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What Are Grantor Trust Rules?

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Written by Troy Werner

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POSTED ON: March 31, 2021

A trust is a legal vehicle for holding assets and property “in trust” for another person. Trusts have three basic elements to them – the trustor, the trustee, and the beneficiary. The trustor is also called the grantor and is the creator of the trust whose assets and property are funded into the trust. Due […]

A trust is a legal vehicle for holding assets and property “in trust” for another person. Trusts have three basic elements to them – the trustor, the trustee, and the beneficiary. The trustor is also called the grantor and is the creator of the trust whose assets and property are funded into the trust.

Due to their inherent flexibility, trusts can be molded to do nearly anything with this structure – which has led to the creation of many trust archetypes, some of which have received special regulation to avoid tax evasion.

In the case of a so-called grantor trust, the Internal Revenue Service (IRS) instated specific rules to ensure that the income on trusts controlled and owned by the same person who created and funded them is still taxed properly.

Grantor trusts describe a long list of different trust types, each of which shares the quality of being managed and accessed by the trust’s grantor. When the grantor dies, the contents of a grantor trust are counted towards their estate's total value for taxation purposes, even if those assets do not go through probate.

Explaining Grantor Trusts

To understand grantor trusts, we need to take a step back and go over trust creation and estate planning basics. Assets and property must be redistributed after death, usually to one are next of kin or according to one’s last will.

Certain legal measures can automatically transfer assets and property without a will, such as through a trust. A trust is usually created while one is alive (thus, living trust), funded, and managed until death. After death, the trust’s managing trustee distributes the trust as per the grantor’s wishes contained in the trust document.

This may involve making small distributions to the trust’s beneficiaries over the course of years or distributing the entirety of the trust as soon as possible after the grantor’s death and many variations in between.

There are several reasons why some people might go through the trouble of doing this rather than simply writing these assets and properties into a will.

      1. For one, it can be faster to utilize trust. Wills must pass through probate, and everything therein is subject to the probate process before it can be distributed. For smaller estates, this process is often expedited, including in California. But estates past a certain value must count on a probate process over 18 months.
      2. Second, there is a much greater degree of flexibility in how trust assets and properties are managed and distributed versus those written into a will. Grantor trusts further allow the creator of the trust to manage and maximize their investments and trust income.
      3. Third, trusts used to be taxed favorably as individuals, meaning they had their own distinct income taxes based on the trust’s generated income rather than the grantor’s income tax bracket. This allowed grantor trusts to become a tax haven for wealthy individuals who wished to manage better and grow equity that they were planning on bequeathing to their loved ones.

Today, trust income is taxed more harshly than individual income to avoid this misuse. A trust’s income still determines the rate at which it is taxed, but the maximum tax rate of 37 percent is now achieved at an annual income of just $12,750 as of 2020. Grantor trusts are taxed at the grantor’s income tax rate rather than the trust’s harsher tax brackets.

This means grantor trusts can no longer benefit from a lower tax rate, but they can be used to avoid the now high tax rates for trusts taxed as separate taxable entities. Grantor trusts also remain beneficial to individuals who feel the need to exert greater control over how their trusts are managed in life before being distributed in death.

Grantor Trust Rules

Grantor trusts must:

      • Be controlled by the grantor. The trust creator must play a large managing role in a grantor trust for it to be considered one.
      • Be taxed utilizing the grantor’s income tax rate. Because the grantor is treated as the trust’s owner, and the trust isn’t considered a separate tax entity, any income it generates is effectively the grantor’s income. Again, turning the trust irrevocable will often raise the taxes the trust would have to pay out on its income. Irrevocable trusts also require their own tax identification number (TIN) for the IRS.

Grantor trusts are usually revocable because revocable trusts allow for much greater control over a trust’s assets and allow the trust to be taxed as per the grantor’s income tax rate, rather than the tax rate the trust would have to obey if it was a separate entity.

However, an irrevocable trust can be considered a grantor trust if the grantor retains some level of control over how the trust is managed. In cases like this, a grantor usually tries to separate the trust from their estate to keep their estate's value within the bounds of the federal estate tax exemption limit.

Trusts configured in this way do not count towards a grantor’s total estate value but are still taxed according to the grantor’s income tax rate rather than regular trust income tax rates. Consult a tax and estate planning professional to learn more about this type of trust.

As an additional note, a trust’s principal is not taxable. This is because the principle of trust is typically wealth that has already been taxed. To avoid double taxation, trusts are only taxed on extra income that they generate through rental payments, dividends, investments, and so on.

Setting Up a Grantor Trust

Trusts are set up through trust documents that outline the rules and contents of the trust. These contents must then be subsequently funded into the trust via amending certain ownership documents (i.e., when funding property into a trust, a deed must be written transferring the property into the trust via the trust’s name).

Grantors must additionally beware that controlling a grantor trust means filing Form 1041 in addition to one’s own income taxes to report on the trust’s income. Whether you are interested in setting up a grantor trust to minimize the income taxes, your trust would have to pay. Because you want to set assets aside for your loved ones without going through probate, it is always a good idea to consult an estate planning professional first.

Trusts can be complicated and expensive to set up correctly and efficiently, and not every estate needs them. On the other hand, those that do can save themselves a small fortune in taxes and spare themselves and their loved ones a significant headache.

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