Grantor trusts are a thing of beauty (well, for a tax geek, anyway). All of the income of a grantor trust is taxed to the grantor of the trust, even if it is distributed to the beneficiaries. A non-grantor trust, by comparison, is taxed to the trust itself or to the beneficiaries (if there are distributions carrying out “distributable net income”). The result is that a trust could be set up for which the income tax liability is that of the grantor. Of course, this makes sense in the case of a revocable trust. But, even irrevocable trusts may be created as grantor trusts.
For now, at least, it is possible to draft a trust so that it is irrevocable and out of the taxable estate for estate tax purposes, yet taxed to the grantor for income tax purposes. (Sometimes such a trust is confusingly referred to as a “defective grantor trust.”) Such a trust provides extra bang for the transfer-tax buck. Let’s look at an example to see the reason.
John had a taxable estate and wanted to remove as much as possible from his estate. He set up two trusts, Trust A and Trust B. He contributed $1 million to each trust. Trust A is drafted as a grantor trust, Trust B is drafted as a non-grantor trust. Each trust has $50,000 of income each year. With Trust A, the income is taxed to the grantor, increasing his tax bill by $20,000. Trust B pays its own taxes from the trust corpus. The result is that Trust A can grow at 5% per year, while Trust B grows at only 3% per year, on an after-tax basis. After 20 years, Trust A would have $2.65 million, while Trust B would have only $1.81 million. (The payment of tax by the grantor is not considered an additional gift.)
The opportunity to have the best of both worlds with a grantor trust may be coming to an end. The administration would like legislation to align grantor trust rules and estate tax rules. In other words, if Treasury has its way, all grantor trusts would be included in the taxable estate of the grantor.
While such a change would not be welcome, estate planning attorneys and their clients would be well to make hay while the sun shines. While you can, use this tool that the administration recognizes is too good a deal for the taxpayer. If you draft a trust as a grantor trust, you may want to consider using a provision that allows an independent trust protector or special co-trustee to toggle off the grantor trust status, just in case Treasury gets its way.
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: (800) 846-1555