Many kinds of trusts are used in estate planning. Trusts can be revocable or irrevocable, and their primary purpose may be to provide for such things as a means for planning for incapacity or disability, minimizing or eliminating estate tax, promoting a charitable purpose, or even avoiding probate, to name a few. They can be set up for the use and benefit of the creator of the trust or for other individuals. The creator of a trust is known as the grantor. The person or a member of the class of people for whom the trust assets are intended to benefit is known as the beneficiary (which could be or include the grantor), and the person or entity that manages the trust is the trustee.
The term “Grantor Trust” can sometimes be a source of confusion or uncertainty for clients and even their advisors. That’s because the term Grantor Trust is not generally used to identify the purpose for which the trust was set up, or who receives the income or assets of the trust, but, rather, it is to denote how the trust’s income is taxed.
The general rule is that all trusts are separate taxpayers, each with its own tax year and accounting method. The exception to this rule is trusts that are ignored for income tax purposes under the IRS’s “Grantor Trust” rules. Just like their human counterparts, trusts are taxed on income and receive deductions for certain authorized expenses. Unlike human taxpayers, however, trusts are taxed under a compressed rate schedule which results in a significantly higher tax at any level of income when compared to an individual taxpayer. For instance, in 2019 the highest tax bracket of 37% is reached by a trust at just $12,750 in taxable income, whereas an individual would need an income of $510,300 to reach that same tax bracket. The compressed tax rates only apply to ordinary income. Capital gains and dividend income are taxed the same for individuals and trusts. Thus, setting up a trust to be taxed as a Grantor Trust has its advantages.
So, what makes a trust a Grantor Trust? The answer can be found under Sections 671-679 of the Internal Revenue Code, known informally as the Grantor Trust rules. These rules state that the trust will be taxed as a Grantor Trust when the grantor retains control over the trust. Control can be powers such as the power to revoke or amend the trust, to appoint and change trust beneficiaries and determine who receives income from the trust. In the typical Grantor Trust scenario, the grantor is the person making all of these decisions and he or she assumes the tax liability and the trust is ignored for income tax purposes.
As noted, a Grantor Trust is an effective estate planning tool. Revocable living trusts are the most common type of Grantor Trust. A grantor usually acts as trustee of his or her own living trust, retaining control over its income and assets. The grantor can appoint and change trust beneficiaries and determine who receives income from the trust.