Grantor Trust Rules: What They Are and How They Work

What Are Grantor Trust Rules?

Grantor trust rules are guidelines contained in the Internal Revenue Code (IRC) that outline certain tax implications of a grantor trust. These rules provide that the individual who creates a grantor trust is recognized as the owner of the assets and property held within the trust for income and estate tax purposes.

Understanding Grantor Trust Rules

Trusts are established for various reasons. They're designed as separate legal entities as part of estate planning to protect the grantor's or originator's assets and the income generated from those assets so that the beneficiaries can receive them. A grantor trust is one in which the grantor or owner retains the power to control or direct the income or assets within the trust.

Grantor trusts were originally used as tax shelters by wealthy people. The tax rates for trusts graduated at the same rate as income tax rates. The income was taxed at the personal income tax rates as more and more income was earned in the trust. The grantor reaped the benefits, shielding money that was taxed as if it were a personal account and not a separate legal entity.

Grantor trust rules were established by the IRS to thwart the misuse of trusts. The income generated from trusts now graduates to a higher tax bracket more quickly than the individual marginal income tax rates. Any trust income over $14,450 in 2023 or $15,200 in 2024 would be taxed at the highest tax rate of 37%.

The trust income wouldn't be taxed at the highest rate of 37% until it earned $578,125 in 2023 or $609,350 in 2024 if it was taxed at the individual tax rate. It doesn't take this much income earned in a trust to be thrust into a higher tax bracket.

A grantor trust isn't the type of tax shelter for wealthy people that it once was before the IRS made changes but these trusts are still used. They have characteristics that might be beneficial to the grantor, depending on their income and family situations.

Benefits of Grantor Trust Rules

Grantor trusts have several characteristics that allow the owners to use the trusts for their specific tax and income purposes.

Trust Income

The income the trust generates is taxed at the grantor's income tax rate rather than to the trust itself. But grantor trust rules do offer individuals a certain degree of tax protection because tax rates are generally more favorable at the individual level than they are for trusts.

Beneficiaries

Grantors can also change the beneficiaries of their trusts along with the investments and assets held within them. They can direct a trustee to make alterations as well. Trustees are individuals or financial companies that hold and manage assets for the benefit of a trust and its beneficiaries.

Revocable Trusts

Grantors can also undo their trusts as long as they're deemed mentally competent at the time the decision is made. This distinction makes a grantor trust a revocable living trust that can be changed and/or canceled at any time by the owner, originator, or grantor.

Changing the Trust

The grantor is also free to relinquish control of the trust making it an irrevocable trust. This type of trust can't be amended or canceled without the permission and agreement of all the beneficiaries of the trust. The trust itself will pay taxes on the income it generates in this case and it would require its own tax identification number (TIN).

Special Considerations

Trusts are established for various purposes, including storing the owner's assets in a separate legal entity. Trust owners should therefore be aware of the risks that the trust could be triggered into a grantor trust. But the Internal Revenue Service (IRS) defines some exceptions to avoid triggering the grantor trust status.

A trust is exempted if it has only a single beneficiary who is paid principal and income from the trust or if it has multiple beneficiaries who receive the principal and income by their shareholding in the trust.

How Grantor Trust Rules Apply to Different Trusts 

Grantor trust rules also outline certain conditions under which an irrevocable trust can receive some of the same treatments by the IRS as a revocable trust. These situations sometimes lead to the creation of what are known as intentionally defective grantor trusts.

A grantor is responsible for paying taxes on the income the trust generates in this case but trust assets aren't included in the owner's personal estate. But such assets would apply to a grantor's estate if the individual runs a revocable trust because they would effectively still own property held by the trust.

The property is transferred out of the grantor's estate and into a trust with an irrevocable trust, which would then effectively own that property. Individuals often do this to ensure that the property is passed down to family members at the time of death. A gift tax may be levied on the grantor based on the property's value at the time it's transferred into the trust in this case but no estate tax would be due upon the grantor's death.

A grantor trust agreement dictates how its assets are managed and transferred after the grantor's death. Ultimately, state law determines if a trust is revocable or irrevocable as well as the implications of each.

The Bottom Line

The grantor of a personal trust is typically its creator. The grantor transfers their assets, money, and property into the ownership of the trust except in the case of a grantor trust. The creator/grantor is still considered the owner for income and estate tax purposes and can dissolve or
change the trust’s terms in the case of a revocable trust.

Several intricate rules apply, however, which is why rules have been established in the Internal Revenue Code to govern these tax implications. Always consult with an attorney to help you decide whether the option of a grantor trust is right for your estate plan.