While many trusts are required to file an income tax return each year, not all trusts are required to do so. One type of trust that has become more common in recent years is the Intentionally Defective Grantor Trusts (“IDGT”). These trusts are treated as “grantor trusts” for federal income tax purposes under the federal tax code and their assets are usually held and invested under the grantor’s social security number, and the trust’s income is picked up directly by the grantor on their individual tax return. The remainder of this article will focus on the use of this type of grantor trust and present a general overview of some of the opportunities and risks involved in using them. As always, please consult with a tax professional to discuss your specific situation before undertaking this type of planning.
Income Tax Consequences and Benefits of a Grantor Trust
Like most irrevocable trusts, the IDGT is created by the grantor by making an irrevocable gift to the trust for the benefit of his/her beneficiaries – typically the grantor’s children and grandchildren. The typical purpose of the trust is to create a vehicle allowing the grantor to preserve the wealth he/she has accumulated in a trust that provides assets protection for their beneficiaries, minimizes the ultimate tax burden to the beneficiaries, and keeps the assets out of the grantor’s taxable estate at death.
When a trust qualifies as a grantor trust for income tax purposes, due to certain powers the grantor has under the terms of the trust (“grantor powers”), the grantor is treated for federal income tax purposes as the owner of the trust and the assets held within the trust. Thus, the trust’s income is taxed to the grantor as if he or she received the trust income directly. The benefit of this treatment is that the trust assets can continue to grow without the burden of paying income tax out of the trust’s assets. Since the tax on the trust income is required to be paid by the grantor, this amounts to an additional transfer of wealth to the trust that is not subject to gift tax – basically a tax-free gift. Because the trust is receiving the income (not the grantor) and the grantor is paying the tax, it is critical that the grantor has the necessary means from sources other than the trust to pay the tax generated by the trust income.
One very common planning technique utilized in conjunction with this type of trust is a sale by the grantor of assets to the trust in return for a promissory note. This type of sale (usually referred to as a “sale to a defective trust”) is a sale that occurs without recognizing taxable gain or loss. Since the grantor is treated for federal tax purposes as the owner of the trust, the sale is characterized as though the grantor made a sale to themselves, and the sale is, therefore disregarded for income tax purposes. If a promissory note from the trust to the grantor is used to facilitate a sale, the trust is required to pay interest to the grantor at a minimum IRS prescribed interest rate, but the interest income is not taxable to the grantor.
Potential Pitfalls of a Grantor Trust
While there are many benefits that can be provided by a grantor trust, the grantor trust status may become undesirable at some point. As mentioned before, the grantor is responsible for the tax liability created by the trust. At some point, whether due to the performance of the trust investments, the potential sale of a highly appreciated asset, or merely due to the lapse of time, it may no longer be financially feasible or desirable for the grantor to continue paying the tax. This is becoming more and more common in our experience. The good news is that most grantor trusts are structured to allow the grantor trust status to be turned “off” or “on”. Changing the grantor trust status is referred to as “toggling” the grantor trust powers.
The toggling of grantor trust powers is by no means a simple “flip of the switch” nor should the feature be used as such. As with most tax strategies, toggling is not a one size fits all solution. Depending on the specific situation at hand, it may be possible to turn off the grantor trust status and the grantor owe no tax, but this is not always the case. For example, consider the case of a sale to a defective trust. If the sale to the trust by the grantor was of appreciated assets in return for a promissory note and the obligation is still outstanding at the time the grantor trust powers are “turned off”, a portion of the previously avoided capital gains tax will be due. Due to the complex nature of these transactions, consulting with a tax professional and/or the lawyers involved in drafting the trust document is critical.
The key to remember is that a grantor trust allows for a great deal of planning and flexibility. For instance, in some situations when the trust expects a large capital gain it might call for a need to switch the grantor status off so that the grantor would avoid the tax to be generated and allowing the trust to pay the capital gains tax out of the transaction proceeds. However, this could also be a prime situation where “turning on” the grantor status may be a benefit. For example, let’s say the grantor were to be expecting a large capital loss through his or her other personal investments. If the trust were expected to have a large capital gain, it would potentially be beneficial to leave the grantor status “turned on” as this would allow for those transactions to offset against one another. This would allow for the grantor to use up a large capital loss rather than carry it forward and it would help keep the trust from paying a large amount of tax.
While the benefits of a grantor trust can be very alluring, the grantor should be very diligent in monitoring the assets and activity within the trust, as the tax consequences can be extreme. The flexibility gained with a grantor trust is an invaluable estate planning tool to many, but only if used with proper caution and continuous attention.
To summarize, a grantor trust, much like any tax strategy, has its benefits and pitfalls and vary from case to case. Grantor trusts can provide wealth preservation by giving the assets within the trust certain asset protection, keeping these assets out of the grantor’s estate, and alleviating the burden of tax from the trust assets and the beneficiaries of the trust. However, with the good also comes some bad. As mentioned before, grantor trusts are not one size fits all and can have very significant tax ramifications that can cause the grantor trust status to become financially unfeasible or undesirable to the grantor. Thus, it is important to seek the appropriate professionals in aiding with these strategies.
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Content provided by LBMC tax professionals, Michael Ganschow and Julie Dunkin.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.