Revocable and irrevocable trusts are common estate planning vehicles. Depending on your financial situation, a grantor trust, whether revocable or irrevocable, may be an ideal estate planning tool to help get your estate's assets into the hands of your heirs as efficiently as possible.
Whether or not a trust qualifies as a grantor trust is important from a tax perspective. According to the Internal Revenue Service (IRS), a grantor trust is simply any trust in which the grantor , or person who created the trust, continues to hold power or control over the trust's assets or income.
Grantor trust rules
The IRS description set out above is simplified. The actual technicalities as to when a trust qualifies as a grantor trust are more complicated. The Internal Revenue Code also contains a set of provisions known as the "grantor trust rules," which more fully describe what types of trusts the IRS classifies as grantor trusts and dictate the situations in which a grantor or other individual is regarded as the substantial owners of a trust's assets.
Creating a grantor trust
When setting up a grantor trust, you are not restricted to working only with a revocable trust. The basic revocable grantor trust is easy to create: you simply structure the trust so that you, as the grantor, retain all power to control the trust's assets and income. You can also turn an irrevocable trust into a grantor trust for income tax purposes. This is accomplished by structuring the terms of the trust so that you, as grantor, meet one or more of the conditions set out in the grantor trust rules, which include the following:
- The revocable trust. Because the grantor in a grantor trust retains the power to control the assets and income of a trust, in most cases a grantor trust is a revocable trust. Unlike with an irrevocable trust, in which the grantor has given up control over the trust assets, the grantor in a revocable trust retains the power to change the conditions of the trust, or grantor trust provisions, in any way, including the revocation or termination of the grantor trust.
- The irrevocable trust. Under the grantor trust rules, irrevocable grantor trusts can be created if a grantor of an irrevocable trust meets any of the conditions or retains any of the powers set out in the rules. When this happens, the irrevocable trust becomes a grantor trust solely for income tax purposes. For example, if an irrevocable trust has been set up to help keep the trust's assets out of the grantor's estate for estate tax purposes, the trust continues to meet that function when it comes to estate taxes, despite being viewed as a grantor trust from an income tax perspective.
Grantor trust taxation
Under IRS rules, a grantor trust is not seen as a taxable entity. Because of this, any income generated by the trust is considered taxable to the grantor rather than to the trust itself.
Because it is often more beneficial for income to be taxed at the individual rate rather than at the tax rate implemented for trusts, establishing a grantor trust enables you to report the trust's income as your own. The advantage of this for beneficiaries is that the trust income can accumulate within the trust on a tax-free basis. In essence, this means that the grantor's payment of the income tax on the trust's income becomes a tax-free gift for the trust's beneficiaries because the funds in the trust are not required to pay the taxes on the income the trust generates.
Grantor trust filing requirements
Because you, as the trust's grantor, are responsible for reporting the trust's income as part of your own personal income, you must file U.S. Income Tax Form for Estates and Trusts (Form 1041). In the section indicating the type of entity for which you are filing the return, there is a box that indicates that the trust is a grantor type trust. By ticking this box, you are telling the IRS that you, as the grantor of a grantor trust, are including the income of the trust in your personal tax return.
Creating a basic, revocable grantor's trust, such as a living trust, is not a complicated process, but with careful drafting, even an irrevocable trust can function as a grantor's trust from a tax perspective. With the tax advantages available to a grantor's trust, you may find that such a trust, whether revocable or not, is the ideal estate planning tool for your circumstances.