A grantor trust is a trust in which the person who created and funded the trust — called the grantor — is treated as the owner of the trust’s assets for federal income tax purposes. This means that the income, deductions, and credits generated by the trust’s assets are reported on the grantor’s personal income tax return rather than on a separate trust tax return.
Grantor trust status has important implications for both income tax planning and estate planning. Understanding how grantor trusts work and when grantor trust status applies can help individuals and families make more informed decisions about their estate plans.
How grantor trust status works
Under normal tax rules a trust is a separate taxpayer that files its own income tax return and pays taxes on its income at trust tax rates — which are typically higher than individual rates. Grantor trust status is an exception to this rule.
When a trust qualifies as a grantor trust the IRS disregards the trust as a separate taxpayer for income tax purposes. Instead all of the trust’s income, deductions, losses, and credits flow through to the grantor’s personal income tax return as if the grantor still owned the assets directly.
This treatment has several practical consequences:
- The grantor pays income tax on trust earnings even if those earnings are retained in the trust rather than distributed to the grantor
- Transactions between the grantor and the trust — such as the sale of assets — are generally not taxable events
- The grantor can swap assets in and out of the trust without income tax consequences
What makes a trust a grantor trust
The IRS rules governing grantor trust status are found in sections 671 through 679 of the Internal Revenue Code. A trust becomes a grantor trust when the grantor retains certain powers or interests in the trust. Common triggers for grantor trust status include:
- Retained income interest — the grantor or their spouse has the right to receive income from the trust
- Power to revoke — the grantor has the power to revoke the trust and reclaim the assets — this is why revocable living trusts are grantor trusts
- Power to control beneficial enjoyment — the grantor can change who receives trust income or principal
- Administrative powers — the grantor retains certain administrative powers such as the ability to borrow from the trust without adequate interest or security
- Power to substitute assets — the grantor retains the power to substitute assets of equivalent value for assets held in the trust
Revocable living trusts as grantor trusts
The most common example of a grantor trust is the revocable living trust. Because the grantor retains the power to revoke the trust and reclaim the assets at any time the trust is automatically treated as a grantor trust for income tax purposes.
This means that during the grantor’s lifetime the revocable living trust does not file its own income tax return. All trust income is reported on the grantor’s personal return using the grantor’s Social Security number. The trust’s existence is essentially invisible for income tax purposes during the grantor’s lifetime.
When the grantor dies the revocable living trust typically becomes irrevocable and loses its grantor trust status. At that point the trust becomes a separate taxpayer and must file its own income tax return.
Intentionally defective grantor trusts
One of the most sophisticated uses of grantor trust rules involves what are called intentionally defective grantor trusts — sometimes abbreviated as IDGTs. Despite the name these trusts are not defective in any negative sense — they are carefully designed to be defective for income tax purposes while being complete for estate tax purposes.
An intentionally defective grantor trust is structured so that:
- The assets are transferred out of the grantor’s taxable estate for estate tax purposes — meaning they will not be subject to estate tax when the grantor dies
- But the trust is still treated as a grantor trust for income tax purposes — meaning the grantor continues to pay income tax on trust earnings
This arrangement has a significant benefit — because the grantor pays the income taxes on trust earnings the trust assets can grow without being eroded by income taxes. The grantor’s payment of the trust’s income taxes is essentially a tax-free gift to the trust beneficiaries.
Intentionally defective grantor trusts are most commonly used by people with large taxable estates who want to transfer wealth to the next generation in a tax-efficient manner.
Grantor trust status and Medicaid
For Medicaid purposes grantor trust status is generally not favorable. When a trust is treated as a grantor trust for income tax purposes Medicaid may also treat the trust assets as available to the grantor for Medicaid eligibility purposes — meaning the assets may be counted toward the Medicaid asset limit.
The Medicaid asset protection trusts used in elder law planning are specifically structured to avoid grantor trust status in order to remove the assets from Medicaid’s asset calculations. This requires the grantor to give up certain powers and interests in the trust — which is why Medicaid asset protection trusts are irrevocable.
What happens when grantor trust status ends
When a grantor trust loses its grantor trust status — typically because the grantor dies or gives up the powers that triggered grantor trust status — the trust becomes a separate taxpayer. At that point the trust must:
- Obtain its own employer identification number — EIN — from the IRS
- Begin filing its own annual income tax return — Form 1041
- Pay income taxes on trust earnings at trust income tax rates
Beneficiaries who receive distributions from the trust may also need to report those distributions on their own income tax returns depending on the nature of the distribution.
Grantor trusts and the step-up in basis
One important tax consideration for grantor trusts relates to the step-up in basis at death. When a grantor dies assets that were included in their taxable estate generally receive a step-up in tax basis to their fair market value at the date of death. This can significantly reduce capital gains taxes when the assets are later sold.
Because revocable living trusts are grantor trusts and their assets are included in the grantor’s taxable estate assets held in a revocable living trust at death generally receive a step-up in basis. This is an important advantage of revocable living trusts over irrevocable trusts for assets that have appreciated significantly in value.
Key terms to know
- Grantor trust — a trust in which the grantor is treated as the owner of trust assets for income tax purposes
- Grantor — the person who creates and funds a trust
- Grantor trust rules — IRS rules in sections 671 through 679 of the Internal Revenue Code that determine when a trust is treated as a grantor trust
- Intentionally defective grantor trust — IDGT — a trust designed to be outside the grantor’s taxable estate for estate tax purposes while remaining a grantor trust for income tax purposes
- Step-up in basis — an increase in the tax basis of inherited assets to their fair market value at the time of the grantor’s death
- Employer identification number — EIN — a tax identification number required for trusts that are separate taxpayers
- Form 1041 — the income tax return filed by trusts and estates that are separate taxpayers
Sources
- Internal Revenue Service — irs.gov
- American Bar Association — Public Resources
- USA.gov — Estate Planning
This article is for general informational purposes only and does not constitute legal or tax advice. Tax laws are subject to change. Consult a licensed attorney and tax professional for guidance specific to your situation.