Grantor trusts are a popular estate planning tool used to minimize tax liability and protect assets. These trusts are named after the Grantor or Settlor, which is a term used to describe the person creating the trust and contributing assets to it. Essentially, a grantor trust allows the grantor to continue to “own” the trust assets for income tax purposes during his/her lifetime, without having the grantor actually own the trust assets. There are several categories of grantor trusts, each with its own set of rules and benefits, based on what “powers” the Grantor has over the trust. These “powers,” often referred to as the “Grantor Trust Powers” (discussed in detail, here), are ways that a Grantor can continue to control the assets in the trust, without retaining actual legal ownership of them, though the degrees of that legal ownership vary depending on the power(s) present in the trust agreement.
Types of Grantor Trusts
Grantor trusts fall into two categories, revocable trusts and irrevocable trusts. Note that by definition, all revocable trusts are characterized as grantor trusts (revocability is a grantor trust power), but not all irrevocable trusts are grantor trusts. In fact, some of the trust types listed below can also be treated as non-grantor trusts if there are no grantor trust powers, or, if a power is present, but irrevocably “turned off.” (This is called “toggling off” and is discussed here.)
Note that grantor trusts only exist while the Grantor is alive. Once the Grantor dies, a grantor trust becomes a non-grantor trust, as the Grantor can no longer theoretically exercise the grantor trust powers he/she possesses under the trust agreement.
CATEGORY 1: Revocable trusts - Code Section 6761
A revocable trust is the most common type of grantor trust. As the name suggests, these trusts are revocable, meaning the Grantor can change the terms of the trust or dissolve it entirely. Revocable trusts allow Grantors to retain full and complete control over their assets while providing non-tax-related estate planning benefits such as avoiding probate.
For tax purposes, revocable trusts are treated as grantor trusts, which means that the Grantor is responsible for paying taxes on any income generated by the trust as if they owned the assets in the trust outright. The assets in the trust are not considered separate from the Grantor's personal assets for tax purposes, and the trust income is reported on the Grantor's personal tax return.
CATEGORY 2: Irrevocable trusts - Code Section 673
Irrevocable trusts are another type of grantor trust that cannot be changed or dissolved by the Grantor once the trust has been established. These trusts are often used for asset protection and tax planning purposes.
For tax purposes, irrevocable trusts can be either grantor trusts or non-grantor trusts. In an irrevocable grantor trust, the Grantor is responsible for paying taxes on any income generated by the trust, just like in a revocable trust. In a non-grantor trust, the trust itself is responsible for paying taxes on its income.
Intentionally Defective Grantor Trusts (IDGTs) - Code Section 675(4)
An Intentionally Defective Grantor Trust (IDGT) is a type of irrevocable trust that is structured in a way that makes it a grantor trust for income tax purposes, but not for estate and gift tax purposes. This means that the Grantor is responsible for paying taxes on the trust income, but the trust assets are not included in the Grantor's estate for tax purposes.
The "defective" aspect refers to the presence of a grantor trust power or powers, which causes the Grantor to be treated as the owner of the trust for income tax purposes, even though the assets are held in an irrevocable trust.
IDGTs are a very common tool for estate tax planning, as they allow the Grantor to transfer assets out of their estate while still retaining some control over those assets.
Spousal Lifetime Access Trusts (SLATs) and Grantor Retained Annuity Trusts (GRATs), discussed below, are commonly structured as IDGTs, though they do not have to be.
**Note on Reciprocal Trusts: It is crucial for estate planners to be aware of the potential risks when setting up two IDGTs to benefit two individuals reciprocally. For instance, if Trust 1 is established by person A for the benefit of person B, and Trust 2 is established by person B for the benefit of person A, it is essential that these trusts differ significantly in terms of their creation and funding timelines, as well as their specific provisions. Failing to establish substantial differences between the two trusts may result in the IRS treating them as an interconnected transaction, based on "quid pro quo" considerations, and negating the intended taxable gift for estate tax planning purposes. This could lead to the inclusion of the assets in the taxable estate, subjecting them to potential estate tax liabilities. Therefore, it is important to exercise caution when structuring reciprocal trusts to avoid potential adverse consequences.**
Spousal Lifetime Access Trusts (SLATs) - Code Section 675(4)(C)
Though a SLAT can also be structured as a grantor trust OR a non-grantor trust, they are frequently structured as grantor trusts. By structuring a SLAT as a grantor trust, the Grantor maintains ownership of the trust assets for income tax purposes and is responsible for paying income taxes on the trust's income.
A SLAT is an estate planning tool that allows one spouse (the Grantor) to create an irrevocable trust for the benefit of the other spouse (the beneficiary). The primary purpose of a SLAT is to transfer assets out of the Grantor's taxable estate while still providing the beneficiary spouse with access to the trust assets during their lifetime. When implemented properly, by removing assets from the Grantor's taxable estate, the values of SLAT assets are not subject to estate tax upon the Grantor's death. SLATs offer a distinct advantage to married couples because, despite the Grantor's inability to directly access the trust assets, the beneficiary spouse is able to utilize the trust assets for their own benefit, which, in many cases, directly benefits the grantor spouse. In most cases, after the death of the beneficiary spouse, the remaining assets in the SLAT typically pass to other designated beneficiaries (usually children or other family members).
This provides a level of control and access to the funds while simultaneously ensuring that the assets remain outside of the grantor's taxable estate. While many have concerns with potential divorce or marital issues, a great estate planner will account for this in the language of the trust to ensure the trust assets are protected from potential creditors or divorce.
There are specific provisions and requirements that need to be met to ensure the SLAT is classified as a grantor trust for income tax purposes. By doing so, the Grantor can transfer assets into the SLAT without triggering gift taxes and can also continue to pay the income taxes associated with the trust, effectively allowing the trust to grow without being diminished by income taxes. This can be beneficial in estate planning, as it reduces the Grantor's taxable estate and allows for the potential tax-free growth of the trust assets.
A SLAT typically corresponds with the grantor trust power known as the “power of substitution.” The power of substitution allows the grantor to swap assets of equal value with those held in the trust, without triggering any adverse tax consequences. By retaining this power, the Grantor can effectively maintain control over the assets in the SLAT. This power also provides flexibility to the Grantor, enabling them to adjust the trust assets if their circumstances or investment preferences change.
By utilizing the power of substitution, the Grantor retains control over the assets and retains the potential to benefit from any appreciation or income generated by those assets. This control also allows the Grantor to keep the trust intact as a grantor trust for income tax purposes, ensuring that they are responsible for any income taxes associated with the trust's earnings.
Grantor Retained Annuity Trusts (GRATs) - Internal Revenue Code Section 2702
A Grantor Retained Annuity Trust (GRAT) is a type of irrevocable trust that allows the Grantor to transfer assets to the trust while retaining an annuity interest in the trust. The Grantor receives a fixed payment from the trust each year for a specified period of time (usually 2-5 years).
At the end of the annuity period, any remaining assets in the trust are distributed to the trust beneficiaries. The value of the gift to the beneficiaries is determined by subtracting the value of the Grantor's retained annuity interest from the total value of the trust assets at the time of the transfer.
GRATs are often used for estate tax planning purposes, as they can help minimize gift and estate taxes by capturing the taxable value of a gift at a moment in time prior to a rapid spike in value. By transferring appreciating assets into a GRAT, the grantor can "freeze" the value of the assets for estate tax purposes, allowing future appreciation to pass to beneficiaries outside of the grantor's estate.
GRATs can also fail, as they are highly dependent on the performance of the assets used to fund the trust, and it is difficult to predict when an asset will increase or decrease in value (if we could, we would all have estate tax problems!). In a worst-case scenario, a failed GRAT can unnecessarily use a Grantor’s precious lifetime gift tax exemption if the asset value drops below the “freeze out” date value.
One way to mitigate the use of the Grantor’s gift tax exemption is to use a “zeroed-out” GRAT, where the annual payments back to the Grantor are designed to exactly equal the initial value of the assets contributed to the trust plus an assumed interest rate set by the IRS (known as the 7520 rate) over the term of the trust. By structuring the annuity payments in this way, the taxable gift value is reduced to zero because the present value of the annuity payments equals the initial value of the assets.
Qualified Personal Residence Trusts (QPRTs) - Internal Revenue Code Section 675(4)
A Qualified Personal Residence Trust (QPRT) is a type of irrevocable trust that allows the Grantor to transfer their personal residence or vacation home to the trust while retaining the right to use the property for a specified period of time. Below are some reasons why people use QPRTs and why they might be appropriate for one or more of your clients.
- Estate Tax Reduction: One of the primary advantages of a QPRT is the potential reduction in estate taxes. By transferring the residence to the QPRT, the property's value is removed from the Grantor's taxable estate, thereby reducing the estate tax liability upon his/her death.
- Continued Use of the Property: Despite transferring ownership to the QPRT, the Grantor can still reside in the property for a predetermined period, which is typically specified in the trust agreement. This allows the Grantor to continue enjoying the property during the trust term.
- Gift Tax Savings: The transfer of the property to the QPRT is considered a gift for tax purposes. However, the value of the gift is reduced by the retained interest of the Grantor to live in the property. As a result, the gift tax consequences are minimized or even eliminated, depending on the value of the retained interest.
- Potential Freeze on Property Value: If the property appreciates in value during the QPRT term, the increased value is excluded from the Grantor's taxable estate. This can be advantageous if the property's value is expected to rise significantly in the future.
- Asset Protection: Assets placed within a QPRT may receive some level of protection from creditors, as they are no longer directly owned by the Grantor. This can be beneficial in shielding the property from potential legal claims or financial liabilities.
At the end of the QPRT term, the property is transferred to the trust beneficiaries. The value of the gift to the beneficiaries is determined by subtracting the retained income interest from the fair market value of the property at the time of the transfer. The retained income interest is the right of the grantor to live in the property for the specified trust term.
1Code Section refers to the Internal Revenue Code of 1986.