What are the Grantor Trust Rules?

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Definition:

Grantor trust rules are a set of Internal Revenue Service (IRS) regulations that describe the tax implications of a trust that someone creates while keeping ownership of the assets in the trust.

🤔 Understanding grantor trust rules

Grantor trust rules are special rules that apply to any trust someone creates in which they keep ownership of the assets in the trust. People often use trusts to set aside money or other assets, like investments or property, for another person’s benefit. Certain types of trusts can bypass probate (the process of divvying up an estate when someone dies), reduce income tax and estate tax, or provide other legal benefits. Typically, when someone creates a trust and puts property in it, they give up ownership of it. Grantor trusts are a special type of trust, however, where the grantor keeps legal ownership of the things in the trust, even if someone else is the trust’s beneficiary. Therefore, the Internal Revenue Service (IRS) considers such a trust to be a “disregarded entity” — that is, for tax purposes, it essentially doesn’t exist, and all income is taxed to the grantor.

Example

An example of a grantor trust is a revocable trust, meaning a trust to which the grantor can make changes. With a revocable trust, the grantor can add or remove assets, change the beneficiary, or make other alterations to the trust’s terms. Because the grantor can still access the assets of the trust, it is a grantor trust. That makes it subject to grantor trust rules, such as requiring the grantor to pay certain taxes, like income taxes, associated with the trust. Most irrevocable trusts are not grantor trusts.

Takeaway

Grantor trust rules are like rules that apply to goalies in sports...

In some sports, such as soccer and hockey, there are rules that apply to all players — And then there are special rules that apply only to the goalies. A soccer goalie can pick up the ball and throw it to a teammate without receiving a penalty. In hockey, goalies can’t pass the center line on the rink. Grantor trust rules are similar in that there are rules that apply to trusts as a whole, but additional, special rules that apply only to grantor trusts, just as there are special rules that apply only to goalies.

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What are the grantor trust rules?

Grantor trusts are a special type of trust where the person establishing the trust keeps ownership over the assets they’ve placed in the trust, even if someone else is the named beneficiary for the trust fund.

When someone sets up a grantor trust, the Internal Revenue Service (IRS) has special rules for how to tax that trust. These rules are called the grantor trust rules.

One of the things outlined in the grantor trust rules is what makes a trust a grantor trust.

In general, all revocable trusts, those that the person setting up the trust can make changes to, are grantor trusts. However, some irrevocable trusts, which can’t be changed after establishment, may still be grantor trusts.

If the grantor does not give up full “dominion and control” of the things they place in the trust, it is considered a grantor trust. For example, someone who places a home in a trust for someone else, but continues to live in it, has created a grantor trust.

If someone creates a grantor trust, they must pay income and other taxes related to the trust because they keep ownership of the things in the trust.

What is the purpose of a grantor trust?

Grantor trusts let the grantor designate certain assets, such as property, investments, or money, for another person’s benefit.

At the same time, the grantor keeps some control over the trust and its assets. If the trust is revocable, this gives the grantor the power to alter the trust or impose additional conditions to make sure the beneficiary uses the funds properly.

The IRS also taxes grantor trusts to the grantor rather than as a separate tax entity — That is, it treats such a trust as what’s called a “disregarded entity.” This may reduce the overall tax liability, including income and estate tax, on the trust. However, it could also push the grantor into a higher marginal tax bracket by increasing their taxable income.

How does a grantor trust work?

In most situations, grantor trusts work very similarly to other trusts. The grantor establishes the trust, naming a beneficiary, and places assets into the trust. However, unlike other trusts, the grantor keeps some ownership or control of the property in the trust and pays income tax related to the trust. The trust does not pay tax as its own entity.

Depending on the type of trust that the grantor sets up, the grantor may be able to make changes to the trust at any time. For example, if the trust is a revocable trust, the grantor may change the beneficiary, adjust the terms of the trust, or remove all money from the trust.

With other types of grantor trusts, the person making the trust keeps the benefits of the property they place in the trust. For example, someone can place their home in a trust but continue living in it.

The beneficiary receives the benefit of the trust according to its terms. For example, they may receive regular payments from the trust’s funds.

How do grantor trust rules apply to different trusts?

If a trust meets one of the requirements of a grantor trust, it is a grantor trust. There are some additional rules that apply to grantor trusts involving foreign nationals or trusts formed in other countries.

For example, any revocable trust, regardless of its other features, is a grantor trust, and all the grantor trust rules about taxation and ownership apply.

What are some examples of grantor trust rules?

The IRS outlines a few examples of rules that make a trust a grantor trust. Any trust that meets one of these requirements is a grantor trust.

  • The trust may distribute trust assets to the grantor or the grantor’s spouse
  • The grantor may use the trust’s money to pay life insurance premiums for themself or their spouse
  • The grantor may alter the terms of the trust
  • The grantor may withdraw funds from the trust

How do I know if a trust is a grantor trust?

There are a few ways to know if a trust is a grantor trust.

The simplest way to know if a trust is a grantor trust is to check whether the trust is revocable or irrevocable. All revocable trusts are grantor trusts. Only some irrevocable trusts qualify as grantor trusts.

If the trust is irrevocable, the person creating the trust must receive some type of benefit or keep some level of control over the trust’s assets for it to be a grantor trust. For example, if someone names themself as the beneficiary of a trust they create, it is a grantor trust.

Another example of a grantor trust is one that holds stocks, but where the grantor keeps the right to vote for those shares. A grantor may also establish a trust that pays them an annuity for a set number of years before becoming fully accessible to the beneficiary. One could also place one’s home in a trust but continue living in it.

What is the difference between grantor and non-grantor trust?

The primary difference between grantor and non-grantor trusts is whether the person who establishes the trust keeps control over the assets in the trust.

With a non-grantor trust, the person who establishes the trust immediately gives up ownership and control of the things they place in the trust. They also stop receiving benefits from those assets, such as income or the option to live in a home placed in the trust.

When someone creates a grantor trust, they keep some control over the things in that trust. This lets them make changes to the trust or continue to benefit from the things in the trust.

How are grantor trusts taxed?

Trusts typically pay taxes as their own unique entity, but the Internal Revenue Service (IRS) treats grantor trusts differently.

The person who establishes a grantor trust must treat the trust’s income as their own and report it on their income tax return. The IRS considers the grantor the owner of the things in the trust for income tax purposes, and thus considers the grantor trust a “disregarded entity.” Often, this can be an advantage and reduce the overall tax that the trust pays. It can also push the grantor into a higher marginal tax bracket by increasing their taxable income.

Because the grantor keeps ownership of funds in a grantor trust, they do not have to pay gift tax on the things they contribute to the trust.

Can a grantor receive income from an irrevocable trust?

Yes, grantors can receive income from irrevocable trusts they establish.

For example, Grantor Retained Annuity Trusts are specially designed trusts for this purpose. The grantor places money or investments in an irrevocable trust, but receives income from the trust for a set period after establishing the trust. Once that period ends, the funds in the trust pass to the named beneficiary.

What happens to a grantor trust when the grantor dies?

Trusts are a popular estate planning tool to reduce taxes on inheritances. When the grantor of a grantor trust dies, the assets in the trust become the property of the trust. The trust will now pay taxes as its own entity instead of the grantor paying taxes for the trust.

If the trust is a revocable trust, it automatically becomes irrevocable and the trustee begins to manage the trust’s assets. The beneficiary also starts or continues to receive benefits from the trust based on the terms outlined in the trust document.

This article contains general estate planning concepts and is not legal advice. Please consult with your attorney before entering into any legal agreements.

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