Take-Away: The problem with non-grantor trusts is the very high federal income tax imposed on the trust’s accumulated income. There are, though, some sophisticated planning strategies that can be used to mitigate and shift that income away from the trust and to other beneficiaries who will presumably be in a much lower marginal federal income tax bracket.

Background: Trusts serve several purposes as part of a comprehensive estate plan. Trusts help to avoid the dissipation of assets by a beneficiary. Trusts provide asset protection. Trusts often allow efficient income tax planning by the ability to shift income out of the trust to the trust beneficiaries. Trusts can shift that taxable income, with hindsight,  within 65 days after the close of the income tax year, back to trust beneficiaries. [IRC 663(b).] And, unlike individuals, an irrevocable trust can obtain an unlimited income tax charitable deduction [IRC 642(c)]. In limited situations,  if the trust structured properly and located in a favorable jurisdiction, it avoid having to pay state income taxes. An irrevocable trust is either a grantor trust for income tax reporting purposes, or it is  a non-grantor trust, which is taxed as a separate taxpayer.

Grantor Trusts: The popularity of grantor trusts as an estate planning vehicle is undeniable, with the non-taxation of transfers between the grantor and the grantor trust  when appreciated assets are involved, and most importantly, the grantor’s estate burn that results from the grantor’s obligation to pay the income taxes  generated by the grantor trust, which payment is not treated as a taxable gift by the grantor. In addition, if there is a sale of appreciated assets by the grantor to a grantor trust in exchange for a promissory note [an IDGT] the interest charged on the promissory note need only be at the AFR rate and the interest will not be subject to tax. [Revenue Ruling 85-13; IRC 1274.]  From recent legislative proposals, it is also fair to say that grantor trusts are on Congress’ ‘hit list’ and their days may be numbered.

Non-Grantor Trusts: Some grantors, however, for a variety of reasons would prefer to create and fund a non-grantor trust, often called a dynasty trust. Assets held in an irrevocable non-grantor trust avoid federal estate and GST taxes when the trust beneficiary dies. The trust’s assets are creditor protected. Another major benefit of using a non-grantor trust is that it can shift taxable income, to the extent of its distributable net income (DNI), to trust beneficiaries. A non-grantor trust can also be used to avoid certain state income taxes, even if the settlor and the beneficiary are subject to those state income taxes.

Taxation of Non-Grantor Trusts: That said, the major drawback to a non-grantor trust is that the trust will reach the top federal income tax rate of 37% at slightly over $13,000 of accumulated trust income [compared to an individual who does not reach that top federal income tax bracket until their income is well over $500,000.] [IRC 1(e); (J)(2)E.] Add to that income tax the net investment income tax of another 3.8% [IRC 411] and it is easy to see that non-grantor trusts are heavily taxed, so much so as to induce settlors avoiding them.  Finally, while an individual can use a standard deduction of about $12,000, a non-grantor trust’s standard deduction is only $100 (or $300 for a qualified disability trust, IRC 642(b)(2)(C).)

Planning for Dynasty Trusts: What these heavy income tax rules mean is that if a senior family member decides to aggressively fund a non-grantor trust at this time (a dynasty trust) to take advantage of their temporarily high applicable exemption amount ($12.06 million, until, that is, 2026, when it drops to about $6.0 million) any undistributed taxable income of the non-grantor trust will likely face a heavy income tax burden than if the trust’s income were taxed to the individual family members. Some planning steps can be used when creating the non-grantor trust to mitigate, but not completely eliminate, the federal income tax burden faced by the trust.

  1. Discretionary Distributions of Income: As noted above, the trustee of a non-grantor trust has the ability to shift the trust’s taxable income to trust beneficiaries since the distribution will be deductible by the trust up to its DNI. Accordingly, a trust is entitled to an income tax deduction for distributions of its DNI to a beneficiary, the amount of which the beneficiary is then  required to include in his or her gross income. [IRC 651-52; IRC 661-62.]  Therefore, a trustee that possesses discretion to distribute trust income to trust beneficiaries can choose to distribute that taxable income to the trust beneficiary in who is in the lowest marginal federal income tax bracket, thus reducing overall federal income taxes. However, the state income taxes the beneficiary is subject to may erode this perceived tax savings (assuming that the non-grantor trust may not be subject to state income taxes if the situs of the trust is administered in another state with no, or lower, state income taxes. Other complications can arise from relying upon the distribution of DNI to trust beneficiaries, if the beneficiary is receiving Medicaid, or they have creditor problems. Finally, a distribution out of the non-grantor trust to the beneficiary simply then exposes that distributed net-income to estate taxation on the beneficiary’s death.
  2. Separate Trusts as Taxpayers: Rather than use a single non-grantor trust, one thought is to create a separate non-grantor trust for each beneficiary. However, two or more trusts will be treated as one trust for federal income tax purposes if they have substantially the same settlor or settlors and substantially the same beneficiary or beneficiaries, if the principal purpose of the multiple trusts is to avoid federal income tax. [IRC 643(f).] Yet, if one non-grantor trust was created primarily for each child or grandchild of the settlor (and their descendants) then it is possible to avoid the application of IRC 643(f). The drawback to this approach is that if there is a separate trust for each child or grandchild, then the trustee’s distribution of DNI to the beneficiary who is in the lowest marginal income tax bracket is limited; restated, with multiple trust beneficiaries, the trustee can choose to make unequal distributions of DNI among the trust beneficiaries, thus making taxable distributions to those trust beneficiaries who are in the lowest marginal income tax brackets. With only one primary trust beneficiary in the non-grantor trust, the trustee’s ability to pick-and-choose to spread the taxable income generated by the trust among several trust beneficiaries is substantially curtailed.
  3. Charitable Beneficiary Safety-Value: Exploiting the tax deduction available to a non-grantor trust for distributions to a trust beneficiary, if the trust includes charities as potential discretionary beneficiaries, the trustee can claim a deduction for its gross income paid for a charitable purpose. [IRC 642(c).] Thus, a distribution from the non-grantor trust to a charity will not only reduce the trust’s taxable income but it may also reduce its DNI and would thus reduce the threshold exposure for the net investment income tax. Consequently, a distribution carrying out DNI from the trust could be made to a donor advised fund that is controlled by the settlor or the settlor’s family. Or, a distribution of DNI could also be made to a charitable remainder unitrust (CRT) previously established by the settlor. [IRC 664.] The DNI distributed by the trustee to a CRUT will not be subject to income tax in the hands of the CRUT trustee as that trust is exempt from income tax, although follow-up distributions to the CRUT beneficiary may be included in the gross income of that beneficiary. [IRC 664(c).] If the CRUT were a NIMCRUT (net-income with make-up CRUT), that NIMCRUT might allow for the postponement of the income tax on the distribution to the NIMCRUT.) Not quite as clear is if the trustee made a distribution from the non-grantor trust to a charitable lead trust (CLT) since a CLT is not exempt from income tax, unlike a CRUT. However, the distribution deduction to the trustee of the non-grantor trust should nonetheless be allowable [under IRC 661] to the CLT, but the distribution will then be subject to income tax at the CLT level.
  4. Beneficiary-owned Trust: Since income, expenses, and credits pass through automatically to the grantor of a grantor trust, it might be possible to cause a beneficiary of the non-grantor trust to be treated as its grantor for income tax reporting purposes. Under IRC 678, a person other than the grantor is treated as the owner (and essentially taxed under the grantor trust rules as though the person were the grantor) of any portion of an irrevocable trust with respect to which that person has a power exercisable alone to vest the income or corpus in that person. Accordingly, a trust where a beneficiary has the right to only withdraw income, either in a fiduciary accounting sense or tax sense, would be subject to this rule and would have to report the trust’s income as their own, presumably though at a much lower marginal income tax bracket. For example, a trust beneficiary could be given the unilateral right to withdraw all or a portion of the trust’s tax income subjecting them to the trust’s taxable income; perhaps that right is limited by formula to only withdraw an amount that the income tax paid by the beneficiary would not be any greater than what the trust would otherwise pay.
  5. Qualified Subchapter S Trust: A qualified subchapter S trust, or QSST, must have only one beneficiary who is a U.S. individual taxpayer, and which must be required to, or does, in fact, distribute all of its fiduciary accounting income each year to that beneficiary, and the beneficiary of the QSST must elect to be treated as the income tax owner under IRC 678. [IRC 1361(d)(3); 643(b).] In short, a QSST is treated as though it were a grantor trust as to the beneficiary or the portion of the trust that consists of qualifying subchapter S stock. The QSST beneficiary, in effect, is treated as the shareholder of the S corporation. Hence, if a QSST is used as opposed to another type of irrevocable trust, the income of the S corporation will be taxed to the QSST beneficiary  rather than  the trust as a separate taxpayer. Unlike the beneficiary-owned trust, as described in #4, the QSST will provide more creditor protection to the trust beneficiary, and it will not jeopardize any governmental benefits that the beneficiary may then be receiving. Recall, too, that with an S corporation, the shareholder must report his/her/its allocable share of the corporation’s income annually, whether or not the S corporation actually distributes its gross income. [IRC 1368(b).] It is possible, too, that the QSST trust might be authorized only to distribute as much of the trust’s assets as necessary to assist the trust beneficiary pay his/her income tax liability resulting from the QSST election, including the QSST trustee paying that beneficiary’s income tax liability directly. [Private Letter Ruling 8907010.]

Conclusion: As more wealthy individuals explore the use of a dynasty trust over the next couple of years to use their large applicable exclusion amount before it is cut in half, the terms of that dynasty trust need to be carefully considered. The ultimate goal is to build flexibility into that irrevocable trust, not only to make modifications or decantings in anticipation of changes in future circumstances, but also in the income taxation of that trust if the goal is to accumulate wealth in the trust. Adding some of the features to the non-grantor trust that are summarized above can help to contain the high federal  income taxation of non-grantor trusts in the future.