Author: Jeffrey D. Scibetta
Originally published in October 2017
Copyright © 2017 Knox McLaughlin Gornall & Sennett, P.C.
The concept of a “grantor trust” is one that is derived from the federal tax code, although you will not find the term “grantor trust” anywhere in the Internal Revenue Code (“IRC” or “Code”) or the income tax regulations issued under the Code.
A “grantor trust” is a trust in which the grantor (or some other person) retains control over the trust to such an extent that the grantor (or such other person), rather than the fiduciary or beneficiary, is treated for federal income tax purposes as the owner of all or part of the trust, and is therefore taxed directly on the income and/or other tax attributes of the trust.
In the case of a grantor trust, the trust’s separate legal existence is (for federal income tax purposes) disregarded altogether. So instead of the trust’s income and other tax items being allocable as between the fiduciary and the beneficiary, those parties are in effect disregarded, those items are imputed directly to the grantor as if the trust did not even exist.
A “grantor trust” can, in a given case, be either revocable or irrevocable, although most types of “grantor trusts” involve an irrevocable trust.
Certain types of trusts (such, as for example, a revocable trust) are disregarded not only for income tax purposes but also for federal estate and gift tax purposes. However, most types of grantor trusts are irrevocable trusts that are recognized for federal estate tax and other purposes but not for federal income tax purposes.
Applicable Tax Rules
The tax rules governing “grantor trusts” are set forth in IRC §§671 through 678, and the regulations under those Code sections.
Historical Background / Reason for the Grantor Trust Rules
The grantor trust rules were first developed in the late 1960s in order to thwart taxpayers’ use of trusts to shift income into lower tax brackets. At the time the grantor trust rules were first developed, trust income tax rates graduated at the same rate as individual income tax rates, and so it made sense for wealthy grantors to fund trusts that benefitted their offspring solely for the purpose of utilizing the lower income tax rates that applied to the trusts. It was also possible to transfer assets to a trust for a number of years and have those assets revert back to the grantor after that time period had passed.
So, the combination of those circumstances made it possible for wealthy individuals to establish multiple trusts that benefitted other family members (such as children or grandchildren), were taxed at a lower income rate during that time, and then ultimately have the trust assets revert back to the grantor afterward.
That was perceived by some as an abuse of the tax rules then in existence, and so the grantor rules were developed to combat that abuse by tracing the income generated by the trust assets back to the grantor in those circumstances where the grantor retained too much control over the trust.
Changes in Tax Rates Applicable to Trusts
As part of the Tax Reform Act of 1986, the income tax rates applicable to trust were completely revised. Under the law in effect today, the income tax rates for trusts and for individual are the same, BUT trust income tax rates graduate much more quickly than individual income tax rates. A trust therefore does not have to have very much taxable income before it reaches the top marginal tax rates.
Because of this fact, trusts are not as useful a tool for shifting income into lower tax brackets. Therefore, the original rationale for the grantor trust rules (to combat income shifting) for the most part no longer applies, BUT the grantor trust rules remain a part of the Internal Revenue Code today largely for historical reasons.
As just noted, even though the original rationale for the grantor trust rules no longer apply, the grantor trust rules remain a part of the fabric of the tax code. Taxpayers and their advisors have come up with creative ways to utilize the grantor trust rules to their own advantage.
So, in other words, the grantor trust rules were originally created to give the IRS additional tools to combat practices that were perceived as abusive. But today taxpayers often utilize grantor trusts affirmatively in order to achieve specific tax objectives and other objectives.
When trusts are intentionally designed as grantor trusts for tax purposes, they are sometimes called “intentionally defective” trusts or “intentionally defective grantor trusts” (also called “IDGTs”). Some of the ways in which a grantor trust can be used affirmatively by taxpayers include the following:
One of the most common ways that grantor trusts are used is to avoid probate. Creators of trusts (at times called “Settlors” or “Grantors”) commonly establish and fund trusts that are, by their terms, amendable or revocable at the behest of the settlor. Such trusts are typically called “revocable trusts”. If a trust is revocable, then under the grantor trust rules, the trust’s existence will be disregarded for federal tax purposes, and all of the trust income/deduction/credit/etc. will be imputed to the grantor of the trust.
Medicaid/LTC Planning - Exemption for Gain on Sale of Residence
In planning for long-term care (“LTC”) (also sometimes called “elder care planning” or “Medicaid planning”), it is common to transfer assets out of a Medicaid applicant’s name and into an irrevocable trust in order to minimize the applicant’s countable resources in the hope of accelerating the applicant’s ability to qualify for Medicaid funding of his/her LTC. The particular type of trust to be used is an irrevocable trust over which the Medicaid applicant retains at least some right to draw income from the trust but no right to withdraw trust principal.
This particular type of trust is sometimes known as an “income only” trust” or a “Medicaid asset protection trust”. One of the challenges with this particular type of trust is to determine which assets to use to fund the trust. One of the most common assets used to fund a Medicaid trust is the individual’s home. The home is a particularly attractive asset for Medicaid planning because of the fact that the trust agreement can be written in a way that allows the transferor/applicant to live in the home for the rest of his lifetime.
However, if the Medicaid trust were treated the same as most other types of trusts for federal income tax purposes, then transferring the home to the Medicaid trust could possibly be disadvantageous for tax purposes. This is so because if the applicant were to sell the house himself, any gain realized on the sale of the home would be tax-exempt up to $250,000 ($500,000 in the case of married couples) if certain tax requirements are met.
Conversely, if the home is sold by the trust, and if the trust is recognized as a separate taxpaying entity, then the exemption for gain realized on the sale of the home would be lost. The exemption would be lost because, as to the trustee/seller, the property is not a “home”.
In order to avoid loss of the exemption for gain on the sale of a personal residence, the trust can be structured as a grantor trust for federal tax purposes. Because a grantor trust’s existence is disregarded for federal income tax, the applicant is viewed as the seller, even though the property is actually owned and sold by the trust.
Family Planning – Avoiding Trusts’ Compressed Tax Brackets
Often a wealthy individual may wish to make gifts to children or other family members, but they may not want to give cash or other valuable assets directly to those family members, perhaps because of their age and immaturity, perhaps because they’re not good at handling money, or possibly for other reasons. The donor may therefore decide to instead give the funds to a trustee to manage for the benefit of the intended beneficiary at least until such time as the donor thinks the beneficiary will be ready to receive the funds outright. If the trust is recognized for tax purposes as a separate taxpaying entity, it will often prove to be disadvantageous from a tax standpoint because of the compressed tax bracket structure applicable to trust for federal income tax purposes. For that reason, the donor may wish to structure the trust as a grantor trust for federal tax purposes, so that the trust’s income can be taxed to the grantor (or possibly to the beneficiary) if the marginal tax rate applicable to the grantor (or beneficiary) is lower than that of the trust, as it often will be.
Federal Estate Tax Planning – “Leveraging” the Gift
Grantor trusts are often used as means to enhance the value of a gift to a beneficiary even beyond the value of the item given. This is sometimes referred to as “leveraging” the gift. If a donor creates a trust to benefit an individual (the beneficiary) and if the trust never has to pay tax on the income earned on the entrusted funds, then the gift has a value to the beneficiary that is even greater than its value at the time of the gift. This can be accomplished by structuring the trust as a grantor trust. The grantor is treated as the owner of the entrusted assets, and therefore has to pay the tax on any income generated on the trust assets.
The grantor is in effect paying “an additional gift” each year to the beneficiary in the amount of the taxes paid by the grantor on the trust income. The accumulated trust income will ultimately be distributable to the beneficiary free of tax, even though the beneficiary never had to pay tax on that income. The one disadvantage to the grantor to be aware of is that the tax burden from the trust income could present a “cash flow” issue to the grantor.
Protecting Business Assets
Often, it will be advantageous for non-tax reasons to have a small business corporation’s stock held in trust. The most important non-tax reason for entrusting the corporation’s stock is to protect ownership of the company in the event that the person holding the stock gets sued or gets divorced or develops financial or other personal problems at a future point in time. Most small business corporations are structured as “S Corps” for federal tax purposes. S Corporations are corporations that have made a special tax election that permits them to be taxed at only one level (as opposed to two levels for most other types of corporations) on their corporate income. Protecting an S Corporation’s “S Election” is therefore generally a very important thing.
In order to qualify as an S Corporation, a corporation must meet a number of requirements. One of the requirements for the S Election is that only individuals and certain types of trusts are permitted shareholders. A “grantor trust” is designated by statute as one of the types of trusts that are permitted to hold stock of an S Corp. Because the trust is in effect a “look through” entity for federal tax purposes, the IRS views it as though the grantor holds the S Corp stock directly. Because the grantor is an individual, the corporation will meet the S Corp requirement that the corporation’s stock only be held by permitted shareholders.
Identifying the Grantor
The “grantor” of a trust is the person who provides the property or other funds to the trust that becomes the trust corpus (assets). It is the person who funds the trust. In most cases, the person who funds the trust is identified in the trust agreement as the person who created the trust (i.e. the settlor/grantor). However, for federal tax purposes, the criterion for determining who the grantor is is who funded the trust, not who is identified as the grantor in the trust agreement.
If an individual is identified as the grantor in the trust agreement, then he will presumptively be treated as the grantor, and that person will have the burden of proving that he did not supply the cash or property that funded the trust.
It is possible for a trust to have multiple grantors. If more than one person funded the trust, then they will each be treated as grantors in proportion to the value of the cash or property that they each provided to fund the trust.
If a trust has a U.S. person as a beneficiary and a foreign person would be treated as the owner of the trust under the grantor trust rules, the beneficiary is treated as the grantor of the trust to the extent that the beneficiary made gifts (directly or indirectly) to the foreign person.
Example #1: A is a U.S. citizen and B is a foreign person. A gives property valued at $100,000 to B’s wife who in turn gives other property of equivalent value to B. B transfers the property that she received from A to a trust of which A is a discretionary income beneficiary. A is treated as the owner of the trust in which he has an income interest and is therefore taxed on the trust income without regard to whether it is distributed to him.
Powers Held by Grantor’s Spouse
For the purpose of the grantor trust rules, the grantor of a trust is treated as owning any powers or interests held by his or her spouse. Accordingly, a grantor cannot circumvent the grantor trust rules by having prohibited powers or interests held by the grantor’s spouse.
Example #2: Lois and Clark are married. Lois funds a trust and gives Clark a reversionary interest in the trust that take effect 5 years after the trust is created. Lois is treated as the owner of the trust assets and is taxed on the trust income.
The term “grantor trust” is often used generically to describe any type of trust arrangement where the trust’s existence is disregarded for federal tax purposes and some person other than the trustee is treated for tax purposes as the “owner” of the trust assets and taxed accordingly.
In most types of grantor trusts, the person who creates and funds the trust (the grantor) has retained some “strings” that cause that person (the grantor) to be treated as owning the trust assets and taxed accordingly. So, in those types of grantor trusts, it is the grantor (also sometimes called the “settlor” or “trustor”) who is subject to tax on any taxable income earned by the trust. However, if a person other than the grantor retains certain powers over the trust assets, then that person can be treated as the owner of the trust and taxed on the trust income.
Grantor Owned Trusts (Type 1)
The first and most common type of “grantor trust” is the type where the person who is the “grantor” is the deemed owner and is taxed on the trust income. There are many different types of powers that can cause the grantor to be treated as the owner of the trust, and taxed on the trust’s income. The rules that cause a grantor to be treated as the owner of the trust are set forth primarily in IRC §§673 through 677. Other Code provisions, specifically IRC §§671 and 672, lay the foundation for the grantor trust rules, but the specific triggers for treating a grantor as the owner of the trust assets are set forth in IRC §§673 through 677.
Beneficiary Owned Trusts (Type 2)
A second type of “grantor trust” involves a trust where a person other than the grantor is treated as the owner and therefore taxed on the trust’s income. Under IRC §678, a person other than the grantor (almost invariably a trust beneficiary) is treated as the owner of the trust and taxed on the income earned by the trust if that person:
Grantor Trust Powers Generally (IRC §671)
IRC §671 sets forth the general principle that if the grantor (or another person) is treated as the owner of any part of a trust, then the grantor (or such other person) must include the trust’s tax items (income, deduction, and credits) in calculating his or her own personal taxable income and credits against tax. §671 is the basic foundation on which the more specific grantor trust rules are premised.
Definitions and Rules (IRC §672)
In order to understand how the grantor trust rules are applied, it is necessary to understand the meaning of certain terms and rules that are defined in IRC §672.
“Adverse Party.” An “adverse party” is defined as any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise (or non-exercise) of the power which the person possesses in regard to the trust.
So, for example, a trustee is not an adverse party merely because of his interest as a trustee. However, a trustee with the power to distribute income or corpus to himself is an adverse party.
“Non-adverse Party.” A “non-adverse” party is defined as any person who is not an adverse party.
“Related or Subordinate Party.” A “related or subordinate party” is defined as any non-adverse party who is:
Reversionary Interests (IRC §673)
The “5 Percent” Rule – Under IRC §673(a), a grantor is treated as the owner of trust assets if:
Valuation Date. The value of the reversionary interest is measured on the date that the property subject to the reversionary interest is transferred to the trust.
Valuing the Reversionary Interest. Under IRC §7520, the reversionary interest is valued under tables issued by the IRS, based on the federal midterm interest rate in effect for the month in which the transfer is made. One must first determine the applicable interest rate, which is published monthly by the IRS. Once the interest rate is determined, you must go to the applicable IRS table, which will set forth a valuation factor, based on the prevailing interest rate and the number of years (in the case of a reversion following a term interest) or the life expectancy (in the case of a reversion following a life interest).
The IRS has issued Table B for valuing a reversionary interest that takes effect following a term of years. The IRS has issued Table S for valuing a reversionary interest that takes effect on the death of some person (such as the beneficiary).
Example #3: G creates a trust that benefits his son, S, for 25 years. Under the terms of the trust, S receives income from the trust for 25 years after which the corpus reverts back to G. The transfer to the trust is made in April 2017. In April 2017, the midterm rate is 2.6%. So one must go to Table B to value the grantor’s reversionary interest because it follows a term interest. Table B reveals that, at an interest rate of 2.6%, the valuation factor for a remainder/reversionary interest following a 25 year term is 0.526400. So G’s reversionary interest is 52.64% of the value of the interest conveyed to the trust. So the trust is a grantor trust as to G, based on IRC §673(a).
Exception – Interests following a Minor Child. IRC §673(b) sets forth an exception to the general rule regarding reversionary interests. Under this exception, a grantor will not be taxed as the owner of a trust solely on the basis of a reversionary interest that takes effect upon the death of a lineal descendant (child or grandchild) before that beneficiary reaches 21 years of age.
Example: G transfers property to a trust. Under the terms of the trust, the trust will pay income to G’s daughter, D, until she reaches age 30, at which time the trust will terminate and the trust principal will revert back to G. If D dies prior to reaching age 21, the trust terminates, and the trust principal reverts back to G at that (earlier) time. Under these facts, G is not treated as the owner of the trust.
Capital Gains. If a grantor retains a reversionary interest in property transferred to a trust, then he is taxed on the capital gains attributable to the reversionary interest. The capital gains are taxed to the grantor because they are deemed to be accumulated as part of the trust corpus for future distribution to the grantor. [IRC §677(a)(2).] (NOTE: The requirement that the reversionary interest exceed 5% of the value of the transferred property does not apply because it is taxed under a different Code section.)
Example #4: G transfers property for the benefit of his son, S, who is 8 years old at the time. Under the terms of the trust agreement, the trust’s ordinary income (dividends, interest, etc.) is distributable to S during his lifetime and capital gains are added to corpus. The trust agreement further provides that the trust will terminate when S dies and at that time, the trust corpus will revert back to G. G is taxed on any capital gains realized by the trust.
Exception – Capital Gains Allocated to Income (rather than Corpus). If, under the terms of the trust agreement, capital gains are allocated to income rather than to corpus, then the grantor’s reversionary interest in the corpus would not cause him to be taxed on the trust’s capital gains.
Example #5: Same facts as the earlier example, except that, under the terms of the trust agreement, capital gains are allocated to trust income rather than to corpus. Now G will not be taxed on any capital gains realized by the trust.
Power to Control Beneficial Enjoyment (IRC §674)
General Rule. IRC §674(a) sets forth the general rule that a grantor is treated as the owner of a trust and taxed on its income if the grantor or a non-adverse party (or both) have the power to affect the beneficial enjoyment of the trust corpus or income without the approval or consent of an adverse party.
Example #6. If the grantor holds the power to sprinkle the trust’s income among beneficiaries of the trust, then the grantor will be treated as the owner of the trust’s ordinary income.
Example #7: If the grantor holds the power to sprinkle the trust’s corpus among beneficiaries of the trust, then the grantor will be treated as the owner of the income allocable to corpus, such as capital gains and also the trust’s ordinary income, because the power affects future income distributions from the trust.
Exceptions. There are a number of exceptions to the general rule (that a grantor is treated as the owner of a trust if he can affect the beneficial enjoyment of the trust corpus or income). Under these exceptions, which are set forth in IRC §674(b), (c) & (d), certain classes of persons are permitted to exercise specific powers over the beneficial enjoyment of the trust without triggering grantor trust status.
Powers Exempt WITHOUT REGARD to Holder. IRC §674(b) lists certain powers that can be held by anyone, including the grantor, without causing the grantor to be treated as the owner of the trust.
Power to Apply Income to Support a Dependent. A power to distribute trust income to support a beneficiary whom the grantor is legally obligated to support does not cause the trust to be treated as a grantor trust, except to the extent that the income is in fact used for such purpose. This exception applies even if the power is held by the grantor or the grantor’s spouse. [IRC §674(b)(1).]
Power affecting Beneficial Enjoyment only after the Occurrence of an Event. A grantor will not be treated as the owner of a trust based on a power to affect beneficial enjoyment of the trust if that power is not exercisable for a long enough time period such that, had the postponed power been a reversionary interest, it would not have triggered grantor trust status under IRC §673. Thus, a power to control beneficial enjoyment does not trigger grantor trust status if it cannot be exercised by the grantor (or a non-adverse party) for a period of time that, if the power had been a reversionary interest, it would have a value of less than five percent (5%) of the trust. To determine whether this criterion is met, it is necessary to determine the prevailing interest rate, and then go to the applicable IRS Tables under the regulations. However, after the stated event has occurred (e.g. expiration of a stated time) and the power becomes immediately exercisable, the grantor will be treated as the owner unless he relinquishes the power earlier. [IRC §674(B)(2).]
Power exercisable only by Will. A grantor will not be treated as the owner of a trust based on a power to affect beneficial enjoyment if the power is exercisable only by Will, except for a power to appoint accumulated trust income by Will if the trust provides for the mandatory or discretionary accumulation of trust income by the grantor or a non-adverse party. [IRC §674(b)(3).]
Example #8: Grantor creates a trust and gives an independent bank trustee the power to accumulate income or pay it currently to the beneficiaries. Grantor retains a testamentary power to appoint any accumulated income among the beneficiaries. The bank is an independent trustee but is a non-adverse party. So grantor’s ability to appoint the accumulated income causes him to be treated as the owner of the trust.
Power to Allocate Among Charitable Beneficiaries. A grantor will not be treated as the owner of a trust based on a power to determine the beneficial enjoyment of the trust corpus or income if the corpus or income is irrevocably payable for a charitable purpose as defined in IRC §170(c). [IRC §674(b)(4).]
Example #9: Grantor creates a trust that provides that the income is payable to specified educational institutions, but the grantor retains the ability to allocate income among those institutions. Grantor is not taxed on the trust’s income.
Power to Distribute Corpus Limited by a Standard. A grantor will not be treated as the owner of a trust based on a power to distribute corpus to beneficiaries if the grantor’s power to distribute the corpus is subject to a reasonably definite standard which is set forth in the trust instrument. [IRC §674(b)(5).]
Example #10: A power to distribute corpus for the “health, education, maintenance or support” of the beneficiary is subject to a reasonably definite standard.
Example #11: A power to distribute corpus for the “pleasure”, “desire” or “happiness” of the beneficiary is not limited by a reasonable definite standard.
Power to Withhold Income Temporarily. A grantor will not be treated as the owner of a trust based on a power to distribute or apply income to any current beneficiary or to accumulate the income if the accumulated income must ultimately be paid to one of the following:
Power to Withhold Income during Minority of Disability. A grantor will not be treated as the owner of a trust merely because the grantor (or a non-adverse party) holds a power to distribute income or to accumulate income and add it to principal during a time when the income beneficiary is under 21 years of age or is under a legal disability. Furthermore, income withheld during such periods need not ultimately be payable to the income beneficiary or his or her estate. It can be paid to whomever the trust names as recipient of the trust principal.
Powers Exempt ONLY for an INDEPENDENT TRUSTEE. IRC §674(c) enumerates powers that will not trigger grantor trust status if they are held by an independent trustee. An independent trustee may be given fairly broad powers over beneficial enjoyment without causing the grantor to be treated as the owner. Examples:
Administrative Powers (IRC §675)
General Rule. The grantor is treated as the owner of a trust if he possesses certain administrative powers which are exercisable for his benefit rather than the beneficiaries. The existence of such powers may be determined either from the wording of the trust instrument or from the way in which the trust is actually operated.
Categories of Administrative Powers. The prohibited administrative powers fall into four (4) basic categories.
Power to Revoke (IRC §676)
General Rule: The grantor will be treated as the owner of any part of a trust in which the grantor (or a non-adverse) party has the power to revest title to trust assets in the grantor. In other words, if the grantor (or a non-adverse party) has the power to revoke any part of a trust and reclaim the trust assets, then the grantor will be taxed on the trust income. [IRC §676(a).]
Power to Revoke Held by a Non-adverse Party. The grantor will be taxed as the owner of a trust even if the power of revocation is held by a person other than the grantor unless that person’s interest is adverse to that of the grantor. [IRC §676(a).]
Power to Revoke with the Consent of a Non-Adverse Party. Similarly, the grantor will be treated as the owner of a trust if the grantor holds a power of revocation even if that power can only be exercised with the consent of a trustee who has no economic interest in the trust. [IRC §676(a).]
Power to Revoke with the Consent of an Adverse Party. Although the statute is silent on this point, the regulations make clear that if the grantor’s power to revoke is conditioned on the consent of an adverse party, then the power will not cause the grantor to be treated as owning the trust assets. [Reg. §1.676(a)-1.]
Power to Alter, Amend or Terminate. The regulations clarify that a power of revocation will trigger grantor trust status, even if it is not described as such. So, for example, an unlimited power to “alter” or “amend” or “modify” the trust or a power to “terminate” the trust would likewise be viewed as effectively a power of revocation over the trust assets.
Power to Revoke AFTER Occurrence of an Event. A power to revoke does not create a grantor trust under Section 676 if the power of revocation can only be exercised after a time period that is so long that, if the power to revoke had been a reversionary interest, ownership of that interest would not cause the trust to become a grantor trust pursuant to IRC §673. Thus, a power to revoke will not trigger grantor trust status if it cannot be exercised for a period of time that is so long that, the power of revocation (if it had been a reversionary interest) would not be valued at more than 5% of the trust assets.
Income for the Benefit of the Grantor (IRC §677)
General Rule: The grantor will be treated as the owner of any portion of a trust if the income from the trust is or may, in the discretion of the grantor (or a non-adverse party) be:
This rule applies whenever income is distributable by the grantor, his spouse, or a non-adverse party without the consent of an adverse party. [IRC §677(a).]
Exception – If Consent of Adverse Party Required. The grantor is not treated as the owner if the consent of an adverse party is required to make the distribution to (or for the benefit of) the grantor or his/her spouse.
Distribution of Income. The grantor will be treated as the owner of the trust if the trust income is, or can be:
Accumulation of Income. The grantor is treated as the owner of a trust if income is accumulated for future distribution to the grantor or his/her spouse without the consent of an adverse party. The grantor is taxed in the current year, even if he must wait for an extended period of time before obtaining access to the accumulated income. [IRC §677(a)(2).]
Exception – 5% Rule. If the value of the income accumulated for future distribution to the grantor does not exceed 5% of the value of the trust, the income is not taxed to the grantor.
Example #12. G creates a trust and under the terms of the trust agreement, the trust is to accumulate income for 10 years, and then at the discretion of the grantor (or a non-adverse trustee) may be distributed to the grantor. Assuming that the applicable rate for discounting the accumulated income interest under Table B is 6%, the discounted value of the accumulated income will be well in excess of 5% of the trust value, and so the grantor will treated as the owner of the trust and taxed on the income.
Payment of Insurance Premiums. The grantor is treated as owning a trust if the trust income is, or may at the discretion of the grantor (or a non-adverse party), be applied to pay premiums on policies insuring the life of the grantor (or the grantor’s spouse). [IRC §677(a)(3).]
Exception – Unfunded Trusts. The grantor will not be taxed if the grantor did not transfer any income producing property to the trust. So, most life insurance trusts that are not funded with assets other than an insurance policy ordinarily do not trigger the grantor trust rules.
Support of the Grantor’s Dependants. A grantor is not treated as the owner of a trust merely because the trust income, at the discretion of the grantor (as trustee) or another person, may be used for the support of a beneficiary (other than the grantor’s spouse) whom the grantor is legally obligated to support. The grantor is only taxed on the trust’s income if the income is actually distributed for such purposes. [IRC §677(b).]
However, the “support” exception does not apply if trust income is required (without any discretionary determination) to be applied to support a beneficiary whom the grantor is obligated to support. In such a case, the grantor will be taxed on the trust income under the general rule of §677(a).
Persons Other than the Grantor treated as Owner (IRC §678)
General Rule: Under IRC §678, a person other than the grantor of a trust (such as, for example, a trust beneficiary) will be treated as owning the trust assets if that person holds one or more of the following powers:
Power to Withdraw Principal or Income. A person (ordinarily a trust beneficiary) is deemed to own any part of a trust over which such person has the power “solely exercisable by himself to vest the corpus or the income in himself.” [IRC §678(a)(1).]
A §678 withdrawal power will cause the holder of the withdrawal power to be treated as owning the trust (or part of the trust) even if it is never exercised. A §678 withdrawal power causes the holder to be treated as the trust owner even if the trust income or corpus is paid to someone else. The holder will only be treated as the owner if he can exercise the withdrawal solely by himself and without consent or approval of any other persons. So, for example, if a trust beneficiary owns a withdrawal power that can only be exercised with the consent of his spouse, parents, or children, the beneficiary will not be treated as the owner of the assets.
Partially Released Withdrawal Powers. Even if a beneficiary does not currently hold a §678 withdrawal power, the beneficiary can still be treated as owning the trust (or a portion thereof) if he previously held and released a withdrawal power, and if, after the release of that power, the beneficiary still retains such control over the trust as would cause a grantor of the trust to be treated as the owner under the grantor trust rules (§§671-677). [IRC §678(a)(2).]
This rule prevents a beneficiary from ending his deemed ownership of a trust by releasing a withdrawal power while still retaining a significant degree of control over the trust assets. Thus, by way of example, a beneficiary who releases a power of withdrawal over trust assets will still be treated as owning the trust assets if, following the release:
Example #13: Grantor creates a trust for the benefit of his children, A, B and C. Under the terms of the trust agreement, B is named as Trustee and has the power to sprinkle the trust income and principal among the beneficiaries (A, B and C) as he sees fit. In addition, B is given a general power of appointment (i.e. effectively a withdrawal power) over the trust assets. B relinquishes his power of appointment (withdrawal power). After B has released the withdrawal power, B retains the right to allocate income and principal among the beneficiaries, including himself without regard to any definite standard. Accordingly, even after releasing the withdrawal power, B is treated under IRC §678(a)(2) as still owning the trust assets because he has retained a “grantor trust-like” power over the trust assets under IRC §677.
Payments Discharging a Support Obligation. A beneficiary will not be treated as owning the trust under IRC §678 merely because he has the power to apply trust income to support or maintain a person whom he is already legally obligated to support, provided that the beneficiary holds that power in a fiduciary (trustee) capacity. However, if trust funds are actually used to discharge the beneficiary’s legal support obligation, then the actual application of the trust funds for that purpose will be treated as a trust distribution to the beneficiary holding the power.
Also note: This exception does not apply if the beneficiary holds the power in a non-fiduciary capacity. If the beneficiary holds the power to apply trust funds in a non-fiduciary capacity, then the mere holding of the power will cause the beneficiary to be treated as owning the trust assets.
Grantor creates a trust for the benefit of his 4 nephews, A, B, C and D, all of whom are minors. Grantor names his sister, T, trustee of the trust. T is the mother of A, B, C and D. As trustee, T is authorized to sprinkle trust income among A, B, C and D. Because T holds that power in a fiduciary capacity, she is not treated as owning the trust assets. However, T will be taxed on any income that is actually distributed to A, B, C or D.
Example #15: Assume the same facts, except that Grantor instead names a bank as the independent trustee of the trust. Even though T is not trustee in this example, she is given an overriding power to appoint the trust income among A, B, C and D, as she considers appropriate. Because T holds the power in a non-fiduciary capacity, she will be taxed on the trust income, whether or not it is in fact distributed to A, B, C, or D, or accumulated for future distribution.
When the Grantor is already treated as the Owner (“Dueling Powers”). If the grantor holds a power over the trust assets that would cause him to be treated as the owner of the trust income and the beneficiary at the same time holds a power over the same trust income that would under §678 otherwise cause him to be treated as an owner, then the beneficiary’s power is disregarded and the grantor is treated as owning the trust income. So the grantor’s powers under §§673-677 “trump” those of the beneficiary under §678.
Example #16: Grantor creates a trust in which an unrelated, independent trustee has the power to allocate income to the grantor or other beneficiaries of the trust. At the same time, beneficiary “B” holds a general power of appointment over the same trust income. B’s power of appointment is disregarded and Grantor is taxed on the trust’s income.
It may be desirable, in some instances, to structure a trust as a “grantor trust”. There could be any number of reasons for that, including (i) a desire on the part of the donor to leverage the impact of an entrusted gift, (ii) a desire to protect the tax status of an entity whose shares have been entrusted, (iii) a desire to maintain certain tax benefits that would otherwise be available to the grantor (such as the exemption for gains on the sale of a residence), etc.
In other instances, it may be more advantageous to avoid triggering the grantor trust rules. For example, a grantor might want to avoid having to pay tax on “phantom income” realized by the trust.
For a variety of reasons, including the compressed tax rate structure applicable to ordinary trusts, it will often be preferable for a trust to be structured as a “grantor trust”.
Certain grantor trust provisions will cause the trust assets to be included in the grantor’s gross estate for federal estate tax purposes, while other grantor trust rules do not cause an estate tax inclusion. If a trust is revocable, it will also be includable in the grantor’s estate for federal estate purposes. Similarly, if the grantor creates an irrevocable trust that pays income to the grantor throughout his lifetime, the trust will be taxed to the grantor for income tax purpose and also includable in his estate for estate tax purposes. If the grantor creates an irrevocable trust where a “de minimis” grantor trust power is retained – e.g. a non-adverse party other than the grantor has the power to substitute assets of equivalent value for the trust principal – there will not be an estate tax inclusion.
Obtaining Stepped-Up Tax Basis
In relatively smaller and more modest sized estates where no federal estate tax liability is anticipated, a grantor might be more concerned about potential income tax liability than about federal estate tax. One potential concern is that an asset be passed on to the grantor’s heirs with a stepped-up basis. If the grantor wants a trust asset’s tax basis to be “stepped up” at his death, then it will be necessary to trigger grantor trust status in a way that causes the asset to be treated as part of the grantor’s gross estate for estate tax purposes, so that the asset’s tax basis will be stepped up at the grantor’s death. So, for example, the grantor might retain a power of revocation over trust assets or retain an ongoing right to trust income, knowing that the retention of such rights/powers will cause the trust asset to be includable for estate tax purposes and lead to a basis step-up for income tax purposes.
Preserving the Home Sale Exemption.
If the trust is created for the purpose of protecting the grantor’s home from the reach of the long-term care creditors (such as a nursing home or the government), then it will often be advantageous to structure the trust as a grantor trust in order to preserve the grantor’s exemption from gain on the sale of a personal residence. If the trust is not structured as a grantor trust, transferring the home to a trust would cause the home sale exemption to be lost. If, however, the trust is a grantor trust, the trust’s existence is disregarded for tax purposes and so the grantor is viewed as still owning the home. Consequently, a sale of the home by the trust could still qualify for the home sale exemption. Any grantor trust power should suffice for this purpose.
Avoiding Estate Tax Inclusion
In larger estates, where the estate assets are anticipated to exceed the federal estate tax exemption, avoiding estate tax inclusion will likely be a more significant concern to the grantor. So, under such circumstances, grantors will most likely want to utilize grantor trust powers that cause the trust to be disregarded for income tax purposes but will at the same time not cause the trust assets to be included in the grantor’s gross estate for federal estate tax purposes. So, in those circumstances, the grantor will want to consider utilizing those grantor trust powers that are least likely to result in an estate tax inclusion. So, for example, the grantor might be inclined to incorporate into the trust document powers such as:
Avoiding Realty Transfer Tax
Another issue that will frequently arise when real estate is used to fund a trust is the issue of realty transfer tax. It will frequently make sense, even during the grantor’s lifetime, to authorize the trustee to distribute the trust assets to persons other than the grantor. Frequently those persons are persons who could be counted to provide for the grantor’s needs in the event that it becomes necessary to do so. The question then becomes who to include as permissible appointees under the trustee’s power of appointment. The grantor’s children are obvious candidates. But if a grantor has only a single child (or few children), then it logically makes sense to expand the circle of potential appointees.
However, under the Realty Transfer Tax statutes of many states (such as Pennsylvania), if a trustee (or other person) can appoint trust property to persons other than those who would be exempt grantees in a direct transfer of the property, then the transfer of the property to the trust can trigger imposition of the Realty Transfer Tax. In certain states (like Pennsylvania), the issue unfortunately presents itself after the transfer has already been made to the trust. Consequently, drafting such trust agreements necessitates a working knowledge of the applicable Realty Transfer Tax laws – specifically, who is an exempt grantee and who is not?
In theory, because a “grantor trust” is disregarded for federal income tax purposes, the trust’s tax items (income, deductions and credits) could be reported under the grantor’s social security number. However, for a variety of reasons, it will often be preferable to assign a separate tax identification number (“EIN”) to a trust. It will ordinarily be necessary or desirable to establish a separate bank account in the name of the trust, and that will weigh in favor of obtaining a separate EIN for the trust for a number of reasons:
First, from a purely practical standpoint, banks will resist opening an account under an individual’s social security number. In fact, one of the first things the bank will ask for when opening a trust account is the trust’s EIN.
Second, it will ordinarily be desirable, from the standpoint of other trust objectives (such as protection from creditors, keeping the trust assets out of the grantor’s estate for death tax purposes, etc.) for the trust account to have a separate EIN, so that the trust assets, income flows, etc. can be more easily segregated from those of the grantor.
So the issue becomes how to “connect” the income earned by the trust from the assets in the trust account (which reflects a separate EIN) with the grantor’s personal income tax return (which reflects the grantor’s SSN).
Income Tax Reporting Methods
Traditional Reporting Method. Under the traditional method of reporting, the trustee files a fiduciary income tax return (IRS Form 1041) BUT that return looks different from a normal fiduciary return. The top of the return is filled out, but the lines where the income, deductions, credits, etc. would normally be reported are left blank. The items of income, deduction, and credit are shown on a separate statement attached to the tax return that
Alternate Reporting Method #1. Under Alternate Method #1, the Trustee does not file a fiduciary return reporting the tax items, but instead facilitates the grantor’s tax reporting by providing information both to the grantor and to parties who are payors (to the trust). The trustee provides the grantor’s name and other identifying information (address and SSN) to all “payors” (parties that made payments to the trust during the year). The trustee furnishes the grantor with a statement that:
Alternate Reporting Method #2. Under Alternate Method #2, the trustee in essence assumes the 1099 reporting obligations of all of the various parties making payments to the trust. The trustee provides all payors (parties who made payments to the trust during the tax year) with the name and other identifying information (address and EIN) for the trust. The trustee then files Form 1099s (showing the trust as payor and the grantor as payee) with the IRS to report each of the payments with the IRS. (Under this method, the trustee has similar obligations for filing the appropriate 1099 forms as a payor making reportable payments.) The trustee must also furnish the grantor with a statement similar to the one described in Alternate Method #1.
Filing Deadline (Under the Traditional Method)
The fiduciary tax return for the trust (under the traditional reporting method) is due by the fifteenth day of the fourth month following the end of the tax year. Since trusts are required to adopt a calendar year, the filing deadline is effectively the April 15th following the end of the trust’s tax year.
Tax Reporting in Year of Grantor’s Death
In the year the grantor dies, the trust continues to report in the same manner previously used before the grantor died. Under the traditional method of tax reporting, the trustee would be required to file a fiduciary tax return for the trust tax year that ends with the decedent’s date of death. The filing deadline for the fiduciary return would be the fifteenth day of the fourth month that began with the first day of the decedent’s taxable year.
Example # 17. Grantor dies on July 1 of the year X1. The trustee must file Form 1041 reporting the grantor’s imputed share of the trust’s taxable income by April 15th of the Year X2.
The tax return must also indicate that it is the final return to be issued under the grantor’s social security number (or the EIN assigned to the trust during the grantor’s lifetime).
Tax Years after the Year of Grantor’s Death
For tax years beginning after the year of the grantor’s death, the trust is (due to the grantor’s death) no longer a “grantor trust”. Accordingly, the trust must obtain an entirely new EIN and the trustee must report the trust’s income, deduction and credits on a fiduciary return under the rules normally applicable to a trust under Subchapter J of the Internal Revenue Code, i.e., the trust is treated as a separate taxpaying entity, with trust income allocated between the trust and the beneficiaries, based on how much (if any) of the income has been distributed to the beneficiaries.
Author: Jeffrey D. Scibetta
Originally published in October 2017
Copyright © 2017 Knox McLaughlin Gornall & Sennett, P.C.