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Planning Opportunities With Grantor Trusts

For tax professionals, a new year means more than new resolutions. The 2023 updated estate, gift and generation-skipping transfer (GST) transfer tax exemptions represent new wealth and estate planning opportunities for clients. The federal estate, gift and GST exemption amounts have increased this year to $12,920,000 per person (an $860,000 increase from 2022). Particularly considering these amounts are scheduled to decrease by half in 2026, the time is ripe for many clients to consider how best to utilize their exemptions before they lose them.

The grantor trust is one of the most powerful tools in an estate planner’s toolbox. In addition to the estate and GST tax benefits of grantor trusts, these trusts are particularly favored for their federal income tax features. This article will summarize the key elements of grantor trusts and the most common strategies for utilizing this powerful tax planning instrument.

Basics of Grantor Trusts

Generally, trusts are treated as entities separate from their creators for income tax purposes, and a trustee is obligated to report a trust’s annual income on an IRS Form 1041 Fiduciary Income Tax Return. However, if a trust has any of the features described in §§ 671 through 691 of the Internal Revenue Code (“IRC” or “Code”), it is taxed as if it is owned by the trust’s grantor (i.e., the person who created the trust or contributed property to the trust). The grantor is required to include in their personal income tax computations those items of income, gain, loss, deduction, and credit allocable to the trust. Thus, the grantor pays tax on the grantor trust income as if the trust does not exist for income tax purposes.

Sections 671 through 691 of the Code specify the powers and interests which, if enjoyed by the grantor or a non-adverse party over a trust, are sufficient to shift the income tax consequences from the trust and its beneficiaries back to the grantor. Broadly, pursuant to the following Code sections, the income of a trust is taxed to the grantor as owner if:

  • § 673:    The grantor has retained a reversionary interest in the trust property or income greater than 5 percent;
  • § 674:    The grantor or a non-adverse party has power over the beneficial interests in the trust;
  • § 675:    Administrative powers of the trust exist under which the grantor can or does benefit;
  • § 676:    The grantor or a non-adverse party has the power to revoke the trust or return the corpus to the grantor;
  • § 677:    The grantor or a non-adverse party has the power to distribute income to or for the benefit of the grantor or the grantor’s spouse;
  • § 678:    The trustee, beneficiary, or other person has the power to take the principal or income for themselves; or
  • § 679:    A U.S. person transfers property to a foreign trust with a U.S. beneficiary.

Each of these rules has its own regulations, case law, and exceptions, which must be thoroughly considered in the planning and drafting of any trust.

Triggering Grantor Trust Status

The most common type of grantor trust is the revocable trust. The essential element of a revocable trust, i.e., the grantor’s power to revoke and amend the trust, triggers grantor trust treatment pursuant to IRC § 676. Revocable trusts are typically used as a will substitute, to simplify the estate administration process and avoid probate. Thus, these trusts are a foundational aspect to most estate plans, regardless of the client’s net worth or other tax attributes.

However, by application of IRC § 2038, all of the assets of a revocable trust are included in the grantor’s gross estate at death for federal estate tax purposes. As this is a highly undesirable result for those engaging in wealth transfer planning, the revocable trust is generally not a preferable vehicle for this purpose, despite its use in other contexts.

Estate planners frequently use the following powers to trigger grantor trust status, as they should not cause the trust property to be included in the grantor’s estate for federal estate tax purposes if drafted correctly:

A.    Power to Add Charitable Beneficiaries. Pursuant to IRC § 674, grantor trust status is triggered if any person has the authority to add new beneficiaries (other than after-born or adopted children) of either the income or principal of a trust. While IRC § 2036(a)(2) would cause estate inclusion for the grantor if the grantor held this power, the power to add trust beneficiaries may be given to a third party, such as the settlor’s spouse. To avoid estate inclusion for the power holder, this power is frequently limited to adding qualified charities as the additional trust beneficiaries.

B.    Power to Make Loans to the Grantor Without Adequate Security. Grantor trust status is additionally triggered under IRC § 675(2) if the grantor or the grantor’s spouse retains the power to borrow trust principal or income without adequate interest or security. The trust agreement must be specific as to the grantor’s authority to borrow, rather than providing a general lending power. Additionally, it is generally recommended that the trustee require adequate interest on any loan to avoid estate tax inclusion for the grantor.

C.    Power of Substitution. One of the most common triggers for grantor trust status is the grantor’s power under IRC § 675(4)(b) to reacquire the trust property by substituting other property of an equivalent value. To ensure the grantor complies with the trust terms, the trust must require the trustee to determine that the properties acquired and substituted by the grantor are in fact of an equivalent value, and that the power cannot be exercised in a manner that would shift benefits among the beneficiaries of the trust.

D.    Power to Pay Insurance Premiums. Finally, for the grantor, grantor trust status is triggered and estate inclusion is likely avoided if the trust income is, or in the discretion of the grantor, may be applied towards the payment of premiums for life insurance on the life of the grantor or the grantor’s spouse under IRC § 677(a)(3).

Advanced Planning with Grantor Trusts

By drafting a trust to gain the income tax benefits of grantor trust status and simultaneously avoid estate tax inclusion, a high net-worth client is able to leverage the best of both worlds for transferred assets. When a grantor makes a gift to a trust, the gift is complete for estate and gift tax purposes and the value of the gift is removed from the grantor’s estate. When the trust assets generate income, under the grantor trust rules, the grantor pays the tax liability. Thus, the trust assets are able to grow and compound free of income tax, and the grantor’s annual tax payments are essentially tax-free “gifts” to the trust beneficiaries.

Another planning technique using grantor trusts is an estate “freezing” technique whereby the grantor makes a sale to the trust with an installment note. Because transactions between a grantor trust and its grantor are disregarded for federal income tax purposes, the grantor will not recognize gain or loss on appreciated assets sold to the trust, nor will they recognize income on interest payable on the note. By selling appreciating and/or income-producing assets to the trust in exchange for a promissory note with a low, fixed rate of interest, the grantor has effectively “frozen” the value of their estate and moved all future appreciation on, and income earned by, the sold assets out of the grantor’s estate for tax purposes. In addition to the estate freeze, when assets such as nonvoting stock of a closely held business are transferred, the asset value may often reflect advantageous discounts for lack of marketability and lack of control.

The grantor’s power to substitute trust assets, noted above in paragraph C, can additionally be utilized for significant tax advantages. While the basis of assets held by a decedent at death are generally adjusted to fair market value pursuant to IRC § 1014, assets held in a grantor trust are not subject to this rule. However, with creative use of the “swap power” prior to a grantor’s death, appreciated assets in a grantor trust can nevertheless receive a stepped-up basis. When a grantor utilizes their swap power to transfer appreciated assets out of a grantor trust in exchange for other assets (usually cash or other liquid assets), the grantor regains the basis step-up advantage for the appreciated assets at death. In the reverse, a grantor may also preserve a loss by transferring a loss asset to the grantor trust prior to death, in exchange for trust assets of similar value, thereby avoiding the loss step-down. However, the effectiveness of this strategy is highly dependent on valuation issues for the appreciated or loss assets, timing, and other estate tax considerations.

Toggling Grantor Trust Status

As with many advanced planning techniques, careful consideration must always be given to both the client’s current circumstances and how they may change in the future. While a grantor trust may be of great benefit for a client in Year 1, in Year 20, the income tax liabilities of the trust may become too burdensome for the grantor to maintain, or a grantor may become concerned about a significant capital gains liability upon the sale of a highly appreciated asset held in their grantor trust. Therefore, when drafting a grantor trust, consideration should be given to how the grantor or another party may “turn off” or “toggle” grantor trust status for planning flexibility.

Generally, the ability to toggle grantor trust status for a trust depends on the powers which triggered grantor trust status in the first place. A grantor often may turn off grantor trust status by disclaiming the triggering power, for example, the grantor’s power to substitute trust assets may specifically provide that the power will terminate upon the grantor’s written notice to the trustee. However, not all powers held by spouses may be disclaimed or toggled off, and disclaimers by spouses may create adverse estate or gift tax consequences for the spouse. Alternatively, because a trust is treated as a grantor trust under IRC § 675(3) if the grantor has taken out a loan from the trust without adequate interest or security, a grantor may turn off grantor trust status for such a trust by simply repaying the loan balance.

Although usually less efficient than the methods described above, when the draftsman has failed to provide toggling provisions, grantor trust status additionally may be turned off by reforming the trust terms or decanting the trust into a non-grantor trust.

The complexity of these considerations highlights the necessity for tax practitioners to carefully plan ahead and consider all of the client’s unique circumstances when engaging in this type of planning.

In conclusion, grantor trusts are an essential estate planning tool for every tax practitioner. Their planning uses vary from simple probate avoidance and estate administration to asset protection and wealth transfer planning. However, the grantor trust rules and estate, gift and GST tax implications are complex, and the advisability of these planning techniques depends on each client’s unique circumstances. Therefore, estate planners, grantors, and trustees must carefully consider the tax implications when implementing this powerful tool.