A prior blog discussed the taxation of trusts generally and that they could be taxed as grantor trusts or nongrantor trusts. This blog will focus on the advantages and disadvantages of taxation as a grantor trust.
A grantor trust is one that is taxed to the grantor (or other substantial owner) pursuant to the rules of Section 671 and following sections of the Internal Revenue Code. For example, if you can revoke the trust, it’s a grantor trust pursuant to those rules. A grantor trust, such as revocable trust, is taxed directly to the grantor and the grantor reports the income of the trust on his or her own Form 1040.
So, you can just give the grantor’s social security number to the bank or other payer of income and the income will be taxed to the grantor, just as if the grantor owned it outright. Even if the trust is irrevocable and the grantor isn’t even a beneficiary, it may still be a grantor trust.
For example, if the grantor retains the power to substitute assets, the trust would be a grantor trust and taxed to the grantor. If the trust is a grantor trust, the income is taxed to the grantor even if the income and other distributions actually go to someone else.
Here are some of the advantages of a grantor trust:
- The taxation is simple. No separate return is required. The income is taxed to the grantor on the grantor’s income tax return, whether the income is distributed to the grantor or to someone else.
- When the grantor pays the tax on the trust’s income it’s not a gift. If the income is retained in the trust, the trust can grow free from income tax, thus maximizing the power of gifting.
- The grantor and the grantor trust are the same person for income tax purposes. Therefore, a transaction between the grantor and the trust is disregarded.
Let’s look at a quick example of the power of a trust being a grantor trust. Let’s say the grantor trust is irrevocable and designed to be outside the estate of the grantor, John. John contributes $100,000 in cash to the trust. The trustee invests in land that appreciates dramatically and is worth $3 million shortly before John’s death. While the family likes the appreciation, they are concerned about the future capital gain.
So, John purchases the land from the trust for fair market value. John gives the trust cash and a note in exchange for the property. This transaction between the trust (which is a grantor trust as to John) and John does not trigger the realization of the gain in the property. It is like selling a property to yourself. Since the transaction is for fair market value, it isn’t a gift taxable event, either. When John dies the following year, the property will be included in his taxable estate and will receive a step-up in basis. A grantor trust can be a great tool for situations like this.
The disadvantages of the grantor trust are the flipsides of the advantages. The grantor may not want to make pay the tax on the income the trust generates, even though it’s a transfer free from gift tax.
For example, let’s say the grantor sets up an irrevocable trust for children from a prior marriage or an ex-spouse. The grantor may not want to pay the income tax for that trust, even though doing so would be free of gift tax if the trust were a grantor trust.
Trusts can be powerful tools. A trust may be taxed as either a grantor trust or a nongrantor trust. They both have advantages and disadvantages. In choosing a trust, it’s important to consider whether you want it taxed as a grantor trust or a nongrantor trust. What kind of trust taxation is right for your situation?
Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
- The Magic of Grantor Trusts - September 19, 2023
- IRS Confirms Grantor Trust Status Alone Does Not Cause a Step-Up in Basis - August 15, 2023
- Double Your Gifting with Spousal Gift-Splitting - January 11, 2022