You probably already know that trusts can be powerful estate planning tools and are useful for transferring property and assets to beneficiaries while minimizing taxes. But there are many different types of trusts, and the way that each one works can be confusing. Grantor trusts, living trusts, testamentary trusts, revocable trusts, irrevocable trusts, and inter vivos trusts are just a few of the terms that you might hear. In this article we will explain everything that you need to know about grantor trusts. You will learn what they are, how they work, and when you might need to establish one.
What Is A Grantor Trust?
In its simplest form, a grantor trust is a trust in which the grantor (or the person creating the trust) retains control of the trust assets and income. Some definitions state that the grantor has the power to affect the beneficial enjoyment of the trust assets. Let’s take a step back and answer the question, “What is a trust?” A trust is simply a legal entity that holds property or assets that are managed by a trustee for the benefit of its beneficiaries. The trustee has a fiduciary duty to the beneficiaries to properly manage the trust assets. Once a trust is established, it must be funded. That means that ownership of property or assets must be transferred to the trust. These assets may be cash, stocks, bonds, or even proceeds from a life insurance policy. In a grantor trust, even though ownership may technically transfer to the trust, the grantor effectively retains control of those assets.
By their very definition, all revocable living trusts are grantor trusts. However, not all grantor trusts are revocable living trusts. When tax time rolls around, the assets and income of the trust are taxed at the grantor’s personal tax rate. In fact, the trust is treated as a disregarded entity by the IRS for income tax purposes. The tax identification number of the trust is simply the grantor’s Social Security number. This means that the grantor must claim the trust income on his or her personal income tax return and pay the taxes from his or her personal funds.
Grantor Trust Benefits
A grantor trust has many benefits that lead people to establishing these entities as part of their overall estate plan. We will discuss some of those here. First, a grantor trust allows for the avoidance of the probate process. This is a huge difference when comparing a living trust vs a will. This means that the grantor may pass property and assets to beneficiaries without going through the probate court. This can save lots of time and money upon the grantor’s death. With a typical will, it can take months or even years before the assets can be distributed to the beneficiaries. In addition, the details of the distribution remain completely private with a trust. When going through probate, everything about the estate becomes public record. That is not the case with a trust.
Grantor trusts also provide the grantor a great deal of flexibility. Should plans change, the grantor may amend or revoke the trust at any time. Perhaps financial stress hits and the grantor needs to sell real estate owned by the trust to raise extra capital. A grantor trust allows the flexibility to do this. Perhaps a specific beneficiary has done something to warrant being removed from the trust. Again, the grantor has the flexibility to make that change at any time.
Common Types Of Grantor Trusts
As previously mentioned, all revocable living trusts are grantor trusts, but not all grantor trusts are revocable living trusts. In fact, there are many different types of trusts that may qualify for grantor trust status according to the grantor trust definition. A few of the most common types are discussed below.
Intentionally Defective Grantor Trust (IDGT)
You might be wondering why someone would create a trust that is intentionally defective. Well, in this case, there are good reasons! An IDGT is a grantor trust that is irrevocable. This type of trust treats the grantor as the owner of the assets for income tax purposes but not for estate tax purposes. Therefore, the trust’s income (even including capital gains) is taxed using the grantor’s personal tax bracket, but the grantor can avoid large estate taxes because the assets are not considered part of his estate. This is a tool that is often used by extremely wealthy individuals to save lots of tax money, and it is completely legal under the Internal Revenue Code (IRC). An IDGT may even prevent you from paying a gift tax on transfers into the trust if done properly!
Qualified Personal Residence Trust (QPRT)
A QPRT is another example of a trust that is established to save on your tax bill. This type of trust allows you to transfer ownership of your primary residence or a second home into the trust and exclude the value of that home from your taxable estate. This practice could save you thousands of dollars in taxes, especially if your home is extremely valuable.
Grantor Retained Annuity Trust (GRAT)
This type of trust allows the grantor to receive annuity payments from the trust assets for a set number of years. Once that period of time expires, then the remainder of the assets will be distributed to the beneficiaries according to the terms of the trust.
Revocable Living Trust
This is likely the simplest form of grantor trust. This is a basic trust established during the grantor’s lifetime in which the grantor retains control of the assets. The drawbacks to a revocable trust are the fact that there is no asset protection from creditors and there are few tax benefits because the assets are still considered part of the grantor’s estate. Upon the grantor’s death, the trust automatically becomes an irrevocable trust. There is no single right answer when choosing between a revocable vs irrevocable trust. It depends on your personal situation.
Grantor Trusts And Income Taxes
As we already mentioned, the income on assets in a grantor trust is taxed at the grantor’s personal tax rate. This even includes capital gains and other types of income that might traditionally be taxed at a much higher rate. The downside is the fact that the grantor must have the personal funds to pay the taxes that are due. The income from the trust’s assets is treated as taxable income of the grantor himself. Under the grantor trust rules, the grantor is the taxpayer and is personally liable for the tax liability. This is in contrast to most irrevocable trusts which are required to file an estates and trusts tax return with the IRS.
The Bottom Line
Grantor trusts offer many benefits when used appropriately, and they can potentially save you lots of money and headache. They allow the settlor the flexibility to retain control of the assets in the trust, yet they can still save some serious cash on tax bills. Whether or not a grantor trust is appropriate for you depends on your personal finances. When deciding whether to establish a grantor trust, you should seek the legal advice of an estate planning attorney. Both grantor trusts and non-grantor trusts have pros and cons, and you should weigh the benefits against the drawbacks before making a final decision.
Frequently Asked Questions
Who pays taxes on a grantor trust?
The grantor personally pays taxes on the items of income from the trust. Though ownership of the assets technically transfers to the trust, the grantor still retains control over the assets. Since the grantor retains this control, the assets are still taxed as though they are owned by the grantor.
What is a trust protector?
A trust protector basically oversees the trustee to ensure that the trustee is performing his or her duty properly. A trust protector is appointed by the grantor, and the trust protector can fire the trustee for improper conduct. The trust protector is there to provide oversight and ensure that the dealings of the trustee are all on the up and up.
What makes an irrevocable trust a grantor trust?
An irrevocable trust is a grantor trust if the grantor retains control over the trust assets. This would most commonly be the case of an intentionally defective grantor trust. This is an irrevocable trust in which the grantor retains control over the assets. The income from the trust is taxed according to the grantor’s personal tax rate; however, the assets are not considered part of the grantor’s estate for estate tax purposes. Most grantor trusts are revocable trusts.