, or, as is commonly done, a promissory note), an asset can be transferred to the grantor trust free of both income and gift taxes at the time of the transfer, even if a significant capital gains tax liability would have resulted from a sale to some other party. The asset’s value for transfer tax purposes is thus “frozen” as of the date of the sale. This is a popular method of removing the future appreciation of an asset from a client’s taxable estate in a way that is gift-tax free.
- Asset exchange to maximize basis step-up. One of several ways of intentionally creating a grantor trust is to give the settlor the power to reacquire trust assets by substituting assets of equivalent value. This power can also be of great practical use in the right circumstances. By exchanging high-basis assets which would be includible in a client’s taxable estate for low-basis assets held in a grantor trust when the client is near death, the client can take full advantage of the step-up in basis which occurs at the client’s death under § 1014.
Seth W. Whitaker, Ltd. Co. is a personalized trusts and estates and business law firm for individuals, families, professionals, and entrepreneurs, located in Charleston, South Carolina and serving clients throughout the Carolinas. This article is not legal advice, and no attorney-client relationship is formed by reading it. Please contact us if you would like to discuss your specific situation.