Grantor Trusts and Non-Grantor Trusts
Grantor trusts and non-grantor trusts represent the two primary types of funded trusts or trusts that hold assets. Besides, the difference in name, these two types of trust differ significantly in both form and function, particularly when considering the tax implications of each particular type.
One may be surprised (and rightly so) to read that the main difference between grantor and non-grantor trusts does not lie in the fact that one has a grantor and the other does not. How these two classes of trusts are labeled can cause some confusion. For instance, despite the use of the terminology “non-grantor” this type of trust does have a grantor (the person creating the trust), in fact, all trusts have a grantor. Rather it is the type of powers the grantor can exercise over the trust that distinguishes the two types of trust.
For grantor trusts, the trust agreement allows the grantor expanded powers over the business of trust administration. The grantor also exercises control over the property in the trust, primarily determining how the trust assets will be managed. Grantor trusts may also be structured as a partial grantor trust or a trust where more than one person is considered an owner of the trust.
A non-grantor trust, unlike a grantor trust, involves less control over the management of the trust and is irrevocable. Under this structure and the grantor relinquishes all dominion and control over the transferred assets. As a consequence of the grantor’s limited involvement in trust assets the IRS exposes this type of trust to less tax liability, whereby all income and capital gain realized by the grantor is taxable to the trust except to the extent income or capital gain is distributable to a beneficiary in which case the beneficiary is taxed on the distributable amount.
The Significance of the Grantor/Non-Grantor Distinction
From a functional standpoint, the grantor/non-grantor distinction alters how the trust operates, it is also important for tax purposes. As a rule, the IRS will look at the role of the grantor in a trust to determine the way in which a trust will be taxed. In cases where the grantor holds more authority over the trust, more tax liability will be imposed on the grantor. The reason for the policy is that the IRS presumes that if an individual can exercise control over assets in a trust, it assumed that the assets should be treated similarly to any other assets held in an investment account.
For the purposes of tax treatment, the IRS will examine the role of the grantor to determine if a trust is designated as a grantor trust or a non-grantor trust. The following list illustrates examples under which a trust would be designated as a grantor trust for income tax purposes:
1. a revisionary interest in the corpus of the trust
2. beneficial enjoyment of the corpus or subject to a power of disposition by the grantor without approval or consent
3. certain administrative powers exercisable by the grantor for the sole benefit of the grantor
4. powers exercised in a non-fiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity, including: and
5. being able to use income from the trust without the agreement of another.
As the list above displays, the IRS will expose assets that can be treated in a manner more akin to a non-trust account to a greater tax liability. In this sense, estate and financial planners whose goal is to reduce tax liability are wise to diminish the role of the grantor in trust management.
Revocable Grantor Trust and Irrevocable Grantor Trust
An additional variety of trust that falls into the class of grantor trusts is revocable and irrevocable trusts. The distinction between a revocable trust and an irrevocable trust rests in the grantor’s ability to revoke or amend the trust. Under a revocable trust, a grantor can dissolve the trust at any point during his or her life. Irrevocable trusts, on the other hand, cannot be altered or dissolved after its creation without the permission of the trustee and all of the beneficiaries. Understanding the difference between these two can be significant from the perspective of future tax liability. With an irrevocable grantor trust, the income from the trust falls on the grantor. However, trust assets are not included in the grantor’s estate for estate tax purposes.
Under a revocable trust arrangement, a grantor who retains a right to revoke, amend the trust with the approval of a party with a beneficial interest in the trust will not cause trust income to be taxed. However, granting power to manage and control trust assets to the grantor’s spouse or a non-beneficiary party will cause the grantor’s trust income to be taxed as if the grantor is the owner of the property.