Are you working on an estate plan and unclear what a grantor trust is? Simply put, a grantor trust is when the same individual who owns assets opens and places them into a trust.
As the creator of the trust, the grantor, you may have several purposes for creating such a holding vehicle, such as estate planning or real estate investing for other trust beneficiaries.
To a large extent, trusts usually concern more of your future affairs than your present ones. But, a grantor trust has perks that you can enjoy starting today. The former is a limited understanding of what different trusts can do. In this case, a grantor trust extends what trusts can do for the actor alluded to in its name – the grantor.
What is a Trust?
A trust is an agreement with a third party, called the trustee, which holds assets for a beneficiary in the future. This future could be stipulated according to the preferences of a grantor, but it is most commonly commenced when the grantor dies.
Creating trusts and trust funds involves consulting with an estate planning attorney and laying the groundwork on what you, as the assets owner, plan to do with those when you’re gone and unable to make decisions.
Preference for a trust over a will is often to avoid the probate process, among other reasons and benefits. For example, a will usually involves a lengthy and tedious undertaking that would keep the trust’s assets away from its rightful beneficiaries for longer.
Creating a trust is beneficial for financial and estate planning since it guides the distribution of the grantor’s estate as if the grantor is still exercising control over their wealth at that moment. Consequently, it protects legacy, and in most cases, it can save more on fees, taxes, and potential disputes.
What Is a Grantor Trust?
A grantor trust is a generic term referring to a living trust where the grantor is the owner of the assets in the trust. One of the most common trusts of this nature is the revocable living trust.
This type of trust is given a grantor trust status which means that the trust has the implications of a grantor trust during taxation. Triggering the grantor trust status depends on the grantor’s powers and authority, such as serving as the trustee, adding or removing beneficiaries, and sustaining the capacity to cancel the trust and retrieve the transferred property.
Not all grantor trusts are revocable trusts. An irrevocable trust can also be formed if it meets the guidelines. But, when the irrevocable trust is permanent and has no potential to be undone, the income tax implications will be different than those of a grantor tax.
Grantor Trust vs. Irrevocable Trust
The requirements that can turn an irrevocable trust into a grantor trust depend on several criteria – the grantor continues to hold reversionary interest, retains the administrative control of the trust (including the beneficial enjoyment of the trust income), and retains the power of revocation.
However, irrevocable trusts not given grantor trust status differ from grantor trust in the following cases. First, the grantor trust can reclaim assets from the trust while an irrevocable trust completely and permanently surrenders control over the grantor’s estate. This would mean that a third party acts as the trustee who manages the trust assets. Second, income from the trust assets is included in the grantor’s income tax under a grantor trust. But, for the irrevocable one, the trust acts as a separate tax entity and follows the trust income tax rates. Third, the trust assets are subject to estate tax for grantor trusts, but this is not the same for an irrevocable trust which is not subject to estate taxes.
Income Tax Purposes
When owners retain control over their assets in a trust, income taxes will follow a different process. As the grantor in a grantor trust, you will be paying taxes on the income generated by the trust’s assets, such as the income produced by bonds. This has three implications.
First, it simplifies the process when filing income taxes. The grantor does not need to file a separate income tax return because the income is taxed to the grantor. Second, if the grantor wants to remove value from their estate tax, then having the tax paid for in the grantor’s personal income tax is the preferable option. Third, as a natural consequence of this process, the trust is able to grow tax-free. This allows for the trust to increase its compounding value, making it a sound financial investment.
The income generated from trusts belongs to a higher tax bracket compared to individual income tax rates. It takes much more earnings to qualify for a higher tax bracket under income taxes than trust tax brackets.
Types of Grantor Trusts
There are four grantor trusts to choose from during your estate planning – each with its purpose and merit on your financial goals.
Revocable Living Trust
A revocable living trust is the simplest type among the four grantor trusts. The process follows that of creating a revocable trust. You create a trust, name yourself as the trustee to manage the assets, and do as you wish for the future of the trust.
This will immediately follow the implications of a grantor trust as it meets the requirements necessary to qualify for grantor trust status.
Grantor Retained Annuity Trust (GRAT)
A grantor-retained annuity trust, or GRAT, is an irrevocable trust whose distinguishing factor allows you to draw income from the trust assets.
As the name suggests, the grantor will receive annuity payments during a specific time. Once this ends, the remaining assets will be distributed among the identified beneficiaries.
Qualified Personal Residence Trust (QPRT)
A Qualified personal residence trust or QPRT is an estate planning tool that aims to reduce taxes. The identifying element of the QPRT is the grantor can transfer the ownership of their primary or secondary residence and exclude its value from their taxable income.
This option is best for those with a high-value estate that the grantor would want to pass on to their beneficiaries with tax advantages.
Intentionally Defective Grantor Trust (IDGT)
An intentionally defective grantor trust or IDGT is another type of irrevocable trust that meets grantor trust conditions. Under this type of grantor trust, the grantor is treated as the owner of the trust assets for income tax purposes, but this ownership does not apply to estate tax.
The grantor must pay for the income taxes on any applicable income generated by the trust’s assets before the grantor dies. After which, the beneficiaries receive the trust without estate taxes. This type of grantor trust decreases the financial impact of gift taxes and estate taxes for wealthier families whose asset values within a trust are significant.
Grantor Trust Rules
As we have established, a trust can exist for multiple reasons. And as we have seen, these reasons could include personal ones that affect a grantor’s current financial standing rather than solely for their beneficiaries.
Wealthy families initially used grantor trusts as a tax haven since the income generated by the trust’s assets was not treated as a separate entity. An additional benefit includes the flexibility of removing assets from the trust or even canceling it as a whole when the decision calls for it. Thus regulations were established to prevent and address the misuse of this trust.
Examples of Grantor Trust Rules
The grantor trust rules apply to the different types of grantor trusts. Rules specify how grantor trusts should operate:
- The guidelines on adding or changing beneficiaries.
- The procedure for adding or removing assets in the trust.
- The power to borrow from the trust.
- The ability to substitute the assets of the trust with something of equal value.
- The procedure of using the income from the assets to pay premiums or mortgages.
Benefits of a Grantor Trust
There are three main benefits of a grantor trust, both in the short and long term:
- Managing the trust income: If you have assets that generate significant value in a trust, you will be subject to taxes. But, some tax classifications are better than others. For example, grantor trust rules allow individuals to be protected from taxes to some extent as the income taxes on an individual level have a higher threshold to be taxed in a high-income bracket than a trust tax.
- The flexibility of elements: The grantor can change the beneficiaries, the composition of the trust, and the continuance of the trust. Aside from these, grantor trusts outline specific instances when you can create specific tax strategies depending on your assets. An example is the ability to exclude your residence from the taxable income.
- Guarantee for your beneficiaries: Estate taxes will have to be paid by the beneficiaries when a grantor dies. They can use the money from the trust to fund this, which will, unfortunately, result in fewer assets up for distribution. A grantor trust can decrease this impact by paying for the taxes upfront so that the beneficiaries can receive assets tax-free.
Is a Grantor Trust for you?
Before creating a grantor trust, your short-term financial stability and goals are significant considerations. A grantor trust assumes that the grantor has the financial capacity and liquidity to pay for the income tax obligations during their lifetime. This becomes a more pressing problem when the capital gains or income generated by the trust assets are more than what’s expected, especially for investment assets.
Therefore, a grantor trust is for those who can afford the uncertainty of increasing income and increasing tax liability or those who foresee a stable income from the trust assets that are comfortable with reporting those under their personal taxable income.
Under the Biden administration, some of the proposed changes governing grantor trust rules include including all assets in the grantor trust in the grantor’s estate when they die, classifying distributions from the trust as gifts subject to gift tax, and the tax implications when switching from a grantor to non-grantor trust. These changes, if passed, will have consequences on the financial viability of creating a grantor trust and whether the costs outweigh the potential short and long-term benefits.
But, for now, a grantor trust with its different types has unique strategies to offer such that the grantor can enjoy being a beneficiary of their hard work as well.
Josh is a financial expert with over 15 years of experience on Wall Street as a senior market strategist and trader. His career has spanned from working on the New York Stock Exchange floor to investment management and portfolio trading at Citibank, Chicago Trading Company, and Flow Traders.
Josh graduated from Cornell University with a degree from the Dyson School of Applied Economics & Management at the SC Johnson College of Business. He has held multiple professional licenses during his career, including FINRA Series 3, 7, 24, 55, Nasdaq OMX, Xetra & Eurex (German), and SIX (Swiss) trading licenses. Josh served as a senior trader and strategist, business partner, and head of futures in his former roles on Wall Street.
Josh's work and authoritative advice have appeared in major publications like Nasdaq, Forbes, The Sun, Yahoo! Finance, CBS News, Fortune, The Street, MSN Money, and Go Banking Rates. Josh currently holds areas of expertise in investing, wealth management, capital markets, taxes, real estate, cryptocurrencies, and personal finance.
Josh currently runs a wealth management business and investment firm. Additionally, he is the founder and CEO of Top Dollar, where he teaches others how to build 6-figure passive income with smart money strategies that he uses professionally.