Is A Grantor Trust Right for Your Estate Plan?

When you’re building your estate plan, one goal is to minimize the tax burden for your heirs. One tool to accomplish this is a grantor trust. In this article, we will examine these types of trusts, including their pros and cons, for your long-term financial plan.

What is a Grantor Trust?

The term "grantor" describes the person who creates a trust and owns its property and assets for both income and estate tax purposes. Therefore, a grantor trust is a living trust in which the grantor is treated as the owner of all portions of the trust.

A grantor needs to have one of the following powers for a trust to be considered a grantor trust.

•       The power to revoke or amend the trust
•       The power to borrow or substitute assets from the trust
•       The power to distribute trust income to the grantor or the grantor’s spouse
•       The power to add more beneficiaries to the trust

The grantor usually is a trustee and beneficiary of the trust’s income and principal. This income from a grantor trust is taxable to the grantor and should be listed on the grantor's personal tax return.

The IRS allows grantor trusts to file taxes under the grantor’s personal Social Security Number (SSN) rather than a separate Tax Identification Number (TIN). A married couple who files joint taxes and who share the grantor’s trust powers may use either spouse’s SSN to file taxes for the trust. Grantors may request a TIN for the purpose of privacy. The trust will need to apply for its own TIN upon the death of the grantor(s).

What is a Non-Grantor Trust?

A non-grantor trust is simply any trust that is not a grantor trust. That means that in a non-grantor trust, the person who established the trust has given up all right, title, and interest in the principal.

Only the trustee has the legal right to revoke or amend a non-grantor trust. Also, the grantor cannot serve as a trustee or as a beneficiary of the trust and cannot have any remainder interest in the trust.

The IRS requires a non-grantor trust to have its own TIN. As a separate tax entity, non-grantor trust must pay taxes on all income received.

What is an Intentionally Defective Grantor Trust?

Despite its ominous-sounding name, an intentionally defective grantor trust (IDGT) refers to an irrevocable trust where the grantor pays the trust’s income tax bill during their lifetime.

The grantor does this by making an irrevocable gift of property into a trust -- typically set up for the grantor’s children -- and names someone else as the trustee. In an IDGT, the grantor retains the right to substitute other property of equal value for the initial property.

The grantor of an IDGT must obtain a TIN and file an IRS Form 1041 with trust income reported every year. However, unlike with a standard grantor trust, a typical IDGT is not subject to estate tax upon the grantor’s death. Instead, the grantor pays a gift tax on the value of the property when it is transferred into the trust.

Are Land Trusts Seen As Grantor Trusts?

A Land Trust is a private legal agreement in which the trustee agrees to hold title to a piece of real estate for the benefit of another person (the beneficiary). The individual who establishes the entity is called the grantor.

For the most part, Land Trusts are structured as grantor trusts and are considered to be disregarded entities. A disregarded entity is an LLC or trust that is “disregarded” in the sense that the IRS does not recognize it as a separate taxpayer.

In other words, disregarded entities do not pay tax and do not file a tax return. Instead, the owner of the trust must report the entity’s income and deductions directly on their tax return.

Pros and Cons of Grantor Trusts

The main advantage of having a grantor trust in your financial plan is the opportunity to preserve your hard-earned wealth while minimizing the tax burden for your heirs. Typically, you pay less income tax on trust assets at your own personal tax rate instead of at a rate set for the trust.

A grantor trust can also serve to protect your assets against creditors in a lawsuit. You can transfer assets to a grantor trust for long-term care planning, and your assets held in a trust won’t be subject to the lengthy and costly probate process after your death.

On the other hand, setting up a grantor trust assumes that you have the financial resources to pay the income tax on trust assets throughout the rest of your life. A large capital gain inside the trust could significantly increase your tax burden.

Keep in mind that grantor trusts and IDGTs become non-grantor trusts upon the grantor’s death. On December 31 of the year of the grantor’s death, the administrator must obtain a TIN for the trust must then be obtained and become responsible for filing a Form 1041 for this now non-grantor trust.

Should I Set Up A Grantor's Trust?

There is no one-size-fits-all answer to this question. It depends on your individual financial situation. Talking to an estate planning attorney can help you determine whether you would benefit from a grantor trust and which type of trust is best for you and your family.