Trusts can be a great planning tool for all sorts of circumstances, particularly now with the ability to create very flexible trusts. With tax season upon us, it seems like an appropriate time to describe the tax implications of one type of irrevocable trust called a grantor trust, sometimes referred to as an intentionally defective grantor trust (IDGT).
Irrevocable Trusts are typically used for making gifts and are generally structured one of two ways for tax purposes: (1) as a trust whose grantor (creator) pays the taxes on behalf of the trust while he or she is alive (a grantor trust); or (2) as a trust that pays its own taxes (a non-grantor trust).
In the case of a grantor trust, by the grantor paying the taxes on behalf of the trust, the principal remains more intact and not drawn down by taxes, including both taxable income and capital gains. Absorbing the tax liability for the trust is often viewed as a tax-free gift by the grantor that does not count against an individual’s annual or lifetime gift tax exclusion. For example, Julia sets up a grantor trust and contributes $1 million to the trust. The trust has $50,000 in taxable income. The $50,000 of taxable income is taxed on Julia’s personal income tax return. Julia pays the tax owed on the $50,000 of income from her own funds, not diminishing the trust’s assets. When Julia pays the tax owed on the $50,000 of income, she is not making an additional gift to the trust.
Income generated inside of a non-grantor irrevocable trust reaches the highest tax bracket at only $14,451 of taxable income, whereas an individual doesn’t reach that 37% bracket until they have over $691,750 of taxable income. Thus, it is very often a better outcome, from a tax standpoint, to have the grantor pay the tax on behalf of the trust. However, if at any point it is no longer desirable for the grantor to pay the taxes on behalf of the trust, the grantor has the one-time power to “turn off” the grantor trust status, resulting in the trust paying its own taxes going forward. This power is permanent and irrevocable, so once the grantor has exercised it, the trust cannot go back to being a grantor trust.
Grantor trusts can be an excellent tool for wealth preservation by removing the assets from the grantor’s estate, alleviating the burden of tax from the trust assets while the grantor is alive, and allowing them to grow essentially tax free outside of the grantor’s estate, all while providing creditor protection and tax benefits to the next generation.