What Is a Grantor Trust?
A grantor trust is a "disregarded entity" for tax purposes—as far as the Internal Revenue Service is concerned, it doesn't exist. The term "grantor" isn't actually a legal term at all. It indicates that the grantor or creator of the trust and not the trust itself is responsible for paying the taxes associated with it.
All grantor trusts are living trusts, but not all living trusts are grantor trusts.
How a Grantor Trust Is Taxed
Let's say that you've set up a grantor trust and you've "funded" it with interest-bearing assets—you've transferred ownership of these assets into the trust's name. They generate $10,000 in income over the course of the year. It also cost the trust $1,000 in tax-deductible costs to maintain and manage them.
Because this is a grantor trust, this income would be reported and the deductions would be claimed on your personal Form 1040 tax return under your own Social Security number. The trust would not be required to file its own return.
This might not be a convenient arrangement for everyone. Your taxable income would increase by $9,000 in this scenario, and this could push you into a higher marginal tax bracket.
Grantor trusts automatically convert to non-grantor trusts upon the death of the grantor because the grantor is no longer alive to file a tax return. Any distributions made by the trust at that time would be taxable to the beneficiaries who receive them.
Grantor Trusts Are Revocable
According to the Internal Revenue Code, the term "grantor" describes any trust where the person who creates the trust is treated as the owner of its property and assets for both income and estate tax purposes. This makes them revocable living trusts. The grantor retains control over the trust's income and assets.
Grantors typically act as trustees of their own revocable living trust. This is the role that allows them to retain the power to control its income and assets.
Grantors can amend these trusts and make changes to them at any time during their lifetimes as long as they remain mentally competent. They can name or change the trust's beneficiaries. They can manage stock options for the trust and control trust fund investments. They can also undo this type of trust.
Any income these trusts generate is taxed to their grantors personally because the grantors personally reserve all these rights.
Revocable Trusts vs. Irrevocable Trusts
Although all revocable living trusts are considered grantor trusts during the lifetime of the grantor, most "irrevocable trusts" are not. In most cases, the grantor of an irrevocable trust does not report the trust's income on their own tax return because they have irrevocably given up ownership and control of the assets funded into the trust. They no longer own them—the trust does.
Grantors of irrevocable trusts cannot act as trustees of their own trusts. They must hand over the reins of operation to someone else.
State laws and the trust's formation documents determine whether a trust is revocable or irrevocable. If the trust deed does not specify that the trust is irrevocable, most states will consider it revocable.
As with all things taxes, some exceptions exist. An irrevocable trust can be treated as a grantor trust for tax purposes when the grantor meets the Internal Revenue Code requirements to become the owner of the assets.
In this case, the irrevocable trust may be disregarded as a separate tax entity and the grantor will be taxed for all its income.
Intentionally Defective Grantor Trusts
Irrevocable trusts are referred to as "intentionally defective grantor trusts" (IDGTs) when they treat the grantor as the owner for income tax purposes but not for estate tax purposes.
IDGTs can evolve when a grantor makes an irrevocable gift to the trust or sells an asset into its ownership. That asset is no longer considered to be owned by the grantor, but by the trust, so it would not be included in the grantor's taxable estate.
The grantor reports trust income on their personal return in this case and pays any taxes due, but the trust assets are not included in the grantor's estate for estate tax purposes when they die. This is a major advantage not shared with revocable trusts.
The Bottom Line
State and local laws change frequently, and this information may not reflect the most recent changes. Please consult with an accountant or an attorney for up-to-date tax or legal advice. The information contained in this article is not tax or legal advice, and it is not a substitute for tax or legal advice.