A Grantor Trust serves as the centerpiece of most estate plans because it allows the Grantor to transfer assets out of his or her gross estate for Federal estate and gift tax purposes (by contributing such assets to a Trust) while treating the Grantor (and not the Trust) as the owner of such assets for Federal income tax purposes.
As a result, the Grantor Trust structure provides certain Federal gift, estate and income tax benefits to the Grantor and its beneficiaries. Specifically, the structure allows the Grantor to pay the Trust’s income tax liability rather than having the Trust (or the beneficiaries) make such payments. This results in the following “double beneficial” effect: (i) the Trust’s value is not reduced by the amount of the tax payment producing greater Trust market value as well as the potential for reinvestment of this sum resulting in further appreciation of Trust assets; and (ii) the Grantor’s estate is reduced by the amount of the tax payment resulting in less (or no) Federal estate tax at his death (i.e., a tax-free gift to the beneficiaries).. In addition, the Grantor Trust structure also results in a lesser Federal income tax liability for Grantor Trusts as opposed to Non-Grantor Trusts. Non-Grantor Trusts are subject to the Trust and Estate tax brackets, which tax income at the highest rate (37%) after earning only $13,051 of income. Grantor Trusts are disregarded for Federal income tax purposes and therefore its income tax liability is computed by applying the Individual tax bracket attributable to the Grantor, which is not subject to the highest rate (37%) until after the Grantor’s income (including that earned by the Grantor Trust) exceeds $523,601 or more. For example, if a Non-Grantor Trust earns $23,051 in income, it will be subject to $6,846.37 of income tax using the trust tax brackets1, while the tax on the same amount of income earned by a Grantor Trust (assuming it is the Grantor’s only source of income) is only $2,567.12 using the individual tax brackets2. Finally, the Grantor Trust structure provides the Grantor and the beneficiaries with flexibility to conduct future transactions with the Trust while continuing to protect the assets from Federal gift and estate taxes. The Trust Agreement will provide the Grantor with certain powers that qualify it as a Grantor Trust, such as the power to borrow from the Trust on an unsecured basis, the power to add a charitable beneficiary, and the swap power.
The swap power is perhaps the most significant, useful and flexible of the “Grantor Trust Powers”. It allows the Grantor (in a non-fiduciary capacity) to reacquire assets from the Trust by substitute property of equivalent value. As a result, it can help maximize the step-up in basis for any low basis Trust assets by having the Grantor transfer cash to the Trust in exchange for such low basis assets, which will receive a stepped-up value at the Grantor’s death. In addition, the swap power can be used in an ILIT to help the Grantor elude Federal estate tax on any life insurance policy transferred to the Trust within 3 years of the Grantor’s death (the “3 year rule”). This is because the swap power requires the Grantor to receive assets of equivalent value in exchange for the insurance policy, there is no gift or transfer for value to the Trust and therefore the 3year rule is inapplicable (as it only applies to transfers). In addition, the swap power does not create “an incident of ownership” that will cause the life insurance policy to be subject to Federal estate tax at the Grantor’s death.
As you can see, the Grantor Trust structure is an ideal estate planning vehicle for an individual who wants to (i) reduce the size of his or her estate, (ii) provide for himself or herself during his or her life and for his or her family after his or her death; (iii) continue to retain some control over the Trust assets; (iv) benefit from lower income tax liability while making additional tax-free gifts to the beneficiaries in the form of income tax payments; and (v) ensure flexibility to make future estate planning changes using the Grantor Trust Powers. Due to such benefits, we have recently seen an increase in the number of Grantor Trusts that we administer on behalf of our clients. If you think that you or your clients would benefit from the use of a Grantor Trust, or would simply like to learn more, please contact me at firstname.lastname@example.org or (302) 510-6011.
Seth R. Raivetz, Esq.
Assistant Vice President/Trust Officer
1 The trust tax brackets provide that there is $3,146 of tax on the first $13,050 of income and the next $10,001 of income is taxed at 37% ($10,001 x 0.37 = $3,700.37).
2 The individual tax brackets provide that there is $995 of tax on the first $9,950 of income and the next $13,101 of income is taxed at 12% ($13,1010 x .12 =$1,572.12)
The posts expressed are views of FSTC and are not intended as advice or recommendations. For informational purposes only. FSTC does not offer tax or legal advice, professional counsel should be sought for tax or legal advice.