Grantor Trust vs Non-Grantor Trust
A grantor trust is where the creator (grantor) retains some privilege or power and tax pay the creator on the trust income, but a non-grantor trust is an independent entity for tax purposes where the beneficiaries or the trust tax the income. The major distinction is who has the power over the trust and who tax pay.
Introduction to Types of Trusts
In doing estate planning or managing assets, it is useful to know the difference between grantor trusts and non grantor trusts. Each of the two trusts has a different purpose and a different tax implication that can significantly affect your financial planning.
Most people are puzzled when selecting between these trust arrangements. The decision affects not only the way your assets will be managed but also who will be paying tax on the trust income and the level of control you will have over your assets.
Grantor and non-grantor trusts have benefits that are distinct from one another based on your individual circumstances. Your decision will be based on considerations such as your need for control, tax planning strategies, and long-term estate planning intentions.
What is a Grantor Trust?
A grantor trust is a trust relationship where the person creating the trust (described as the grantor or settlor) retains some benefit or control which causes him or her to be considered an owner for tax purposes. In other words, the grantor must pay income taxes on all trust income, whether it is distributed to the beneficiaries or not.
The regulations of the Internal Revenue Service state when a trust is a grantor trust. They are implemented in sections 671-679 of the code and are known as the "grantor trust regulations."
Key Elements of Grantor Trusts
In a grantor trust, the grantor will usually enjoy some significant control over trust property. It can be in the way of the power to terminate the trust, the power to replace assets of similar value, or the power to dictate beneficial enjoyment of trust property.
The grantor can also retain administrative control of the trust. This can include the power to appoint and dismiss trustees, to manage investments, or to dictate distributions from the trust to beneficiaries.
The second indispensable element is that the grantor receives the tax benefits and disadvantages of ownership. All income, deductions, and credits pass through to the grantor's personal tax return as if he or she owned assets directly.
Typical Grantor Trusts
The most common grantor trust is a revocable living trust. Since such trusts may be revoked at any moment by the grantor, they are grantor trusts per se for tax purposes.
Intentionally defective grantor trusts (IDGTs) are another popular choice. They're "defective" under the federal income tax in the sense that the grantor's paying the taxes, but they're beneficial for estate planning in the sense that the property is removed from the grantor's taxable estate.
QPRTs are typically grantor trusts for the first term. Since the grantor has the right to occupy the home, the grantor is liable for the taxes on the trust.
What is a Non-Grantor Trust?
Non grantor trusts are separate tax entities that file separately and are taxable on undistributed income. In the non grantor trust, the grantor has surrendered sufficient control so that the grantor is not considered the tax owner of the trust property.
These trusts are treated separately from the grantor for tax purposes. The trust is taxed on retained income, and distributed income is taxed to recipients in general.
Principal Features of Non-Grantor Trusts
The principal typical feature of non grantor trusts is the absence of control by the grantor. The grantor cannot terminate the trust, substitute property, or retain significant administrative rights without incurring grantor trust status.
These trusts are separate taxpayers and receive tax identification numbers. These are mandated to make annual returns of tax (Form 1041) and pay tax on any income they possess.
Taxation on the trust income is covered by rules of distribution. Distributed income to beneficiaries is generally taxed to them, and undistributed income is taxed at the trust level through compressed tax brackets.
Types of Non-Grantor Trusts
Irrevocable life insurance trusts (ILITs) are usually non grantor trusts. Once trusts are established, the grantor is unable to revoke them or retain control over the life insurance policies in them.
Charitable remainder trusts are usually non grantor trusts. The grantor gives up control of the assets in exchange for potential income streams and charitable tax benefits.
Dynasty trusts, that are long-term trusts intended to last for multiple generations, typically exist as non grantor trusts in an attempt to achieve the long-term estate planning objectives.
Key Differences Between Grantor and Non-Grantor Trusts
The distinction between grantor and non grantor trust can be established by examining some of the main differences that influence both long-term and short-term planning.
Control and Revocability
Degree of control is the primary difference between these kinds of trusts. Grantor trusts allow the grantor to maintain more control over trust assets and management.
Non grantor trusts, on the other hand, require that the grantor relinquish significant control. This loss of control is sometimes the cost of gaining some estate planning or tax benefits.
The revocability aspect is central to the following distinction. A trust may be revoked at will by a grantor; it is therefore a grantor trust for tax purposes by default.
Differences in Tax Treatment
Tax treatment also gives a large distinction between these trusts. Grantor trusts are transparent entities for tax purposes, and all income is passed through to the grantor's individual return.
Non grantor trusts are taxed as separate taxpayers, which provides possibilities for income splitting and tax planning not available for grantor trusts.
Tax timing is also much different. Income of the grantor trust is taxed to the grantor immediately, while income of a non-grantor trust may be delayed or transferred to beneficiaries through selective distributions.
Estate Planning Implications
For estate planning, the trusts are utilized for varied purposes. Grantor trusts are typically utilized for avoidance of probate and grantor control for life with asset protection.
Non grantor trusts are typically utilized for transfer of wealth and estate tax minimization. Through abdication of control, grantors are typically allowed to exclude assets that appreciate in value from their taxable estates.
Generation-skipping transfer tax consequences are mixed between the two trusts and affect multi-generational planning.
Tax Implications and Requirements
Tax implications is probably one of the most important factors to be considered in choosing to use grantor or non grantor trusts.
Grantor Trust Taxation Rules
The grantor trust taxation rules place the tax burden of the trust on the grantor. In other words, the grantor reports all of the trust's income, deductions, and credits on his or her personal tax return.
The grantor is taxed without distributions made by the trust. This can be a cash flow issue because the grantor might have to pay tax on income that never reaches them.
This tax can be turned to benefits, too. The grantor taxing of trust income is basically making additional gifts to beneficiaries without spending through gift tax limitations.
Non-Grantor Trust Taxation
Non grantor trusts raise unique tax concerns. The trusts are compressed-bracketed, meaning they hit high tax rates at low incomes.
The trust will be taxed on undistributed income, and beneficiaries will normally be taxed on distributions made. This can lead to income shifting opportunities based on planning with regard to distributions.
Distributable net income (DNI) distributions are typically made by trusts to the beneficiaries, thus creating a tax deduction for the trust and taxable income for the beneficiaries.
Income Distribution Planning
Both types of trusts are vulnerable to income distribution planning. Grantor trusts do not benefit from tax advantages from distributions since the grantor is taxed anyway.
Non grantor trusts can use distributions to tactically shift income from higher trust tax rates to possibly lower beneficiary tax rates.
The timing of distributions is therefore critical to non grantor trusts, as distributions made within 65 days of the end of the year can be treated as having been made in the prior tax year.
When to Use a Grantor Trust
Grantor trusts work best in limited situations where control is wanted and where particular planning objectives are suitable to grantor interests.
Asset Protection and Control
When asset control is an issue, grantor trusts offer the perfect answer. You're still free to control investments, determine distributions, and even end the trust if circumstances change.
Grantor trusts give you wonderful asset protection benefits while remaining versatile. Assets are not subject to probate but become accessible to the grantor during their lifetime.
These trusts are also ideal for individuals who wish to have estate planning benefits without giving up absolute control of property.
Tax Planning Opportunities
Grantor trusts also may have special tax planning. Payment by the grantor of tax on trust income has the impact of giving more gifts to the beneficiaries without gift taxes.
This "tax gift" enables trust assets to increase more quickly because the trust is not giving up value to tax payments. This can be a tremendous advantage to trust beneficiaries in the long term.
Grantor trusts also make tax reporting convenient since all goes through to the grantor's personal return. No other trust tax returns or complex distribution planning need to be done.
Specific Use Cases
Revocable living trusts are best suited for individuals who desire probate avoidance and confidentiality but need to have complete control while they are alive.
Defective grantor trusts are used in sophisticated estate plans where assets will be optimally taken out of the estate and taxes paid on trust income.
Qualified personal residence trusts allow homeowners to transfer their home to beneficiaries but retain the right to live in it for the duration of the trust.
When to Use a Non-Grantor Trust
Non grantor trusts carry out other planning objectives and are best when control is less significant than other estate planning or tax issues.
Estate Tax Planning
If your estate is above federal or state estate tax exemptions, non grantor trusts can be used to exclude increasing assets from your taxable estate.
These trusts are quite beneficial in planning for the transfer of wealth. Assets transferred to non grantor trusts and future appreciation usually remain outside the grantor's estate.
Generation-skipping arrangements often use non grantor trusts to achieve the highest tax efficiency over a number of generations.
Income Tax Advantages
Non grantor trusts face the pinched tax brackets, but they can bring income tax advantages in certain situations.
If the beneficiaries of the grantor are in lower tax brackets than the grantor, planned distributions of non grantor trusts can reduce the overall tax burden of the family.
Non grantor trusts also provide timing of income not available through grantor trusts.
Long-Term Planning
Non grantor trusts come in handy in multi-generational planning. Dynasty trusts created for benefit of successive generations typically operate as non grantor trusts.
These trusts may extend for decades or centuries in some states, providing successive generations with continued benefits yet remaining out of each generation's estate tax grasp.
Planned giving plans often use non grantor trusts to achieve charitable goals and tax benefits.
Benefits and Limitations
Each trust comes with inherent benefits and limitations which must be weighed against your own planning objectives.
Grantor Trust Benefits
The biggest advantage of grantor trusts is tax benefits with estate planning control. You have control over assets and make decisions without being subject to probate and making provision for beneficiaries.
The second largest advantage is ease of taxation. Everything flows through to your individual return, sidestepping complex trust tax planning and several returns.
The cancellability and modifiability of grantor trusts provide comfort for those who are worried about possible future changes in circumstances or family structures.
Drawbacks of Grantor Trusts
The main drawback is tax on income that you never see. This can present cash flow problems, especially for trusts that build up income to be distributed at some future time.
Grantor trusts are not useful for estate tax because the property will usually still be part of your taxable estate from your continued control.
Limited wealth transfer advantages translate to these trusts not being the best choice for those whose main goal is to lower estate taxes.
Non-Grantor Trust Benefits
Non grantor trusts are great for pulling assets out of your taxable estate. After you give up control, assets and future value typically won't be includable in estate tax.
They help with income tax planning also by making discretionary distributions and can be valuable to families who have lower tax bracket beneficiaries.
The long-term planning benefit of non grantor trusts makes them great for multi-generational planning and dynasty planning.
Limitations of Non-Grantor Trusts
Loss of control is the most significant drawback. After you establish them, you generally cannot end these trusts or reclaim control over assets.
Complex tax rules and thinning tax bases can make non grantor trusts expensive on a tax basis, especially where income is retained at the trust level.
Administrative complexity is greater for non grantor trusts, such as having separate tax returns, more complex planning, and generally higher professional fees.
Real-World Examples
It is worth noting how these trusts are utilized in the real world so as to learn about the underlying differences and correct applications for each.
Grantor Trust Example
Sarah, a business owner, creates a revocable living trust to take title to her personal home and investment accounts. She is the trustee and can revoke the trust at any time.
For income tax purposes, Sarah still reports all of the trust income on her own return. The trust gives probate avoidance and privacy advantages and keeps her full control over all assets.
Upon the death of Sarah, the trust becomes irrevocable and will presumably be a non-grantor trust unless there are specific provisions in which grantor trust treatment can be maintained.
Example of Non-Grantor Trust
John creates an irrevocable life insurance trust to maintain a $2 million life insurance. He cannot revoke the trust or control the policy.
The trust has taxes paid on it and files its own tax returns on any income realized on trust assets. The life insurance is paid at John's death to the trust and received by beneficiaries tax-free.
This strategy keeps the life insurance out of John's taxable estate while providing liquidity to his beneficiaries.
Comparison Scenario
Two brothers, both with $15 million, divide. Brother A uses a revocable trust (grantor trust) to keep control but may be liable for estate taxes on the full $15 million.
Brother B uses an irrevocable trust (non-grantor trust) and contributes $10 million. Brother B gives up control of the funds but removes them from his estate, potentially saving millions in estate taxes.
The decision between them will rely on each brother's priorities about control, tax advantages, and long-term planning goals.
Making the Right Decision for Your Case
Selecting between grantor and non grantor trusts involves careful consideration of a series of variables unique to your case.
Things to Consider
Your net worth and exposure to estate tax are important considerations here. If your estate is larger than available exemptions, non grantor trusts may be necessary to achieve tax advantages.
Your need for control is another important consideration. If control is essential, grantor trusts are the way to go even though they will not supply estate tax advantages.
Family dynamics and beneficiary scenarios influence this decision as well. Complex family situations can benefit from the versatility of grantor trusts, whereas simple situations can appreciate the security of non grantor trusts.
Professional Advice
Trust taxation and estate planning is sophisticated enough to warrant professional advice. Tax attorneys, estate planning attorneys, and seasoned CPAs can review your specific situation.
These professionals can model every possible situation and make you aware of the long-term implications of every choice. They can even help design trusts to suit your specific objectives.
Regular meetings with expert consultants guarantee your trust plan aligns with changing legislation, family circumstances, and financial fates.
Conclusion
The non grantor or grantor trust choice is among the most consequential estate planning decisions. They serve different functions and provide different benefits depending on your specific needs and circumstances.
Grantor trusts are better when control and probate avoidance are critical. Grantor trusts are simple, versatile, and provide general estate planning advantages.
Non grantor trusts are most suitable where control is not so significant and estate tax reduction and wealth transfer are more significant. They provide excellent long-term planning benefits for sizable estates.
Through being aware of it, you can ensure that you avail yourself of the trust structure most favorable to your loved ones and most beneficial to your estate planning requirements. Either way can be very beneficial to you and your heirs with proper planning and professional guidance.
The most critical is ensuring your decision aligns with your priorities, be they retaining control, reducing taxes, or ensuring a legacy for generations to come that they can enjoy. Take time and effort to consider these and take counsel from qualified professionals in order to implement the most appropriate strategy under your unique circumstances.
