For income tax purposes, there are two types of irrevocable trusts: grantor trusts and non-grantor trusts.  Grantor trusts are totally ignored for income tax purposes (but not necessarily for gift and estate tax purposes) which means that all of the income from a grantor trust is included in your tax return (or in other words like the grantor trust doesn’t exist as a separate entity for income taxes).  Non-grantor trusts are separate taxpayers and as a result file their own tax return and pay their own taxes.  In this article, we will discuss the differences between these two types of trusts and their different benefits — and help you decide which one is right for you.

What is a Grantor Trust?

Grantor trusts are creatures of the Internal Revenue Code (the “Code”). Sections 673 through 678 of the Code lay out a series of tests that define whether a trust is a grantor trust. It comes down to what powers the trust agreement creating the trust gives to the grantor (the person who created the trust). If a trust agreement contains provisions that satisfy one or more of the tests — such provisions are known as “grantor trust triggers” — the trust is a grantor trust. If a trust doesn’t have any grantor trust triggers, it’s a non-grantor trust. The most common grantor trust triggers are:

1. The grantor’s power to revoke the trust.
2. The trustee’s power to distribute income to the grantor or the grantor’s spouse.
3. The trustee’s power to lend to the grantor without adequate security.
4. The grantor’s power to swap assets with the trust: This means that the grantor can exchange assets with the things that are in the trust. For example, if the trust owns a house, the grantor can exchange the house for cash (or something else) in an amount of equal value.
5. The grantor’s power (or a non-adverse party’s power) to add beneficiaries.
6. The trustee’s power to use the trust’s income to pay life insurance premiums.

(There are several other grantor trust triggers, but these six come up most often.)

Grantor trusts can be revocable or irrevocable, and they can exist inside a grantor’s taxable estate or outside of it. The revocable ones are often called “revocable living trusts” or simply “revocable trusts.” The irrevocable ones are often referred to as “intentionally defective grantor trusts.” Grantor Retained Annuity Trusts (GRATs) and Qualified Personal Residence Trusts (QPRTs) are other common examples of irrevocable grantor trusts. Most irrevocable grantor trusts are used for estate planning or to help families minimize estate taxes.

Benefits of Grantor Trusts

Grantor trusts have three chief benefits.

1. Administrative Simplicity. Since they are ignored for income tax purposes, they don’t need to file complicated income tax returns. Instead, the grantor can simply report the trust’s income on his or her income tax return.
2. Indirect Gifts. Grantor trusts have a major estate tax benefit: The grantor can pay the trust’s income taxes without those payments being considered gifts. To understand why that matters, imagine that you were to set up an irrevocable grantor trust for the benefit of your child and fund it with your entire remaining gift tax exemption amount. Assuming the gift tax exemption didn’t increase, you wouldn’t be able to fund the trust with any additional assets without paying a 40% gift tax. But, you could indirectly make gifts to the trust by paying its income taxes and the IRS wouldn’t care. A trust with $10 million or more in assets could easily generate several hundred thousand dollars a year in income tax liability, making a grantor’s annual tax payments on a trust’s behalf potentially quite significant. To frame this differently, every dollar in taxes you pay for your kids/trusts is an additional dollar you are passing on to your children PLUS the future growth on that dollar and that you can avoid the estate tax on the wealth you are indirectly passing on to your heirs.
3. Tax-Free Transactions. Grantors can transact with their grantor trusts without there being any income tax consequences. For example, a grantor can loan money to a grantor trust without having to pay income tax on the interest payments. Or, a grantor can sell appreciated assets to his or her grantor trust without realizing any capital gain. There are a number of important estate tax minimization strategies involve loans and/or sales to trusts that are able to amplify the estate tax savings for families.

The Definition of a Non-Grantor Trust

As noted above, the Code does not define “non-grantor trusts.” Rather, a non-grantor trust is simply a trust that is not a grantor trust. With a non-grantor trust, the grantor or person setting it up forfeits all income and tax benefits associated with the trust’s assets as the trust is the owner of the assets and legally its own taxpayer with its own tax identification number (TIN).

The Benefits of a Non-Grantor Trust

Non-grantor trusts provide a separate set of benefits.

1. Federal Income Tax Savings. While the federal income tax brackets for non-grantor trusts are more compressed than for individuals, non-grantor trusts are taxed favorably in other ways. Non-grantor trusts are eligible for their own $10 million QSBS exclusions — a single QSBS-stacking non-grantor trust can save a family millions of dollars of income tax. Non-grantor trusts also get their own $10,000 state and local income tax deductions, their own excess business loss deductions, and their own Section 199A small business tax deductions.
2. State Income Tax Savings. Some states have their own income taxes in addition to federal taxes. But a few states like Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming don’t have state income tax — and a few others do have state income taxes but don’t apply them to trusts in certain circumstances. By setting up non-grantor trusts in one of these zero-tax states, wealthy individuals can avoid paying state income tax on that money no matter where they personally live. This is especially helpful for people who live in high-tax states like California or New York.

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