Take-Away: While grantor trusts are popular in estate planning from a gift, estate, and GST perspective, non-grantor trusts are gaining popularity for a variety of income tax reasons. If the income tax rules are changed by Congress, the use of non-grantor trusts will gain even more attention, along with the possible use of multiple non-grantor trusts to shift or ‘spread’ income.

Background: For decades multiple trusts were used to split taxable income among separate taxpayers to exploit progressive income tax rates, i.e. the higher the income, the higher the income tax rate applied. It was only until 1984 that Congress got around to addressing the use of multiple non-trusts for income tax avoidance with the Tax Reform Act of 1984  when it adopted what is now known as IRC 643(f).

  • IRC 643(f): IRC 643(f) provides that if there are two or more trusts, they are going to be treated as one trust if the trusts have substantially the same grantors and substantially the same primary beneficiaries, and the principal purpose of the multiple trusts is avoidance of income tax. Moreover, under IRC 643(f) spouses will be treated as one person.
  • Compressed Income Tax Rates: The concept of using multiple non-grantor trusts for tax avoidance was further impacted when compressed income tax brackets for trusts and estates first appeared under the Tax Reform Act of 1986. Today, the compression in income tax brackets for trusts detracts from the use of non-grantor trusts, if a trust is at the highest marginal income tax bracket with reported income just over $13,000. [For comparison purposes, an individual is at the highest marginal income tax bracket at $523,600, and joint filers are at the highest marginal income tax bracket at income over $628,300.]

Reasons for Non-Grantor Trusts: Despite the reasons why there is not much of a reason to use multiple non-grantor trusts, there are still good reasons to use a non-grantor trust.

  • The Grantor Does Not Want to Pay the Trust’s Taxes: While grantor trusts are used to consume the grantor’s taxable estate through the payment of that trust’s income tax liability (a tax-free gift to the trust beneficiaries under Revenue Ruling 2004-64) a grantor may need their own cash flow, they may be illiquid, or they may not have the cash to pay the trust’s income tax liability. In these situations, a non-grantor trust would make more sense than a grantor trust.
  • Defer State Income Taxes: If a non-grantor trust is established in a handful of jurisdictions [Delaware, Nevada, Alaska, Texas, Florida] the trust may not have to pay any state income taxes, if there is no sourced-income from the estate where the trust is sitused. Consequently, an out-of-state non-grantor trust can save income taxes if that state has little nexus to the trust.
  • IRC 199A Deduction: This is the 20% income tax deduction that was created under the 2017 Tax Act. For individuals, this income tax deduction is limited or phased out, subject to wage and asset ‘tests’ once income exceeds $164,900. Each non-grantor trust has its own phase-out limit. If multiple non-grantor trusts owned qualified businesses, each one of those non-grantor trusts would receive its own IRC 199A 20% deduction, and its own phase out limit.

SALT Limitation: The 2017 Tax Act also created the state and local tax (SALT) limitation on deductible state and local taxes of $10,000. Non-grantor trusts could be used to create multiple owners of an asset to each claim their own $10,000 limitation. Example: A mansion has a real property tax of $40,000 each year. The owner transfers title of the home to 4 non-grantor trusts, one for each of the owner’s children. Each of those non-grantor trusts could deduct its pro rata share of the real property tax for the year, or $10,000. If the home remained in the name of the owner, then $30,000 of the $40,000 property tax bill could not be deducted.