Often, there is confusion regarding the income taxation of trusts. There are two general types of trusts for income tax purposes: grantor trusts and non-grantor trusts.
A grantor trust gets its status because the grantor has one of the powers listed in sections 671-678 of the Code. Some of these powers also trigger estate tax inclusion, like the power to revoke. Thus, a RLT is a grantor trust because, as its first name suggests, it is revocable. Some of the powers do not trigger estate tax inclusion, such as the power to substitute assets. Thus, you can have a trust which is out of the grantor’s estate for estate tax purposes, but is income-taxed to the grantor. This has become known as an “intentionally defective grantor trust.”
A grantor trust is taxed directly to the grantor for income tax purposes. It can use either the grantor’s social security number or a tax ID number. Financial institutions may give some resistance on using the grantor’s social security number, but it’s right in the regulations. (See Treas. Reg. § 1.671-4).
One of the best ways to get value out of an estate is through the use of a grantor trust that is out of the estate for estate tax purposes (an intentionally defective grantor trust). With such a trust, the grantor pays the tax on the income, even though it will be held for or distributed to the beneficiaries of the trust. Let’s look at a quick example. Mary sets up a grantor trust, using $5 million of exclusion. The trust earns income of 2%, or $100,000. The $100,000 gets reported on Mary’s Form 1040 and she pays the tax, say $40,000. That $40,000 is not an additional gift to the beneficiaries or the trust. Thus, the trust gets to grow without the diminishment from payment of the income taxes.
A non-grantor trust is taxed to the trust itself. A non-grantor trust gets a distribution deduction when it makes distributions to the beneficiaries that carry out its income. This carries out the taxability to the beneficiary. Thus, a non-grantor trust which distributes the income has it taxed to the beneficiary.
Non-grantor trusts have a significantly compressed run-up in income tax rates. They hit the maximum income tax rate of 39.6% on less than $12,000. Thus, it often makes sense to distribute the income to the beneficiaries, especially if they are in lower income tax brackets.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128