When I told my boss that I was going to write an article on grantor trusts, he responded (without hesitation sensitivity, or thought), “You know, a lot of people have written about grantor trusts.”

He’s not wrong. Not helpful—but not wrong

Search Google, and you will find numerous websites with cursory discussions on grantor trusts.  Look a little deeper, and you may even find some of the very good scholarly articles that I drew from in writing this article.  The articles go through the Code, sometimes paraphrasing, sometimes not.  If the Treasury Regulations contain an example, they might even give the grantor a name instead of simply a letter, as the Treasury is wont to do.

If you have spent any time on Briefly Taxing, you know that our goals for an article are twofold.  First and foremost, we try to make complex tax concepts accessible.  Grantor trusts are complex, in and of themselves.  The Code and Treasury Regulations contain exceptions to exceptions, with caveats and carveouts along the way.  Many of the articles that I came across lacked sufficient analysis to gain a more holistic understanding of the concepts.  Even fewer of the articles contained examples for the majority of such concept.  And none of them featured Uncle Bill, Aunt Ethel, and their motley crew.

So, yes, much has been written on grantor trusts, but not like this.

In Part I of this series on Grantor Trusts, we look at the nature of trusts in general.  In Part II, we shift to a look at grantor trusts, and a few definitional rules.  In Part III and Part IV, we take a deep dive into the interests that a grantor may retain that will cause a trust to be treated as a grantor trust as well as instances in which a person other than the grantor will be treated as the owner of a trust under the grantor trust rules.

A Few Words on Terminology (and Parentheses)

The term “grantor” trust is, in my opinion, somewhat misleading. All trusts have grantors, also referred to as a settlor, creator, (less commonly) a trustor, or (for purposes of this article) Uncle Bill. In fact, the existence of a grantor is one of the prerequisites of trust themselves. Nevertheless, the IRS in its infinite administrative wisdom has long divided trusts into one of three categories: the grantor trust, the nongrantor trust, and the charitable trust.

In this article, we will look first at the most basic definitions that shape the trust law, and then we will take a deep dive into the Internal Revenue Code (the “Code”) to determine whether a trust should be treated and taxed as a grantor trust.  Along the way, we will use examples to shed a light on areas of the law that otherwise might be deemed “esoteric” or “boring” or “drool-inducing,” lest you, dear reader, lose interest or the desire to carry on.  Sally forth, and Briefly Taxing shall sally with you.[1]

What is a Trust?

At its most basic, a trust is a relationship between three parties—the grantor, the trustee, and the beneficiary. It is an entity created and governed under the law of the state in which it was formed. The relationship is “fiduciary” in nature. For your Latin lesson of the day, “fiduciary” is derived from the verb fido, which means to trust in or give confidence to. (And yes, this is also the derivation of the once-common dog’s name Fido.) Thus, a fiduciary relationship is one in which a party places a special trust, confidence, and reliance in another party. The trusted party, in turn, has a “fiduciary duty” to that party and the party’s beneficiaries.

In the context of a trust, a fiduciary relationship is created between the grantor, the trustee, and at least one beneficiary for a stated purpose. Trust may be created during the grantor’s life (referred to as an “inter vivos” trust) or at the grantor’s death through his or her will (a “testamentary” trust). A trust may be revocable, meaning that the grantor may amend, modify, or even revoke (terminate) the trust at any time. An irrevocable trust, on the other hand, may not be modified, amended, or revoked after it is created, except in limited circumstances. A grantor trust may either be revocable or irrevocable. If the grantor trust is irrevocable, the grantor may retain only a limited number of rights with regard to the trust. Notwithstanding the limited number, these retained rights—as we will discuss below—can be very powerful.

A trust may be “simple” or “complex.” A simple trust is required to distribute all income on an annual basis and cannot distribute the principal of the trust or make charitable contributions. A complex trust is defined in the negative as being any trust that is not simple. Grantor trusts are neither simple nor complex but are instead creatures of the Internal Revenue Code (the “Code”).

Note: The “principal” of a trust may also be referred to as the trust’s “corpus.” In this article we use principal, in large part because corpus, in Latin, means body, from which the words “corpse” and “corpuscularianism” are derived…and the last thing we want is to bring up the image of a cadaver within a grantor trust or to make our dear readers minds drift to the seventeenth century theory that explains natural transformations based on the result of the interaction of particles, or posits that the introduction of mercury could result in the alchemical transmutation of base metals into gold…

Who is the Grantor of a Trust?

The grantor creates the trust relationship, and generally he or she is the owner of the assets that are initially contributed to the trust. Most commonly, the grantor establishes the terms and provisions of the trust relationship between the grantor, himself, the trustee, and any beneficiary within a written trust instrument.

What Purpose does the Trust Instrument serve?

The actual trust instrument generally sets forth the rights, powers, and duties of the grantor and the trustee—including the powers to amend, modify, revoke, or terminate the trust; the distribution provisions regarding the assets of the trust; the designation of an initial trustee and terms for the selection of successor trustees; and a statement designating the “situs” of the trust, which is a fancy way of saying a designation of the state under which the terms of the trust agreement are to be governed. In a sense, the trust instrument is a contract between the three parties (grantor, trustee, and beneficiary), which governs the rights and obligations of all parties thereto.

What is a Trustee?

The trustee may be an individual or a “corporate trustee.” When assets are contributed to the trust, the trustee takes legal title to those assets and must administer the trust in its assets on behalf of the beneficiaries in accordance with the terms of the trust instrument. As a fiduciary, the trustee is charged with the duty to act for the benefit and in the best interest of the beneficiary or classes of beneficiaries, which may even include the grantor. The grantor can, and in many cases does, serve as the initial trustee of the trust.

Grantor Trusts, in a Nutshell

The term “grantor trust” is used in the Code to describe any trust over which the grantor (or another owner) retains the power to control or direct the trust’s income or assets. Because the grantor (or other owner) retains certain powers over or benefits in a trust, any income generated by the assets of the trust will be taxed to the grantor rather than to the trust. A grantor can be taxed on the income or principal of a trust, or both. If the grantor is treated as the owner of only part of the trust, the grantor will be taxed on the income from that part of the trust, and the rest of the income will be taxed according to the regular rules regarding the income taxation of trusts and estates.[2]

With regard to revocable trusts—since the grantor has the ability to amend, modify, or revoke the trust—these trusts will always be grantor trusts. An irrevocable trust, on the other hand, can be treated as a grantor trust under certain conditions all of which are found in the “grantor trust’s” contained in IRC §§ 671 through 678. If the trust satisfies any of these conditions, then the grantor is treated as the owner of the trust’s assets, and the trust is disregarded as a separate tax entity so that all income is taxed to the grantor.

Income Taxation of Trusts

The rules related to the taxation of all trusts are contained in subchapter J of the Code, which encompasses IRC §§ 641 through 692. All trusts (except grantor trusts in certain circumstances, as discussed below) must file a Form 1041 in any year where the trust has at least $600 in income, or the trust has a nonresident alien beneficiary. The Form 1041 is an income tax return used by estates and trusts to report their income and pay taxes thereon. Because, as mentioned above, all of a grantor trust’s income is taxed to the grantor, no Form 1041 is necessary for grantor trust—provided that the individual grantor reports all income and expenses on his own Federal income tax return (e.g., a Form 1040).

In most respects, a trust computes its taxable income and deductions in much the same way as an individual taxpayer. To this end, a trust is generally allowed most of the same credits and deductions an individual would be allowed. Similarly, if a deduction is not allowed for an individual, it will not be allowed for a trust (e.g., personal living expenses, recreational expenses cost of a child’s education, depreciation of a personal residence, etc.). Like a partnership, trusts are required to prepare Schedules K-1 for its beneficiaries, disclosing any amounts distributed by the trust to such beneficiaries. As with distributions from a partnership disclosed on a Schedule K‑1, a beneficiary is required to pick up and report such distributions as income on the beneficiary’s Federal income tax return.

Like individuals, trusts (other than simple ones) may make charitable contributions and made the corresponding deductions. Such charitable deductions must meet similar rules to those deductions that apply to individuals, except that the percentage limitations in IRC § 170 do not apply to trusts.[3] It should be noted, however, that a charitable contribution made to a grantor trust will be aggregated with the grantor’s other charitable contributions to determine their deductibility under the limitations of IRC § 170(b)(1).[4]

One important difference to note between individual income taxes and trust income taxes is that the marginal tax rate for trusts graduates much more quickly than for individuals. Thus, a trust with only $13,050 in income will pay the top marginal rate ($3,146 plus 37% of the excess over $13,050). In contrast, an individual will only hit the top tax bracket (as of the writing of this article) when the individual has income of $523,601 or more ($628,301 for married individuals). Thus, grantor trusts offer significant advantages vis-à-vis the marginal tax rate because the income of the trust would be taxed at the grantor’s individual marginal tax rate, which in many cases will be less than the trust’s marginal tax rate.

Gift Taxation of Trusts

For purposes of the Federal gift tax, contributing assets to a trust may or may not require the filing of a Form 709 (Gift Tax Return). For gift tax purposes, a gift is complete (and gift tax is due) only when the donor (the person making the gift) has “irrevocably parted with dominion and control” over all or part of the transferred property—whether directly or indirectly—thereby leaving the donor without the power to change its disposition (whether for the benefit of the donor or for the benefit of others). Thus, for irrevocable (non-grantor) trusts, a gift is complete once the contribution is made to the trust, and gift taxes are due at the time of the contribution.

With respect to irrevocable inter vivos trusts, however, a gift tax return would generally be due, because the gift (the contribution of property to the trust) is “complete.” Similarly, testamentary trusts are subject to estate and gift tax rules and filing requirements.

If the trust is a grantor trust, generally no gift tax would be due the donor contributes property to the trust. This is so, because there is no completed gift due to the grantor’s retained powers over the assets. Thus, a grantor’s contribution of assets to a grantor trust amounts to a transfer of wealth that is not subject to gift tax during the grantor’s life.

Footnotes:

[1] Generally, sally is a noun or, in this case, an intransitive verb and is derived from the Middle French saillie, itself derived from the Old French, saillir, meaning to rush forward, itself derived from the Latin verb salire, meaning “to leap.”  Now you know…and now you also know what to expect from the footnotes in the rest of the article… Don’t say you weren’t warned.

[2] Treas. Reg. § 1.671-2(d).

[3] We touch on these charitable contribution limits in this post in the Taxing, Briefly series.

[4] See Treas. Reg. § 1.671-2(c).

Briefly Taxing’s Primer on Grantor Trusts

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