What Are Grantor Trust Rules?
Grantor trust rules are guidelines within the Internal Revenue Code (IRC) that outline certain tax implications of a grantor trust. Under these rules, the individual who creates a grantor trust is recognized as the owner of the assets and property held within the trust for income and estate tax purposes.
A grantor trust is a trust in which the individual who creates the trust is the owner of the assets and property for income and estate tax purposes.
Grantor trust rules are the rules that apply to different types of trusts.
Grantor trusts can be either revocable or irrevocable trusts.
With intentionally defective grantor trusts, the grantor must pay the taxes on any income, but the assets are not part of the owner's estate.
Understanding Grantor Trust Rules
Trusts are established for various reasons, and in many cases, they're designed as separate legal entities to protect the grantor's (or originator's) assets and the income generated from those assets so that the beneficiaries may receive them.
For example, trusts are created when performing estate planning to ensure the assets get distributed properly to the named beneficiaries upon the death of the owner. However, a grantor trust is any trust in which the grantor or owner retains the power to control or direct income or assets within the trust.1 In other words, the grantor trust rules allow a grantor to control the assets and investments in the trust.
Grantor trusts were originally used as a tax haven for wealthy people. The tax rates graduated at the same rate as income tax rates. As more and more income was earned in the trust, the income was taxed at the personal income tax rates.
In other words, the grantor got the benefits of a trust, such as shielding money but was taxed as if it was a personal account and not a separate legal entity. Also, grantors could change the trust and remove the money whenever they chose to do so. Grantor trust rules were established by the IRS to thwart the misuse of trusts.
Today, the income generated from trusts graduate to a higher tax bracket more quickly than the individual marginal income tax rates. For example, any trust income over $12,750 would be taxed at the highest tax rate of 37%.2
Conversely, if the trust was taxed at the individual tax rate, the trust income wouldn't be taxed at the highest rate of 37% until it earned $518,400, according to the 2020 marginal tax rates, and $523,600 according to the 2021 marginal tax rates.34 In other words, it doesn't take as much income earned in a trust to be thrust into a higher tax bracket.
As a result, a grantor trust is not the type of tax haven for wealthy people that it once was before the IRS made changes to it. However, grantor trusts are still used today because they have characteristics that might be beneficial to the grantor, depending on their income, tax, and family situation.
Benefits of Grantor Trust Rules
Grantor trusts have several characteristics that allow the owners to use the trusts for their specific tax and income purposes.
The income the trust generates is taxed to the grantor's income tax rate rather than to the trust itself. In this regard, grantor trust rules offer individuals a certain degree of tax protection because tax rates are generally more favorable at the individual level than they are for trusts.
Grantors can also change the beneficiaries of the trust, along with the investments and assets within it. They can direct a trustee to make alterations as well. Trustees are individuals or financial companies that hold and manage assets for the benefit of a trust and its beneficiaries.
Grantors can also undo the trust whenever they please as long as they are deemed mentally competent at the time the decision is made. This distinction makes a grantor trust a type of revocable living trust. A revocable trust is a trust that can be changed and canceled by the owner, originator, or grantor.
Changing the Trust
However, the grantor is also free to relinquish control of the trust making it an irrevocable trust, which is a trust that cannot be amended or canceled without the permission of the beneficiaries of the trust. In this case, the trust itself will pay taxes on the income it generates, and then it would require its own tax identification number (TIN).
Trusts are established for various purposes, including for the purpose of storing the owner's assets in a separate legal entity. As a result, trust owners should be aware of the risks that the trust could be triggered into a grantor trust.
The Internal Revenue Service (IRS) defines eight exceptions to avoid triggering the grantor trust status. For example, if the trust has only a single beneficiary who is paid the principal and income from the trust. Or, if the trust has multiple beneficiaries who receive the principal and income from the trust in accordance with their shareholding in the trust.5
How Grantor Trust Rules Apply to Different Trusts
Grantor trust rules also outline certain conditions when an irrevocable trust can receive some of the same treatments as a revocable trust by the IRS. These situations sometimes lead to the creation of what are known as intentionally defective grantor trusts.
In these cases, a grantor is responsible for paying taxes on the income the trust generates, but trust assets are not counted toward the owner's estate. Such assets would apply to a grantor's estate if the individual runs a revocable trust, however, because the individual would effectively still own property held by the trust.
In an irrevocable trust, property is basically transferred out of the grantor's estate and into a trust, which would effectively own that property. Individuals often do this to ensure the property is passed down to family members at the time of death. In this case, a gift tax may be levied on the property's value at the time it's transferred into the trust, but no estate tax is due upon the grantor's death.
Grantor trust rules also state that a trust becomes a grantor trust if the creator of the trust has a reversionary interest greater than 5% of trust assets at the time the transfer of assets to the trust is made.6
A grantor trust agreement dictates how assets are managed and transferred after the grantor's death. Ultimately, state law determines if a trust is revocable or irrevocable as well as the implications of each.
Examples of Grantor Trust Rules
Some of the grantor trust rules outlined by the IRS are as follows:
The power to add or change the beneficiary of a trust
The power to borrow from the trust without adequate security
The power to use the income from the trust to pay life insurance premiums
The power to make changes to the trust's composition by substituting assets of equal value