The grantor trust rules came about after high earners tried to lower their income tax consequence by scattering their income to various trusts over which they maintained control. By spreading their income out, the earners were subject to the lower tax brackets since each trust was considered a separate entity, rather than all the income being taxed to one individual. Eventually, the IRS caught on to this technique and the grantor trust rules were born.
The grantor rules state that if the grantor, that is, the creator of the trust, maintains certain “strings” of control over the trust, then all the income from said trusts must be reported on the grantor’s individual tax return. The grantor trust rules can be found under IRC §§ 671–678 and include:
- The power to control beneficial enjoyment
- The power to add or change the beneficiary of a trust
- The power to deal for less than adequate and full consideration
- The power to use the income from the trust to pay life insurance premiums
- The power to substitute assets of equal value
In contrast, the IRS imposed compressed tax rates for non-grantor trusts. For instance, in 2020 once the income of a trust exceeds $12,950.00, the trust is taxed at the highest tax bracket of 37%. An individual would have to earn $518,000 to reach that rate.
If properly drafted, a grantor trust will provide that any income generated within the trust will be reported on the creator’s individual tax return, thus eliminating the possibility of a compressed tax rate. Additionally, if the trust is structured as a grantor trust for estate-tax purposes as well, the assets are includible in the grantor’s estate and there will be a 100% step-up in cost basis equal to the fair market value as of the date of their death. This means that if a grantor purchased her home for $30,000.00 in 1980, the property will be re-assessed upon his or her death to the fair market value. Therefore, when the beneficiaries sell the property there will be no capital gains tax incurred.