Having vast sums of money is not a requirement for doing thoughtful effective estate and tax planning. Often times discussions of trusts and taxes intimidate and even scare people into inaction. Do not miss out on potentially huge tax savings. Here’s how.
Taxation of the “Grantor” Trust
A “grantor trust,” broadly speaking, is a trust (or portion thereof) in which the grantor (or, in some cases, someone else) is treated as the owner of all or a portion of the trust assets and trust income. While generally a taxable entity, a grantor trust is essentially ignored for tax purposes. As discussed below, grantor trusts allow for useful gift and estate tax planning ideas.
Nature of a Trust
Before getting into the taxation of a grantor trust, let’s a take a step back and examine what a “trust” is. Existing as far back as Roman times, a typical trust is a fiduciary relationship created by law in which a grantor (or settlor) transfers assets into trust for the benefit of someone else (called beneficiaries). A third participant called a trustee – which may be the grantor – manages the trust assets and income earned on the trust assets (or trust corpus or trust principal) for the benefit of the beneficiaries.
The trust arrangement creates a number of different property rights including rights to the trust income and rights to the trust corpus after time or specified events (a “remainder interest”). The remainder interest may be held by the grantor (a “reversionary interest”). Additionally, the grantor may hold the income interest. For more on trusts, click here.
One aspect of trust accounting is critical to the grantor trust rules. Specifically, a trust’s income items are either allocated to current income (often referred to as “ordinary income”) or to the trust’s corpus. Under the grantor trust rules, a grantor – or in some cases a beneficiary – may be taxable on the ordinary income, the income allocable to the trust corpus, or both. Ordinary income items include rental income, interest and dividends, while income allocable to corpus includes capital gains. For more on trust accounting, click here.
Trusts are generally taxable entities; in general, a trust will be taxable on undistributed income. They have their own progressive rate structure, and that rate structure is compressed. A trust hits the highest marginal rate (currently 39.6 percent) at a lower income level ($12,400) than will an individual, who hits the 39.6 percent marginal rate at approximately $415 thousand (approximately $467 thousand for married-filing-joint returns). The relationships between the rate structures for trusts and individuals play an important role in the history of the grantor trust.
The grantor trust is an exception and has become an important estate and gift tax planning tool. Recall that the effect of the grantor trust is to not tax the trust itself, but to tax another person, in most cases, the grantor, or in some cases, the beneficiaries. Precisely who gets taxed depends on the powers over the trust assets and income held by the parties to the trust.
Evolution of the Grantor Trust Rules
To best understand the grantor trust rules, let’s go back in time to the 1930s when there were numerous individual income tax brackets and marginal rates reaching as high as 63 percent in the highest bracket. This created significant incentives to “shift” income from a high bracket taxpayer, where, again, the top statutory rate reached 63 percent, to lower bracket taxpayers. The landmark Helvering v. Clifford Supreme Court case, for example, involved an attempt by a taxpayer (Clifford) to shift income to his wife (joint returns did not yet exist) through the use of a trust. Clifford transferred securities to a revocable trust with income payable to, or accrued for the benefit of, his wife, who paid taxes at a lower marginal rate because she had lower total income. The trust had a five year term, after which time, the securities reverted back to Clifford (i.e. he had a reversionary interest).
The Internal Revenue Service (“IRS”), through its then Commissioner (Helvering), challenged the arrangement arguing that Clifford should be treated as the owner of the trust for income tax purposes and taxable (at higher marginal rates) on the trust’s income. The Supreme Court concluded that Clifford’s dominion and control over the trust led “irresistibly” to the conclusion that Clifford, as grantor, continued to “own” the trust’s securities despite the trust arrangement. Thus, Clifford, rather than his wife as the income beneficiary, was taxable on the trust’s income.
The Clifford decision formed the foundation for regulations known as the Clifford Regulations (issued in 1946) which, in turn, formed the basis for the current statutory structure – enacted in 1954 – applicable to grantor trusts. Internal Revenue Code Sections 671-679 , often referred to as “subpart E,” provide the grantor trust rules. The intent was to prevent this shifting of income through trusts by taxing the grantor at the grantor’s applicable marginal tax rate.
But as the late tax lawyer Martin Ginsburg observed, “[e]very stick crafted to beat on the head of a taxpayer will metamorphose sooner or later into a large green snake and bite the [IRS] commissioner on the hind part.” Tax reform in 1986 dramatically reduced the number of tax brackets and significantly lowered the statutory tax rates, while also implementing a very compressed and progressive tax rate structure for trusts; as mentioned above, a trust under current law will reach the its top marginal rate faster than will an individual. This, then, created the opposite incentive: to shift income away from the trust and back to the grantor. Grantor trusts are often referred to as “defective trusts” since the objective is to, generally speaking, make the grantor taxable on the trust income rather than the trust being a taxable entity.
So, What is a Grantor Trust?
As the Helvering v. Clifford case shows, whether a trust will be taxable as a separate entity or, alternatively, ignored and taxed to the grantor is a function of control and retained interests. What makes any particular trust a grantor trust for tax purposes is a function of the powers over the trust assets retained, broadly speaking, by the grantor of the trust or held by the beneficiaries. Code Sections . Grantor trusts include:
- Trusts that are revocable by the grantor;
- Trusts in which the grantor retains a material reversionary interest;
- Trusts in which the grantor retains rights to deal with trust corpus on a favorable basis (for example, loans); and
- Trusts in which a party to the trust – typically the grantor, though it may also be a beneficiary – hold certain powers over the trust corpus and/or income.
For more on the history of grantor trusts, see this outline.
Tax Consequences to a Grantor Trust
As alluded to throughout this article, a grantor trust is an exception to the general taxation of trusts, and the grantor trust rules essentially tax the grantor (or in some cases, a beneficiary) on, generally, the portions of the trust in which the grantor retains control or a reversionary interest. Thus, a trust’s ordinary income may be taxable to the grantor, the income allocable to the corpus may be taxable to the grantor or both. That portion of a trust that is not a grantor trust remains a taxable entity subject to tax, generally, on what it does not distribute to beneficiaries or income recipients. Put simply, a grantor trust is generally ignored for federal income tax purposes. This creates opportunities for estate planning since transfers to a grantor trust often avoid gift taxation. As long as relative rates – between the progressive rate structure applicable to trusts versus that applicable to individuals – favor the individual, grantor trusts will remain a prominent planning tool.
This article provides a brief introduction to the grantor trust. The taxation of trusts, however, is complicated, more so when only a portion of a trust is considered a grantor trust. One should always consult qualified tax advisors when determining how to treat a particularly trust arrangement.