Take-Away: Grantor trusts are  popular estate planning tools these days. They are used to shift appreciating assets out of the grantor’s estate without incurring capital gains (and estate freeze)  and they require the grantor-settlor to continue to pay the income taxes on the trust’s income (and indirect form of a non-taxable gift to the trust beneficiaries.) The trust’s assets (and all future appreciation in the trust’s assets) escape future estate taxation on the grantor-settlor’s death. But some of the provisions that are sometimes used to cause a trust to be classified as a grantor trust for income tax reporting purposes can implicate the trustee’s fiduciary duties. Consequently, some statutory grantor trust ‘trigger’ provisions are perceived to be better than others from the trustee’s perspective, The best grantor trust ‘trigger’ is  the trust settlor’s retained power to substitute assets of equivalent value. If asked to serve as a trustee of a grantor trust pay close attention to the statutory provision that causes the trust to be taxed as a grantor trust for income tax reporting purposes; some of the statutory ‘triggers’ for grantor trust treatment may force the trustee into some tough decisions that implicate the trustee’s fiduciary duties to the trust’s beneficiaries.

Background: As a generalization, a grantor trust is disregarded for income tax purposes. Technically there is no transaction between a settlor-grantor (I will only refer to the creator as the grantor for this summary and not the settlor) and the grantor trust for tax purposes. The grantor trust is viewed as a ‘pocket of the grantor.’ If the grantor sells appreciated assets to a grantor trust no capital gain is recognized. The transaction is not treated as a sale because the grantor is treated as owning the purported consideration both before, and after, the sales transaction. In an installment sale (estate freeze) setting, if the grantor trust’s  trustee gives the grantor a promissory note for the purchase of the appreciated asset sold to the grantor trust, the trust does not gain a new income tax basis in the purchased asset. The grantor is also required to pay the income taxes on the income generated by the grantor trust; but that obligation is not treated as an indirect gift by the grantor to the trust’s beneficiaries, resulting in the beneficiaries enjoying the equivalent of tax-free income on the trust’s assets.

  • Reporting: Generally a grantor trust is not required to obtain an employee identification number (EIN), however many financial institutions will require an EIN for income reporting purposes and they will not permit the grantor’s social security number to be used for the grantor trust. If the entire trust is classified as a grantor trust the trustee need only fill-in the entity information on a Form 1041 and not show any dollar amounts on the Form 1041 itself. Instead,  the trustee of the grantor trust shows the dollar amount on attachments to the Form 1041. The attachment to the Form 1041 is not a Schedule K-1. The trustee then gives to the grantor a copy of the attachment. The information provided to the grantor includes: (i) a report on all items of income, deduction and credit of the trust; (ii) the identity of each payer of income to the trust; (iii) an explanation of how the grantor takes such items into account when preparing the grantor’s own Form 1040 income tax return,; and (iv) a statement that informs the grantor that these items must be included on the grantor’s own Form 1040 income tax return. Thus, the income must be reported in the same detail on the attachment as it would be reported on the grantor’s income tax return had the income been received directly by the grantor. Any deductions or credits that apply to the income also need to be reported in the same detail as they would be if they had been received directly by the grantor. The grantor then reports the items of income, deductions and creditors on the grantor’s personal Form 1040 return. As a generalization, the grantor provides to the trustee a signed W-9. The trustee then gives all of the payers of income to the trust during the calendar year the grantor’s social security number and the trust’s address. As noted earlier, if this procedure is followed,  the grantor trust is not required to obtain an employer identification number. Other options for filing information with regard to the grantor trust exist, but in those situations e.g. where there are two grantors of the same trust who are not spouses, the trustee of the grantor trust must obtain an EIN for the trust.
  • Debt: Key to the success of a grantor trust is that the grantor-settlor is viewed as holding  debt (the promissory note) and neither an asset, nor the right to receive income from the transferred asset, which would otherwise cause the trust’s assets to still be included in the grantor’s taxable estate under IRC 2036. [TAM 9251004 (Sept. 4, 1992.] Successful IRS attacks on grantor trusts have usually been based on the grantor retaining too much control over the transferred asset or possessing the right to receive all of the income generated by that asset held in the grantor trust, thus triggering estate inclusion of the transferred asset. [ IRC 2038 can also act as the cause for the inclusion of the asset values in the taxable estate.]
  • Estate Freeze: The grantor trust technique usually is used with a sale of an appreciating asset in exchange for an installment note given to the grantor. As a result, the grantor holds a non-appreciating assets, i.e. the promissory note given by the trustee, and the income generated by the asset that was sold to the grantor trust hopefully generates sufficient cash flow to service that promissory note- but there can  be no retained ‘right’ to that income held by the grantor. [This is often the reason that a grantor trust is ‘seeded’ with a gift equal to roughly 10% of the value of the asset to be sold to the grantor trust, in order to claim that the obligations under the promissory note are satisfied with assets beyond the income generated by the ‘sold’ asset.]
  • Estate ‘Burn:’ Another benefit that results from the sale of an appreciated asset to a grantor trust (although sometimes this takes a bit of convincing of the grantor) is that the grantor pays all of the income tax on the income generated by the asset held in the grantor trust. This attribute is called the estate burn, because the assets that will be exposed to estate taxes on the grantor’s death will instead be consumed in the payment of the trust’s income tax liability. This essentially permits the trust assets to grow tax-free (in a manner of speaking) inside the grantor trust for the ultimate benefit of the grantor trust’s beneficiaries. In short, the estate burn is just one more legal way to transfer wealth to the next generation without paying a gift tax. The IRS has also formally ruled that the grantor’s payment of the income tax liability on the income generated by the grantor trust is not an indirect taxable gift to the trust beneficiaries. Also, there is no imputed gift by the grantor if the value of the asset sold by the grantor to the grantor trust is equal to the face amount of the promissory note returned to the grantor, and the note bears interest at the prevailing interest rate that is prescribed in IRC 7872. [PLR 9535026.]

Advantages of a Grantor Trust: A quick summary of the advantages of using a grantor trust are:

  • No Capital Gains: No capital gain is realized on the grantor’s sale of appreciated assets to the grantor trust. [Rev. Rul.85-13, 1985-1 C.B. 184;]
  • No Income Realization: No income is realized when the grantor trust pays interest on an installment note obligation  to the grantor as part of the asset purchase by the grantor trust;
  • No Gain Realization: No capital gain is realized if appreciated property is transferred to the grantor as an in-kind in payment of any part of an annuity obligation, in the case of either a grantor retained annuity trust (GRAT,) or in the case of the installment obligation in a sale;
  • S Shareholder: The grantor trust may be a shareholder of an S corporation [IRC 1361(c)(2)(A)(i)] unlike other business entities;
  • Estate Burn: The grantor, not the trustee or the beneficiaries, will pay all of the income taxes on the income attributable to the grantor trust, thus reducing the size of the grantor’s taxable estate for federal estate tax purposes while increasing the wealth available to the grantor’s descendant-beneficiaries;
  • Residence: If a residence is held by the grantor trust, the grantor-beneficiary will be treated as the owner of the residence and the $125,000 capital gain exclusion rule on sale of the residence will be available to the grantor; thus a qualified personal residence trust (QPRT) is also a grantor trust; [Reg. 1.121-1(c)(3)(i)]
  • No Tax Filings: A grantor trust can avoid obtaining a taxpayer identification number and filing separate income tax returns, as all income and tax attributes are reported on the grantor-settlor’s 1040 income tax return. [Treas. Reg.1.671-4.]

Grantor Trust Rules: There are various provisions in the Tax Code that cause (or trigger) an irrevocable trust to be classified as a grantor trust for income tax reporting purposes. Many of these trigger provisions involve to some degree decisions made by the trustee of the grantor trust. While the provisions might be included in the trust to achieve grantor trust classification for the grantor’s tax and estate planning objectives, often overlooked is the trustee’s continuing fiduciary duties to all trust beneficiaries of the same grantor trust.

Key Point: Restated, the trustee’s fiduciary duty to trust beneficiaries is sometimes over-shadowed by the goal to assure grantor trust classification for the trust, primarily for the grantor’s personal benefit.

Portion of the Trust: First it is important to remember that under the grantor trust rules, a grantor may be treated as the owner of any portion (including the ‘entire portion’ (is that an oxymoron in the Treasury Regulations?)) of the grantor trust for income tax purposes. Any remaining portion of the trust of which the grantor is not treated as the owner, is subject to the generally applicable income tax rules for trusts, i.e. the trust may end up paying some of its own income tax liability. [IRC 671.] For example, depending on the power retained by the grantor, the grantor might be treated as the owner of only the trust’s income, the trust’s principal, a fractional or pecuniary share of the trust’s corpus, or only over a specific asset held in the trust. [Reg. 1.671-3(a)(3).] A crummey withdrawal power held by a trust beneficiary, or a 5% or $5,000 power granted to a trust beneficiary,  which is released (not lapsed)  would cause that power holder to be treated as the owner/grantor of the portion of the assets that were subject to the released power, as an example where there might be two separate grantors of the same irrevocable trust for income tax reporting purposes.

Common Grantor Trust Powers:

  • Life Insurance Trusts: If the trust instrument gives to the trustee the power to use trust income to pay premiums on insurance on the life of the grantor or the grantor’s spouse, the trust will be classified as a grantor trust, such as an irrevocable life insurance trust (ILIT.) [IRC 677(a)(3).] Thus, if an ILIT is created and holds a ‘side-fund’ of income producing assets used to pay the insurance premium each year, the grantor will have to report the side-fund’s income on his/her Form 1040 income tax return. Note that the entire trust will be classified as a grantor trust even though only a part of the trust’s income was actually used to pay the life insurance premium. [PLR 8103074.]
  • Substitute Assets: By far the most commonly used trigger provision in a trust instrument to cause it to be taxed as a grantor trust, and probably the safest from the trustee’s perspective who has fiduciary responsibilities to the trust beneficiaries, is the grantor-settlor’s retained power to reacquire the trust corpus by substituting other property of equivalent value in the trust. [IRC 675(4)(C).] This power that is included in the trust instrument is often most favored because it does not affect the interests of the trust beneficiaries. The grantor decides  to exercise the retained right to reacquire assets from the trust, and the trustee’s sole responsibility then is to assure that the assets to be substituted by the grantor are of equivalent value to the assets that are to be reacquired by the grantor from the grantor trust. This power is usually expressly retained by the grantor in the trust instrument itself and it is seldom inferred. As noted, the substitution must be at the then fair market value of the assets, not the initial sale price of the asset. Other trust provisions that are normally found along with a right of substitution grantor trust include: (i) the grantor-settlor who sold an asset to the trust retains no control over the trust or the asset that is sold to the trust, and the trustee if free to transfer the asset at any time often without notice to the grantor ; and (ii) the power of substitution applies to all trust property, not just the property sold to the grantor trust. Moreover, the IRS often looks to confirm if there is a prearrangement or expectation at the time of the grantor’s sale that the asset will be reacquired by the exercise of this retained power, or if  the asset was reacquired it was not reacquired soon after it was sold to the grantor trust. In sum, a finding of a prearrangement by focusing on the facts [not just the trust instrument] may jeopardize the trust from a tax perspective, e.g. causing gain to be recognized on the sale, or inclusion of the value of the trust assets in the grantor’s taxable estate.
  • As noted, this right to substitute assets is the best type of grantor trust trigger since the trustee’s only real duty is to make sure that assets of equivalent value are substituted into the grantor trust (which can sometimes be problematic if the grantor-settlor proposes to give a promissory note in exchange for the trust’s assets, as the fair market value of a promissory note is something the IRS takes a close look at these days.) Note, however, that this retained trigger power is only exercisable in a non-fiduciary capacity [Rev. Rul. 2008-22, 2008-16 I.R.B. 796] which means that the grantor is seldom a co-trustee of a grantor trust. It is customary to accompany the power of substitution in a grantor trust with the affirmative requirement that the trustee must be satisfied “ that the properties acquired and substituted by the grantor are in fact of equivalent value.” [Rev. Rul. 2011-28, 2011-49, I.R.B. 830.]
  • Finally,  if the grantor who retains the right to reacquire the trust assets dies, the trust  will cease to be classified as a grantor trust; however, the Tax Code section that includes this ‘trigger’ of reacquisition, reads that it is a grantor trust when the right to reacquire is held by ‘any person,’ which means that if another individual possesses the right to reacquire the assets besides the grantor e.g. the grantor’s surviving spouse,  the grantor’s death will not terminate the grantor trust tax classification.
  • Administrative Powers: Many administrative powers under the Tax Code can cause an irrevocable trust to be classified as a grantor trust. However, these powers tend to involve the trustee’s discretion more than the grantor’s retained substitution power, and thus they can implicate the trustee’s fiduciary duties to the trust beneficiaries.
  • Deal with Trust for Inadequate Consideration: One administrative trigger is the grantor or the grantor’s spouse is permitted to deal with the trust for less than adequate and full consideration; this retained right causes the trust to be a grantor trust, but it also requires the trustee to ascertain what is (or is not) adequate consideration, not to mention the implication that receiving ‘less than full consideration’ means that trust assets will be depleted in favor of a non-trust beneficiaries- the grantor or the grantor’s spouse. [IRC 675(1).] So the grantor (or the grantor’s spouse) can indirectly benefit from the trust, but the trustee has no fiduciary duties to these non-beneficiaries. If assets are acquired for adequate consideration by the grantor or his/her spouse, the trust is no longer a grantor trust, possibly causing the inclusion of the trust assets in the grantor’s taxable estate which might make beneficiaries of the grantor’s estate unhappy. [IRC 2036 or 2038.] The beneficiaries of the grantor trust may not be the same individuals who are the beneficiaries of the grantor’s estate, which means that neither group may be very happy with the trustee’s decision using an ‘inadequate consideration’ grantor trust Does the trustee want to intentionally enter into a transaction with the grantor (or the grantor’s spouse) for less than adequate consideration in light of the trustee’s duty to administer the trust ‘for the benefit of the beneficiaries?’ [MCL 700.7801(1) or ‘solely in the interests of the trust beneficiaries?’ [MCL 700.7802(1)] or ‘as a prudent person in dealing with property of another?’ [MCL 700.03.]78
  • Borrow without Adequate Interest: The grantor’s ability to borrow from the trust without adequate interest paid is yet another way for the trust to be classified as a grantor trust.[IRC 675(2).] But permitting trust assets to be loaned without ‘adequate interest’ involves suggests that the trustee is not carrying out its fiduciary duties to trust beneficiaries to ‘protect and preserve trust assets’ [MCL 700.7810.]  Loaning trust assets to the grantor or his or her spouse without adequate security sounds a lot like a breach of the trustee’s fiduciary duty to trust beneficiaries. So while the trustee may work with the grantor (or the grantor’s spouse)  to achieve the intended income tax consequences of the grantor trust, the trust beneficiaries may suffer as a result and thus the beneficiaries may have a different assessment of the trustee’s lending transaction in concert with the trust’s grantor (or the grantor’s spouse, who may not be the parent of the trust beneficiaries.) Are you beginning to get the picture of the awkward position that some of the Tax Code’s grantor trust trigger provisions places the trustee?
  • Add Beneficiaries: If an independent trustee or another independent person can add beneficiaries and cause distributions to be made to those ‘newly added’ beneficiaries from the trust that power too will trigger the trust to be classified as a grantor trust. [IRC 674(a).] But how will the existing trust beneficiaries feel if the trustee decides to add new beneficiaries and make distributions to them to the exclusion of the existing trust beneficiaries? I would expect that the existing trust beneficiaries will not be very  happy if the trustee exercises that power. Obviously there is less pressure on the trustee if another independent person possesses the right to add new trust beneficiaries and force distributions to the new trust beneficiaries.
  • No Longer a Grantor Trust: What about the situation where a the grantor approaches the trustee and asks it to relinquish or disclaim the power conferred on the trustee to add beneficiaries and to make distributions to those new trust beneficiaries? Assume that the grantor is tired of paying the grantor trust’s income tax bill each year, and he/she asks the trustee to disclaim the trigger power, so the trust will no longer be a grantor trust. If the trustee relinquishes or disclaims the power to add new trust beneficiaries, that would cause the trust to no longer be classified as a grantor trust  for income tax reporting purposes. The obvious result of such relinquishment would be to subject the trust, and indirectly  its beneficiaries,  to an income tax that they would otherwise have avoided. Again, a disclaimer of the power held by the trustee will not make the trust beneficiaries very happy.  While the trustee might possess broad discretion under the trust instrument to disclaim or relinquish powers conferred on the trustee,  that broad authorization might not be sufficient to authorize the trustee to relinquish such a power when there is no reason to do so. In short, mere accommodation of the grantor’s wishes by the trustee does not appear to ever be a proper reason to disclaim a power that harms the trust and indirectly the trust beneficiaries.

Conclusion: There are several tax reasons why an individual may want to establish a grantor trust, perhaps the most important being that the income taxes the grantor pays on the trust’s income will not be treated as an indirect gift from the grantor to the trust beneficiaries, thus permitting the trust beneficiaries to enjoy ‘tax-free’ income from the trust. But the choice of the Tax Code provision that causes the grantor trust tax treatment may be as important to the trustee as it is to the trust’s grantor. It is important to confirm why the trust will be classified as a grantor trust and for the trustee to assess its future liability if a provision, other than the right to reacquire and substitute assets of equivalent value, is intentionally used to cause grantor trust status that involves the trustee’s judgment and  implicates the trustee’s fiduciary duties owed to existing trust beneficiaries. This results in a balancing act by the trustee between accommodating the grantor who intentionally established a grantor trust for several income tax reasons, and the administration of the trust solely for the benefit of the beneficiaries. It also reflects to some extent the current evolution in trust law; for decades conventional trust law was described as the ‘search for and the implementation of the trust grantor’s intention’ but with the advent of the Uniform Trust Code, while there are periodic references in the Code of the need to accommodate the grantor’s material purposes, the emphasis of the Trust Code is now on the trustee’s duty of loyalty to administer the trust instrument solely for the benefit of the trust beneficiaries ( not serve the grantor’s purposes). It is something to think about when asked to serve as trustee of a grantor trust.