Tax Planning with Irrevocable Grantor Trusts

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The grantor trust rules of the tax code provide that if a person who transfers assets to the trust (the “grantor”) retains any of certain prescribed powers or gives those powers to someone connected with the grantor, then the trust is not treated as a separate taxpayer. The tax code treats the trust as the alter ego of the grantor, and items of income or deduction that otherwise would be reportable by the trust are instead included on the grantor’s income tax return. These are known as “grantor” trusts.¹

Why did Congress adopt these rules?

This quirk in the tax code dates to when the federal income tax bracket structure was quite different than it is today. In 1954, there were 14 separate income tax brackets. A taxpayer earning over $400,000 had a part of their income taxed at each of the rates between 20% and 91%. In that environment, there was an advantage to having income earned by separate taxpayers, because each one started over at 20% for the first $4,000 of income. This created an incentive for taxpayers to create multiple trusts to get additional benefit for the lower “bottom bracket” tax rates. Congress responded by enacting the grantor trust rules in 1954.

Initially, planners sought to avoid creating grantor trusts, as the goal was to have a new taxpayer that could use those lower brackets, rather than a disregarded trust whose income would be combined with the grantor’s personal income. However, the tax bracket rules have evolved. Today, not only are there fewer tax brackets and overall lower rates, but Congress has also compressed the brackets for trusts. In 2024, there are four tax brackets for trusts, and the top one is 37%, compared to 14 brackets and a top rate of 91% in 1954. In addition, a trust pays the top 37% rate on income over $15,201, compared to a single individual who only reaches the 37% bracket with $609,351 in income. This means that trusts usually pay tax at a higher rate compared to an individual, so the original rationale of the grantor trust rules is no longer a significant concern.

What are the grantor trust powers?

Sections 671-679 of the tax code contain the grantor trust rules. They relate to (1) the grantor’s retention of rights to benefit from or to control trust assets, or (2) assigning those rights or powers to a person related to or subordinate to the grantor (such as a family member, agent or employee). Certain of these powers are only grantor trust powers if there is not a party adverse to the exercise who must consent.

Powers related to retention of a beneficial interest include one or more of the following:

• Power to distribute to the grantor or the grantor’s spouse² or allow them to use trust assets;
• Obligation to return assets to the grantor in the future (a “reversionary interest”);
• Power to borrow trust assets without adequate interest or security;
• Power to reacquire trust assets or substitute alternative assets for the assets of the trust;
• Power to pay life insurance premiums on policies on the life of the grantor/spouse; and
• Power to revoke the trust and return the assets to the grantor.

Powers that relate to the retention of control include one or more of the following:

• Power to determine who will receive distributions of income or principal;
• Power to change or add beneficiaries, other than afterborn or after-adopted descendants;
• Power to change the trustees;
• Power to veto distributions;
• Power to use trust assets to pay for the grantor’s obligations (including an obligation to support a spouse or child who is a beneficiary); and
• Powers over investments to the extent they impact who receives the benefits.

What are the potential benefits of a grantor trust?

While the grantor is living, the grantor will owe the tax on all income generated by the trust, including capital gains. This can be an effective strategy to increase the value of the trust because, like an IRA, the assets in the trust can grow tax-free. In Rev. Rul. 2004-64, 2004-2 C.B. 7, the IRS confirmed that the payment of the tax is not a gift to the trust since the grantor and not the trust incurs the tax. Many taxpayers use grantor trusts as a tool to maximize their gift.

Example

Deborah plans to make a gift of $10 million to a trust and is considering whether the trust should be a grantor trust. Assume the trust earns 2% in ordinary income annually, the assets grow at 3% per year, all assets are sold at the end of year 20 (and none before then), and both Deborah and the trust are taxed at 37% on ordinary income and 20% on capital gains. The following chart compares the value of the trust at the end of year 20 as well as the cumulative amount of income and capital gain tax paid by Deborah for the grantor trust and by the trust for the non-grantor trust.

In this example, Deborah pays $2.45 million in tax on the ordinary income earned by the trust over 20 years, and then pays an additional $1.98 million in capital gain tax in year 20. If Deborah pays this (an aggregate of $4.43 million), the trust is worth $5.83 million more than when it pays its own income tax. The payment of the $4.43 million is not an addition to the trust and is not subject to gift tax nor does it require allocation of GST exemption to maintain the trust’s exempt status.

Can the trust voluntarily pay the tax?

Some grantors are uncomfortable with the prospect of future income tax liability for transactions outside their control. They often ask if the trust can voluntarily pay the tax for a grantor trust. The answer is generally no. Most taxpayers planning with irrevocable grantor trusts structure them so that the assets are not includible in the grantor’s estate. To accomplish this, the grantor is rarely a beneficiary of the trust. When the grantor is not a beneficiary, and there is no authority under the terms of the trust or applicable state law for the trustee to reimburse the grantor for the tax, it would be a breach of the trustee’s duty to the beneficiary to pay the grantor’s tax.

However, it has become increasingly common for trust agreements to give the trustee discretion to reimburse the grantor for the tax imposed on trust income. Several states, including Delaware, New York and Florida, have passed legislation granting such discretion to a trustee even if the trust agreement does not. While not all trustees are comfortable exercising this discretion, it can provide a way to avoid serious hardship to the grantor due to unforeseen tax obligations. The IRS ruled in Rev. Rule 2004-64 that if the trust agreement or the state statute requires that the grantor be reimbursed, if there is evidence of a prearrangement, or if the grantor is the trustee or can remove the trustee and appoint themself as successor trustee, then the reimbursement power will make the trust includible in the grantor’s estate for estate tax purposes.

How are grantor trusts used today?

In addition to the ability to allow the trust to appreciate tax-free, there are certain transactions between a grantor and a grantor trust that can provide additional tax advantages. Because the grantor and the trust are treated as the same taxpayer, transactions between them are ignored for tax purposes. When grantor trusts engage in these transactions, they are sometimes referred to as “intentionally defective.” The “defect” is the grantor trust power, but it is being used intentionally to create a tax advantage.

What are these transactions:

• Sales between a grantor and a grantor trust are not recognized for tax purposes (no capital gain is incurred) because the grantor and the trust are treated as the same taxpayer.
• When assets are substituted or swapped by the grantor into the grantor trust, there is no recognition of gain, even if the assets are appreciated.
• Interest or rent paid between the grantor and a grantor trust is not recognized as income because they are the same taxpayer.

These rules can enable transfers that are not gifts because they are sales, loans, payments or rentals while, at the same time, not generating the income tax consequences that would otherwise arise in such transactions between separate taxpayers. These types of transactions can provide for planning flexibility in the future due to changes in a grantor’s assets, their value or tax environment.

Example:

In 2020, Greg used his available gift tax exemption to create a trust for his spouse and children. Greg’s trust is a grantor trust because Greg’s spouse is a beneficiary, Greg retained a power to borrow from the trust without interest or security, and Greg’s spouse has a power to add charitable beneficiaries to the trust. Now, Greg wants to transfer units in an investment LLC to the trust. Greg’s basis in the LLC units is $1,000,000 and the appraised fair market value of the units is $11,000,000. Greg would like to avoid paying gift tax to make this transfer.

If Greg sells the LLC units to his children, he will incur capital gain tax of $2,000,000 (20% rate times $10 million in gain). If Greg sells the LLC units to the grantor trust, the sale is ignored for income tax purposes because Greg and the trust are treated as the same taxpayer. Because the sale is ignored for income tax purposes, the trust does not get a new basis in the units and takes over Greg’s low basis. However, the gain is deferred until such time as the trust disposes of the units.

Furthermore, if the trust does not have the liquidity to pay the full purchase price in cash and pays in part with a promissory note, Greg will not recognize any gain on the interest payments received on the promissory note because Greg and the trust are not separate taxpayers. However, this can change if the promissory note is not repaid while the trust remains a grantor trust.

Can grantor trust status be changed?

Some factors that make a trust a grantor trust change from year to year or over time. For example, whether a trust is a grantor trust may depend on who is serving as trustee, a factor that can change. If the trust is a grantor trust because the grantor’s spouse is a beneficiary, it may cease being a grantor trust when the spouse dies. All trusts cease being grantor trusts at the grantor’s death.

There are also ways to voluntarily change the status of the trust from a grantor trust to a non-grantor trust (or vice versa). Powers that make a trust a grantor trust (such as a power to substitute assets or a power to add beneficiaries) can be released or removed, and trust agreements can sometimes be modified to change both beneficial interests and powers attributable to the grantor.

Chief Counsel Advice memo, CCA 202352018 (issued Nov. 28, 2023; released Dec. 29, 2023) illustrates one risk of modifying trusts to change the responsibility for the tax. The trust at issue was a grantor trust that did not grant the trustee discretion to reimburse the grantor for the tax liability, and the trust was not governed by a state statute that granted the trustee that authority. The trustee petitioned a court to modify the trust to grant the trustee that discretion. As required by state law, the beneficiaries of the trust consented to the modification. The CCA found that this consent constituted a gift by the beneficiaries to the grantor. Modifying a trust to shift a benefit to the grantor can be a gift (whether it is a consent to the modification as occurred in the case before the Chief Counsel or occurs without consent and the beneficiaries do not object or otherwise act to protect their interests from being diminished).

The short answer to the question of whether the grantor trust status can change is yes, but it matters how and why that occurs. Grantors concerned about the tax obligations should be proactive in granting the trustee the discretion to reimburse the grantor for tax obligations in the trust agreement itself to avoid the result in the CCA.³