Articles

It is NOT Defective if it is Intentionally a Grantor Trust by Jeffrey M. Mutnik, CPA/PFS

Posted on February 23, 2022

When establishing a trust, grantors must take special care to ensure trust documents clearly communicate how they intend the trust and its assets be treated for income-tax purposes. While there are a variety of different types of trusts with assorted names and features to meet an equally broad range of needs and goals, one of the key differentiators between these estate planning tools is whether they are revocable or irrevocable.

Assets a grantor/donor (grantor) transfers into a grantor trust are considered to be owned by the grantor for income tax purposes. This means grantors are responsible for reporting and paying tax on income generated by the trust, which the IRS treats as a disregarded entity. Because grantors typically pay a trust’s tax liabilities with non-trust assets, they allow assets inside the trust to continue appreciating without being diluted by income-tax liabilities while also enabling themselves to reduce the size of their taxable estates. Moreover, because transactions between grantor trusts and their grantors are disregarded for income-tax purposes, grantors may sell appreciated assets to a trust in exchange for a promissory note. With this strategy, grantors can avoid tax on asset appreciation and escape both income and net investment income tax on the interest payments they receive from the trust. In turn, grantors may treat these mandatory interest payments from the trust as a source of cash flow.

Revocable or Irrevocable

U.S. tax laws automatically classify revocable trusts as grantor trusts because grantors retain the right to rescind the trusts’ terms and reclaim ownership to every asset titled to the trust.  By contrast, an irrevocable trust can be either a grantor trust or a non-grantor trust, based on the rights, control and beneficial interests grantors retain over the trust and/or the trust’s assets.

The distinction between these types of trusts can have substantial income tax implications. Consequently, grantors must be intentional when drafting trust documents and include specific language and provisions to not only identify a trust as a revocable or irrevocable, but to also distinguish an irrevocable trust as grantor or non-grantor.

An intentionally defective grantor trust (IDGT) is one type of irrevocable trust commonly used by grantors to transfer wealth to future generations.  With IDGTs, grantors transfer assets out of their taxable estates, thereby relinquishing ownership for estate tax purposes, but they retain ownership of those assets for income-tax purposes. The grantor essentially freezes the value of the transferred assets at the gift-tax value and continues to reduce his or her taxable estate by reporting and paying tax on trust income with non-trust assets. Consequently, this allows trust assets to grow unfettered by the cost of income tax during the grantor’s life.

Since an IDGT is intended to be a grantor trust, it is critical that grantors retain and specify in trust documents the discretion to terminate grantor status of the irrevocable trust, if the circumstances dictate that is the best path forward. While the original path is chosen once an irrevocable trust is funded, keeping the power to turn off the grantor status allows the grantors to continue to control their own tax lives.

Although some of these estate-planning tools have come under attack by lawmakers, a current lack of Congressional approval means that families can continue using and yielding the benefits of grantor trusts for the time being. Therefore, now is the time to act rather than waiting for a future date when these planning strategies may be subject to government restrictions and limitations.

About the Author: Jeffrey M. Mutnik, CPA/PFS, is a director of Taxation and Financial Services with Berkowitz Pollack Brant Advisors + CPAs, where he provides tax- and estate-planning counsel to high-net-worth families, closely held businesses and professional services firms. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at info@bpbcpa.com.