7 minute read
Understanding the distinctions between grantor and non-grantor trusts is crucial for effective estate planning and tax management. These trust types, which can be either revocable or irrevocable, offer different levels of control and tax implications. Grantor trusts, often revocable, allow the grantor to retain certain powers over trust assets, while non-grantor trusts function as separate tax entities. This comprehensive guide delves into the characteristics of both trust types, exploring their unique features, tax treatments, and ideal use cases. Whether you’re considering an irrevocable non-grantor trust for estate tax reduction or a grantor trust for income tax flexibility, this article will help you navigate the complex world of trust planning. By understanding the nuances of grantor vs non-grantor trusts, including their definitions, taxation, and potential advantages, you can make informed decisions to protect your assets and secure your financial legacy.
Trusts have been one of the most popular tax planning tools for decades, and for good reason. Trusts can help:
However, the term “trust” encompasses a vast array of trust types, and many people feel so overwhelmed by their options that they avoid exploring trusts altogether. While looking into every type of trust would certainly be overwhelming, we can explain one simple thing that will make your tax and estate planning decisions a bit easier.
Before we can move to the more complex topic of Grantor and Non-Grantor trusts, there is another key difference in trust types that needs to be discussed: revocable and irrevocable. A revocable trust is one that the Grantor can revoke or significantly change at any time; including removing beneficiaries or terminating the trust altogether. Because no real transfer has occurred, revocable trusts are typically not subject to gift tax when they are established; but instead will be included in the decedent’s estate upon death.
An irrevocable trust is one where the grantor will have little or no ability to substantially change the terms of the trust. Irrevocable trusts are often used as what is called “an estate freeze,” since the assets transferred are subject to gift tax upon the establishment of the trust and can grow in value without being included in the taxable estate upon the grantor’s death.
All trusts are either grantor trusts or non-grantor trusts. To start, we will take a look at grantor trusts and their characteristics.
When you establish a grantor trust, you retain certain powers and rights over the trust assets and often hold some level of administrative power over the trust itself, either as a trustee or under certain enumerated grantor powers. You won’t have the exact same level of control as if you owned the assets directly, but here are some of the things you may be able to do with a grantor trust:
Grantor trusts are disregarded entities for income tax purposes. This means that trust earnings will be taxable to you rather than to the trust. All earnings within the trust — such as interest, dividends, rents, and capital gains — are reported on your Federal Form 1040 as if you had owned those assets directly.
Being taxed on the individual level on trust earnings isn’t necessarily a bad thing. First, if the IRS views you and your trust as one and the same, you can swap assets with your trust without incurring capital gains tax. Second, because you are paying tax on the earnings directly, your trust can appreciate without being depleted by taxes, which can secure a larger payout for your beneficiaries upon distribution. Finally, trusts are subject to highly compressed tax brackets, so it is possible you will pay less tax on the income by including it in your own income.
Generally, revocable grantor trusts are included in the decedent’s estate upon their death since they are not considered a separate entity from the grantor. In order to remove the assets from your estate, you are required to completely relinquish “dominion and control” over the assets under the IRC rules (I.R.C. Sec. 2038), which can be accomplished by creating an irrevocable grantor trust.
There has been a rise in the use of so-called “Intentionally Defective Grantor Trusts (IDGTs),” which allow for the creation of a grantor trust that is not included in the grantor’s estate upon their death. These are structured in a way that they would normally be considered non-grantor trusts, but have a “defect” that causes the income to be taxable to you as the grantor. The use of these trusts has increased significantly over the past few years, and they have occasionally been targeted by legislation; though no provisions have made it into any final legislation.
When you first establish your trust, the assets you transfer into any irrevocable trust will be subject to gift taxes. Because annual exclusion gifts require what is called a “present interest”, gifts to a trust will generally not count for the annual exclusion amount ($16,000 in 2022). Most gifts can be absorbed by your lifetime estate and gift tax exemption. In 2022, the estate tax exemption is $12,060,000 per individual, and this amount is adjusted for inflation each year. It’s important to know, though, that this exemption amount is only temporary. Beginning in 2026, the exemption will go back to half that amount.
Once the trust is established, you won’t have any continued gift tax obligations unless you increase the amount of gifts given. The annual income tax payments you (as the grantor) make on trust earnings do not count as gifts to your beneficiaries. This allows your gift (i.e., the trust assets) to grow gift tax free.
Additionally, you can continue to fund the trust with the annual exclusion gifts without being subject to further gift taxes if you set the trust up so that the beneficiaries have the right to claim the gift amount. This converts the future interest into a present interest for the beneficiary. Trusts with this set-up are usually referred to as a “Crummey Trust,” after the tax case that allowed them.
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Although you can establish grantor trusts for other reasons, most do so to remove assets from their estate to let them grow for the eventual benefit of their children or grandchildren. By maintaining some control over trust assets with a grantor trust, you can continue to manage your wealth while you’re still living. Just keep in mind that you will be responsible for the annual income tax bill on trust earnings.
When you establish a non-grantor trust, you relinquish control of the trust assets. A trustee is appointed to administer the trust in accordance with the trust document. This person will also have a fiduciary duty to make decisions that are in the best interest of your beneficiaries. You cannot act as the trustee for your non-grantor trust – that would make it a grantor trust!
Typically, the trust document — which outlines when and how distributions are paid, and to whom they are paid — cannot be changed, but most trust documents give trustees some power over the trust assets. This could include the power to borrow money, sell trust assets, or invest in new types of property, as long as those decisions are in the best interest of the beneficiaries.
Unlike a grantor trust, a non-grantor trust is considered its own entity for tax purposes. This means the trust will have its own taxpayer identification number (EIN or TIN). The trust reports all earnings and income on its annual income tax return, federal form 1041. The trust pays tax on those earnings unless the earnings are distributed, in which case they are included in the beneficiary’s income.
As mentioned earlier, trust income tax brackets are much more condensed than individual tax brackets, which means trusts reach their maximum marginal tax rate more quickly than individuals. Here is a comparison of trust tax rates and individual income tax rates:
| Trusts/Estates | Individuals (Single Filer) | |
| 10% | $0 – $2,750 | $0 – $10,275 |
| 12% | $10,275 – $41,775 | |
| 22% | $41,775 -$89,075 | |
| 24% | $2,750 – $9,850 | $89,075 – $170,050 |
| 32% | $170,050 – $215,950 | |
| 35% | $9,850 – $13,450 | $215,950 – $539,900 |
| 37% | $13,450 | $539,900 + |
Because trusts are subject to such high tax rates, many non-grantor trusts are written to allow the trustee to make discretionary distributions to the beneficiaries. Instead of keeping the earnings within the trust to be taxed at the trust’s high tax rates, the trustee can elect to distribute those earnings to the beneficiaries at the end of the tax year. Typically, such distributions are limited to certain ascertainable standards, such as to provide for the health, education, maintenance, or support of the beneficiary. When current earnings are distributed, the beneficiaries will pay the tax. If the beneficiaries are in a lower tax bracket than the trust (as is the most likely scenario), all parties will benefit.
This is a common tax planning tool, but trustees should be careful as they are required to act in the best interests of the beneficiaries. If the intention of the trust was not to burden the beneficiaries with taxable income at a certain point in their life, they may be violating their fiduciary duties if they distribute earnings simply to reduce overall tax liabilities. Additionally, if the trust is not written correctly and allows for fully discretionary distributions not limited to an ascertainable standard, there may be other tax consequences.
If you establish an irrevocable non-grantor trust, those assets will not be included in your estate unless specific provisions in the trust dictate that they must. However, there is a special provision in the tax code that subjects transfers made within three years of the decedent’s death to estate tax. If you are very old or have a terminal illness, you should consider examining all options available in addition to a non-grantor trust.
The gift tax consequences of an irrevocable non-grantor trust mirror that of an irrevocable grantor trust: your contributions to the trust will be subject to gift tax upon funding the trust. Transfers will reduce your $12,060,000 lifetime estate and gift tax exemption. You can still take advantage of annual exclusion gifts using Crummey trusts even if the trust is an irrevocable non-grantor trust if the trust documents are properly drafted.
Non-grantor trusts are great ways to reduce your estate tax liability and remove income-earning assets out of your estate. For example, if you have no need for income earned by rental real estate, transferring your rental real estate business into a non-grantor trust for the benefit of your children or grandchildren can be mutually beneficial!
Non-grantor trusts are also great options if you are in a high tax bracket while your beneficiaries are in a lower tax bracket. By transferring income-producing assets over to the trust for their benefit, those earnings can be distributed to your beneficiaries who will pay taxes on them at a much lower rate.
Keep in mind that if you establish a non-grantor trust, you must be comfortable with giving up a certain amount of control. Once the trust is established, its future is in the trustee’s hands.
Selecting the type of trust that’s right for you is a decision you’ll need to make with help from your tax advisor. There are many other questions you’ll want to ask beyond, “Do I want a grantor or a non-grantor trust?” including:
These tax planning decisions are important, so don’t let the complexity of the decision put you off. Get the ball rolling by reaching out to your tax advisor for help today.
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