A grantor trust is a legal trust under state law that is not recognized as a separate tax entity for income tax purposes as a result of the grantor (or grantor’s spouse or other owner) have not relinquished complete dominion and control over the trust. By definition, a revocable living trust is a grantor trust but an irrevocable trust may also be grantor trust if complete dominion and control of the transferred assets has not be relinquished by the grantor.
Under grantor trust rules, if the grantor transfers property to a trust and retains certain powers the grantor is treated as the owner of the trust’s property for income tax purposes and, as such, is taxed on the trust’s income.
Retained powers that cause a trust to be “tainted” or “defective” for income tax purposes are:
- retention of a discretionary or mandatory reversionary interest – by the grantor or rantor’s spouse – in corpus or income in which the value of the reversionary interest exceeds 5% of trust’s value as of the inception date with one exception:
- reversion occurs due to death before age 21of a beneficiary who is a lineal descendant
- retention of a discretionary power (without approval of an adverse party*) to control beneficial enjoyment of trust income or corpus with the following exceptions:
- an unexercised power to use income to support a dependent or to pay a legal obligation (once exercised the trust is “tainted”)
- a power to distribute income or corpus to charitable beneficiaries
- a power to distribute corpus to beneficiaries based on a reasonable standard (i.e., for health, education, support, or maintenance)
- a discretionary power to temporarily withhold income, e.g., during a beneficiary’s disability or minority, etc.
- dispose of trust corpus by will but not accumulated income
(*) An adverse party is anyone that has a substantial beneficial interest in a trust that would be adversely affected by the exercise or non-exercise of a power a person (i.e., the grantor, grantor’s spouse, trustee, etc.) has over the trust.
- retention of power to add beneficiaries (except for children born or adopted after the trust’s creation) or remove beneficiaries
- retention of administrative powers by grantor or grantor’s spouse, e.g., ability to obtain financial benefits from the trust that are not an “arm’s length” transaction such as buying an asset from the trust for less than FMV, borrowing from the trust at below market interest rates, etc.
- retention of a power to revoke the trust
- income is or may be accumulated for the grantor or grantor spouse’s benefit, or income is distributed to, the grantor or grantor’s spouse or is actually used to pay the life insurance premium (with a non-charitable beneficiary) on the grantor’s, or grantor spouse’s, life
- capital gain that reverts to the grantor when the trust terminates
By definition, a non-grantor trust is irrevocable and the grantor has relinquished all dominion and control over the transferred assets. All income and capital gain is taxable to the trust when it is a non-grantor 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.
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