Parents playing with child after learning about and setting up a grantor trust.

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Grantor Trusts Guide: Definition, Rules & Tax Implications

What is a grantor trust and how does it work? Trust & Will explains what you need to know about grantor trusts, including tax implications.

Patrick Hicks

Patrick Hicks, @PatrickHicks

Head of Legal, Trust & Will

A Trust is a powerful estate planning tool that allows for better protection and control over assets, with the intention of maximizing its benefit for future generations. With that said, there are many different types of Trusts to choose from. Each offers different rules and incentives to help match an individual’s goals and desired outcomes. 

One such type of Trust is the Grantor Trust. It treats the Grantor as the owner of any assets placed into the Trust during their lifetime, allowing them to retain control. However, with this comes unique tax implications. Keep reading to find out how a Grantor Trust works, its rules, and how it’s treated by the IRS for tax purposes. 

What is a Grantor Trust? 

A Grantor Trust is a type of Living Trust. This means that it goes into effect during the Grantor’s (the individual who created the Trust) lifetime, instead of upon their passing. The Internal Revenue Service (IRS) Grantor Trust definition specifies that the Grantor retains control over the Trust’s assets and income. Thus, the Grantor is responsible for any income produced by the Trust for income and estate tax purposes. 

In general, Trusts are a powerful estate planning tool that allows individuals to grow and protect wealth for future generations. Not only do assets owned by a Trust bypass the probate process, they can offer protection from lawsuits and creditors, as well as advanced tax strategies. Further, Grantors can better control the manner and timing in which assets are distributed to beneficiaries after they pass away. 

How does a Grantor Trust work?

A Grantor Trust goes into effect once an individual funds it with an asset. The Grantor maintains access and control over any assets transferred into the Trust during their lifetime. For instance, they can still withdraw income produced by an asset held in the Trust, even if that asset will eventually pass to their beneficiary when they pass away.

According to the IRS, any Revocable Trust is considered a Grantor Trust. These Trusts can be changed or even undone if the Grantor changes their mind at any point. However, when the Grantor passes away, the Trust converts to an Irrevocable Trust. This means that the trust terms become permanent and cannot be changed or undone. Once a Grantor Trust becomes irrevocable, then any income generated by the Trust is taxed to the Trust itself rather than the Grantor.

What is the difference between a Trust and a Grantor Trust?

A Trust is a fiduciary arrangement that allows a third party to hold assets for the eventual benefit of the Trust’s beneficiaries. It’s an estate planning tool used by individuals who want to exert more control over the manner in which their estate is distributed, as well as gain protections and tax advantages that are not offered by the probate process. 

There are several different types of Trusts to choose from, and a Grantor Trust is one of them. Simply put, a Grantor Trust is a type of Trust that allows the Grantor to retain control.

Is a Grantor Trust revocable or irrevocable?

A Grantor Trust is revocable by nature. As the Grantor of a revocable Grantor Trust, you can:

  • Name yourself as the Trustee of the Trust

  • Manage Trust assets

  • Withdraw any income produced by assets held in the Trust

  • Reclaim assets from the Trust

  • Pay taxes on any income generated by the Trust on your personal tax return

  • Can change Trust terms, its beneficiaries, or undo the Trust itself at any time

This is in comparison to an Irrevocable Trust, for which a Grantor:

  • Permanently gives up assets transferred to the Trust

  • Must appoint a third party as the Trustee

The assets of a Grantor Trust are subject to estate tax, while the assets of an Irrevocable Trust are not. Further, an Irrevocable Trust must file its own tax return and pay any taxes owed.

Who is the beneficiary of a Grantor Trust?

Trusts are typically set up for another individual’s benefit. When a Grantor sets up a Trust, they can select any person or entity of their choice as the beneficiary. Oftentimes it is a loved one, such as a spouse or child, or a family member. It could also be an organization, such as a nonprofit or religious organization that the Grantor chooses to support. 

For more tips on how to choose a beneficiary, be sure to check out our guide here.

What is a Grantor Trust for tax purposes?

For tax purposes, the Internal Revenue Service (IRS) defines a Grantor Trust to describe any Trust whose owner retains control over its assets or income. In this case, any income generated by the Trust is taxed to the Grantor rather than the Trust itself. The Trust is not regarded as a separate tax entity, and the income is treated as regular income tax to the Grantor. 

In other words, from the Grantor’s perspective, there is no difference when it’s time to report their income for tax purposes. Any income generated by Grantor Trust assets are reported as personal income, just as it would have been before the Trust was created.  

This is often advantageous for the Grantor, as income tax rates are typically more favorable relative to the tax treatment of Trusts.

The IRS emphasizes that for tax purposes, all Revocable Trusts are Grantor Trusts. Some types of Irrevocable Trusts can also be treated as a Grantor Trust if they meet guidelines laid out in Internal Codes §§ 671, 673, 674, 675, 676, or 677. 

How is Grantor Trust taxed?

In the case of a Grantor Trust, the Grantor is treated as the owner of the Trust assets for tax purposes. The Trust itself is not regarded as a tax entity of its own. This distinction is important because there are types of Trusts that are treated as a separate tax entity; the Trust itself must file and pay income taxes.

Any Grantor Trust income, deductions, and credits must be claimed by the Grantor when they are reporting their personal income come tax time.

IRS Internal Code 671 stipulates that when a Grantor calculates their taxable income, they must also include any income, deductions, and credits for any portion of a Trust in which the Grantor is treated as the owner. Codes 673 through 678 further define how to determine when a Grantor is treated as the owner of any part of a Trust. 

The IRS treats any Grantor Trust income, deductions, or credits as if they were received or paid directly to the Grantor as if the Trust does not exist. For example, if the Trust makes a charitable contribution, then that contribution is added to the Grantor’s personal charitable contributions to help calculate possible tax deductions.

Similarly, if the Trust earns any dividends, those dividends are treated as income attributed to the Grantor him or herself. 

Does a Grantor Trust have to file a tax return?

A Trust typically has to file an income tax return each calendar year. However, Grantor Trusts are treated differently. In the case of a Grantor Trust, filing a separate income tax return is optional. 

Explained earlier, the Grantor of a Grantor Trust is viewed as the owner of Trust assets for tax purposes. They must report any income or losses incurred by the Trust in his or her personal tax return. 

The Trust still serves as an information reporter and must maintain its own taxpayer ID (TIN). However, income is not reported by the Trust. Rather, the Trust reports income as an attachment while identifying the Grantor as the owner of that income. This is done using Form 1041 and attachments. 

How to set up a Grantor Trust  

The process of setting up a Grantor Trust will look different based on each individual’s needs and objectives. However, there are 5 key steps you can expect:

1. Select Trust assets: If you’re thinking about setting up a Trust, then you’ve likely thought about what your Trust will comprise of. Identify and finalize what assets and property you plan to fund your Trust with.

2. Decide your beneficiaries: Trusts are created for the benefit of future generations by design. Be sure to decide who you will be naming as your beneficiary or beneficiaries, as well as back-up beneficiaries (in case the beneficiary of your choice is predeceased.)

3. Draft up your Trust terms: Your Trust rules and terms will be finalized when you create your document. Spend time thinking about your rules, such as the timing and manner in which assets should be distributed to beneficiaries after your passing.

4. Select your Successor Trustee: Grantor Trusts allow you to serve as the Trustee. However, you’ll want to name a successor Trustee who will take over and manage the Trust and its assets when you pass away.

5. Create your Trust document: Last but not least, it’s time to create your Grantor Trust and put it into effect!

If you’re interested in setting up a Grantor Trust or any other type of Trust, Trust & Will is here to help! Our Trust-based Estate Plan is a comprehensive plan that includes other important building blocks of an Estate Plan, such as a Living Will and Power of Attorney. It’s easy to set up and the cost-effective alternative to hiring your own estate planning attorney. We invite you to check out what we have to offer today!

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