Take-Away: Grantor trusts for income tax purposes cause the grantor/settlor of the irrevocable trust to pay the income taxes on the trust’s income. But the trust’s assets will not be included in the grantor’s estate for estate tax calculation purposes. Some of the benefits of a grantor trust are: (i) a transfer of assets between the grantor and the grantor trust will be ignored for federal income tax purposes; (ii) the grantor’s payment of the trust’s  income tax liability will not be treated as a taxable gift by the grantor to either the trust or to the trust’s beneficiaries, the result of which is to transfer more wealth, transfer-tax-free, to the trust beneficiaries; and (iii) the income tax treatment of a grantor trust results in what is commonly called an estate burn, since the grantor’s taxable estate is reduced (burned) over time through the payment of the trust’s annual income tax liability, resulting in a smaller federal estate tax to be paid on the grantor’s death.

Tax Background: If the irrevocable trust is classified as a grantor trust, the grantor of the trust will be treated as the owner of any portion of a trust for income tax reporting purposes, and the grantor must include in computing the grantor’s taxable income those items of income, deductions, and credits against tax of the trust which are attributable to that trust. [IRC 671.]

Grantors: It is possible that there may be more than one grantor of the grantor trust for income tax reporting purposes. Example: A trust beneficiary is given a right to withdraw assets from the trust; by failing to exercise that withdrawal right, that portion of the trust corpus attributable to the assets that were not withdrawn by the beneficiary will cause the beneficiary to be treated as a grantor for a proportion of the trust [the withdrawable portion divided by the entire trust corpus.]

Grantor Trust Classification: How an irrevocable trust becomes classified as a grantor trust for income tax reporting purposes can either be easily accomplished by deliberately adding certain retained powers in the trust instrument, or grantor trust status can materialize under the facts and circumstances of the trust’s administration (the grantor classification possibly changing annually (or toggled on or off.))

Trust Provisions: If a trust instrument gives to the grantor/settlor certain powers, the existence of those powers, whether or not exercised by the grantor, will cause a trust to be classified as a grantor trust for income tax reporting purposes.

Power is retained to borrow from the trust without adequate interest or security. [IRC 675(2).]

Power is retained to add a charitable beneficiary to the trust. [IRC 674(b)(5).]

Power is retained to reacquire trust assets, by substituting property of equivalent value, commonly called the swap power. [IRC 675(4)(C).]

Power is retained to purchase, exchange or otherwise dispose of or deal with the trust corpus or trust income for less than full and adequate consideration. [IRC 675(1).]

Power exercisable by any person, not just the grantor, without approval or consent of any person who is a fiduciary, to vote or direct the vote of stock, to control investments of the trust, or to swap assets from the trust. [IRC 675(4).]

Power is retained by the grantor, or a nonadverse party, to revoke the trust. [IRC 676.]

If income can be distributed at the direction of the grantor or a nonadverse party, for the benefit of the grantor or the grantor’s spouse, or held and accumulated for future distribution to the grantor or the grantor’s spouse, or used to purchase life insurance on the life of the grantor or the grantor’s spouse. [IRC 677.]

  • Trust Administration: If the settlor/grantor borrows assets from the trust and if the loan is not repaid by the beginning of the next taxable year, known as a toggle power, the grantor trust classification exists for the next following calendar year. In contrast, if the loan is repaid before the end of the calendar year, then the trust is not classified a grantor trust for the next calendar year. [IRC 675(3).]

Ability to Affect Beneficial Enjoyment: As noted, a  trust will be classified as a grantor trust for income tax purposes if the beneficial enjoyment of the trust corpus or the trust income is subject to a power of disposition that is exercisable by either the grantor or a nonadverse party, or both, without the approval or consent of adverse party. [IRC 674(a).]

  • Adverse Party: An adverse party is defined as a person who has a substantial beneficial interest in the trust which would be adversely affected by the exercise, or the non-exercise,  of the power which the grantor possesses with respect to the trust. [IRC 672(a).] A trustee is not considered an adverse party merely because of the trustee’s interest as the trustee. [Reg. 1.672(a)-1(a).]
  • Substantial Beneficial Interest: The Regulation’s definition of a substantial beneficial interest is not particularly helpful. The Regulations describe a beneficial interest as being a substantial interest if its value in relation to the total value of the trust property that is subject to the power is not insignificant. [Wow, that’s a big help in guiding taxpayers!] [Reg. 1.672(a)-1(a).] According to the IRS, a contingent beneficiary might be treated as an adverse party to the grantor if there is a likelihood that the contingent interest would vest in the future; the is key to determine if the contingent beneficial interest is Again, this is not much help when intentionally drafting a grantor trust. [Reg. 1.672(a)-1(d).]

Common Powers that Purposefully Cause a Trust to be Classified as a Grantor Trust:  The mere presence of these retained powers, standing alone, will cause the trust to be classified as a grantor trust.

  1. Loans to the grantor without the need to pay adequate interest or the need to furnish adequate security for the loan;
  2. The power to add a charitable beneficiary to the trust; or
  3. The power to reacquire trust corpus (assets) by substituting other property of equivalent value, which is the most commonly used power that is intentionally included in the trust instrument to cause it to be classified as a grantor.

Commonly Encountered Grantor Trusts.

  • ILIT: An irrevocable life insurance trust (ILIT) is often classified as a grantor Often the grantor, or the grantor’s spouse,  is the life that is insured by the policy that is held in the ILIT. A grantor trust is also used to avoid the Tax Code’s transfer-for-value rules that would otherwise cause the death benefit that is paid under the policy to be taxed to the beneficiaries of the policy as ordinary income. The classification is also used when the grantor exchanges one life insurance policy for an ‘old’ policy held by the ILIT- the exchange of policies is ignored for tax purposes as the grantor is treated as dealing with himself/herself.
  • GRAT: A grantor retained annuity trust (GRAT) is a statutory creation under IRC 2702 and Reg. 25.2702-3. The donor receives a retained right to receive an annuity stream for a set number of years under a GRAT. Any remaining assets held in the GRAT after the set number of years ends, pass to children or continuing trusts for the grantor’s descendants, usually gift tax free. Because of its status as a grantor trust, the grantor remains responsible for the any income taxes generated by the assets held in the GRAT. Consequently, the GRAT’s assets are not eroded by income and capital gains tax payments, making it easier to result in assets remaining in the name of the GRAT when the set number of years ends, which assets then pass on to descendants or continuing trusts for their benefit gift tax-free.
  • QPRT: A qualified personal residence trust (QPRT) is also a statutory creation under IRC 2702 and its implementing Regulations. The grantor retains the exclusive use of the residence for a fixed use term. The QPRT permits the grantor to transfer the remainder interest in the QPRT, which is a taxable gift, at a discounted gift tax cost, usually to descendants or to continuing trusts. The QPRT remainder interest is valued when title to the principal residence is transferred to the QPRT- it is the value of the residence but only after the end of the retained fixed use term retained by the grantors. If the QPRT holds additional investment assets besides the residence, the income those assets generate is reported by the QPRT grantor not the QPRT. A QPRT is used to shift all future appreciation of the residence to the remainder beneficiaries over the QPRT’s fixed used term free from any gift tax.

Intentionally Defective Grantor Trusts (IDGT): Unlike a GRAT or QPRT, which are creatures of the Tax Code, a IDGT is a creature of case law (judges.) An intentionally defective grantor trust’s (IDGT) purpose is to deliberately invoke the grantor trust rules. The use of the word defective is because normally it is not considered desirable to be taxed as a grantor trust [i.e. the grantor must pay income taxes on income that the grantor does not receive, which can create a financial and cash-flow hardship for the grantor.] The use of the word intentional is because the trust deliberately includes one or more of the retained powers, summarized earlier, in order to invoke grantor trust treatment for income tax (but not estate tax) reporting purposes. Perceived benefits arising from an IDGT follow:

  • Tax-Free Gifts: The assets held in the IDGT can grow unreduced by income taxes, i.e. the payment of the income taxes by the grantor is viewed as a tax-free gift to the trust beneficiaries, but the trust corpus (its assets) are not included in the grantor’s taxable estate for estate tax purposes. Consequently, the primary benefit of using an IDGT is that the trust’s  assets which have grown in an income tax-free environment (not actually free, however,  because the grantor must pay the income taxes)  can pass to the trust beneficiaries free from estate taxes at the grantor’s death, as well as free from the generation skipping transfer tax (GST.) An IDGT is one way where a grantor, who has maxed out his/her lifetime gifts to descendants, can continue to make indirect gifts to those same descendants through the payment of the grantor trust’s income tax liability.
  • Grantor’s Estate Freeze: An IDGT is often used to freeze asset values for the grantor’s estate tax purposes (but not income taxes.) Typically the grantor funds the IDGT with an initial gift of cash sufficient for a down payment, like 10% of the value of the asset to be sold to the IDGT. The Grantor then sells an appreciating asset to the IDGT in exchange for a promissory note. This note given by the trustee of the IDGT can provide for payments of interest only, or on an annual basis. Often the payments made under the note are made for a specified number of years, with a balloon payment of the principal of the note at the end of the specified term of the note. Why sell appreciating assets to an IDGT? The ‘sale’ is ignored for tax reporting purposes, as the grantor is treated as entering into a transaction with himself/herself, meaning no capital gains are recognized on the ‘sale.’ And the appreciating asset is exchanged for a promissory note that will not appreciate in value while held by the grantor.

To summarize the benefits of an IDGT:

  • (i) Estate Freeze: In effect the ‘sale’ is actually an ‘exchange’ of an appreciating asset, now held by the IDGT,  for a fixed promissory note held by the grantor; the note will not appreciate in the hands of the grantor, unlike the asset the grantor just sold to the IDGT. This is called an estate freeze where all future appreciation of the asset is removed from the grantor’s taxable estate;
  • (ii) Estate Burn: Since the grantor will pay the income taxes on the income earned by the IDGT, so long as the IDGT is classified as a grantor trust, ‘other’ assets owned by the grantor, which will someday in the future be exposed to estate taxation,  will be consumed (burned) to pay the IDGT’s income tax liability. The smaller the grantor’s taxable estate, the less estate taxes that the grantor’s estate will have to pay;
  • (iii) Avoid Capital Gains: Since the grantor and the IDGT are treated as one and the same ‘person’ for federal income tax reporting purposes, the grantor’s sale of appreciated assets to the IDGT will not cause the grantor to recognize any capital gain on the sale of the appreciated asset. Thus,  no capital gains are paid by the grantor on his/her sale of appreciated assets to the IDGT;
  • (iv) Interest Ignored: Because the grantor and the IDGT are treated as the same ‘person’ under the federal income tax rules, any interest payments on the note by the IDGT trustee to the grantor are not subject to income taxation by the grantor; and
  • (v) Basis Step-Up: Arguably one drawback to the use of the IDGT these days is that the appreciating assets sold to the IDGT by the grantor will not receive any income tax basis step-up on the death of the grantor, since the IDGT assets are not included in the grantor’s taxable estate. [IRC 1014.] Moreover, current tax planning is all about saving income taxes more than saving estate taxes considering a taxpayer’s gift, estate, and GST tax exemption is now $11.18 million. But if the IDGT is classified as a grantor trust for income tax purpose,  with the grantor retaining a swap power, prior to the grantor’s death, he/she (or their agent acting under a durable power of attorney) could exercise the swap power and transfer cash or other high basis assets into the IDGT in exchange for the low basis, highly appreciated, assets that were originally transferred into the IDGT. In short, depending on the tax rules in effect near the grantor’s death, the low basis assets can be returned to the grantor through the use of the swap power, exposing them to a basis step-up on the grantor’s death .In short, the grantor can go to his/her grave owning the low income tax basis assets (initially held in the IDGT prior to the swap) and because the grantor owns those assets at death, they will be subject to a full basis adjustment under IRC 1014.

Toggling Grantor Trust Status:

  • Release Retained Powers: Grantor trust status can be turned off and on. But the IRS has announced that the toggling of grantor trust status is a ‘transaction of interest’ that must be disclosed to the IRS. [Notice 2007-73.] The grantor trust status can be turned off by the grantor formally releasing one of the retained powers, identified above, that causes the trust to no longer be classified as a grantor Similarly, grantor trust status can be turned on, such as by a trust protector adding the grantor’s spouse or a charity to the class of trust beneficiaries. But those are more likely to be ‘one-and-done’ toggling events.
  • Loans: The grantor trust classification can also be changed from year to year using an unpaid loan from the trust to its grantor. As noted earlier, the grantor can borrow assets from the trust without adequate interest or adequate security. If the borrowed funds are not repaid by the beginning of the next taxable year, then the trust is treated as a grantor trust for that next calendar year. [IRC 675(3).] Consequently, if the grantor does not want to have to pay the income taxes on the trust’s income for the next year, he/she needs to repay the outstanding loan that is either under-secured or which accrues interest at a below-market rate of interest. While this all sounds fairly clever, turning on or off the grantor trust status each calendar year depending upon whether a favorable loan to the grantor remains outstanding, it can also be very problematic for a couple of reasons. First, figuring out what is inadequate security or an inadequate interest rate is subject to a factual debate, and it is easily subject to dispute by the IRS, long after the fact. Second, trustees should have second thoughts about accommodating a settlor who wishes to toggle on and off grantor trust status when it comes to the trustee’s fiduciary duties to the trust beneficiaries. Intentionally making a loan to the grantor with inadequate security, or making a loan to the grantor at below market interest rates seems to invite claims of breach of fiduciary duties by the trust beneficiaries as a violation of the prudent investor rule. And while intentionally turning ‘on’ the grantor trust classification to force the grantor to pay the trust’s income tax liability might be viewed an acceptable exercise of the trustee’s discretion, shifting the income tax burden away from the grantor and back to the trust and its assets, resulting in less after-tax income available to be distributed to the trust beneficiaries,  may be viewed by the trust beneficiaries as a breach of the trustee’s fiduciary duty of loyalty to administer the trust solely in the trust  beneficiaries’ best interests.

Conclusion: There are still many unanswered questions surrounding grantor trusts, and especially the sale of appreciated assets to an IDGT. But a grantor trust can be very useful tool when the grantor has fully used his/her gift tax exemption and the desire exists to continue to make gift-tax-free gifts to family members. The IDGT can be particularly useful, too, when the goal is to move appreciated assets, like the grantor’s closely held business, from the grantor’s taxable estate without paying any capital gain taxes on that ‘sale,’ in effect exchanging the closely held business for a promissory note which is paid to the grantor in his/her retirement years.