Grantor Trusts

During “tax season,” I often hear tax professionals say…”it’s not a grantor trust, it’s irrevocable.”

All of us who deal in the world of trusts need to be aware of the grantor trust rules. The lawyer who drafts the trust, the CPA who prepares the income tax return (Form 1041), the money manager who allocates assets between growth and income, the trust beneficiary who receives a K-1…we all need to know whether the settlor is supposed to pay the income tax or the trust and its beneficiaries are supposed to pay the tax.

The key to understanding this issue is to keep in mind that the income tax provisions of the Internal Revenue Code are separated from the estate and gift tax provisions of the Code.

This matrix should help.

    Income Tax
    Grantor Trust Non-Grantor Trust
Transfer Tax Incomplete Transfer    
Complete Transfer    




Then, when analyzing the trust, determine which of these four boxes the trust falls into.

The classic example of the trust that is a grantor trust and also an incomplete transfer is the standard revocable trust, at least during the grantor’s life.

And, we are all aware of “intentionally defective grantor trusts,” or trusts that are completed transfers for gift tax purposes, but are grantor trusts for income tax purposes.

A few issues to think about when you are faced with this analysis, especially if the trust is irrevocable.

Can trust income be distributed to the grantor’s spouse? If so, better check out IRC Section 677(a)(1).

Can trust income be used to pay the life insurance premiums on trust owned policies insuring the life of either the grantor or the grantor’s spouse? If so, better check out IRC Section 677(a)(3).

Does a trust beneficiary have a “Crummey” withdrawal power or a “5 and 5” power? Check out IRC Section 678.

Has the family patriarch created a trust for the benefit of his children or grandchildren and named himself as the trustee? If so, take a look at IRC Section 674.

The grantor trust rules are not easy to read; terms like “income” are used in both a “taxable income” context and a state law “income as opposed to principal” context. Interestingly, a trust can be a grantor trust with respect to income and not principal.

At a minimum, we need to avoid the knee jerk reaction that if a trust is irrevocable, we can ignore the grantor trust rules. Why does it matter? Suppose the trust has been paying the income tax on the trust’s income for forty years, and an unhappy beneficiary points out the trust has always been a grantor trust. Who do you think it going to reimburse the trust for forty years of taxes? The drafting attorney? The CPA? The trustee? All of the them?

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