Although trusts are effective estate-planning tools used to avoid probate and minimize estate and gift taxes, their income-tax implications must also be considered to ensure that there are no unintended tax consequences. The drafting attorney should point out the advantageous and disadvantageous fiduciary income-tax implications for the type of trust being considered and then determine which trust is the best fit for the client.
For income tax purposes, all trusts can be divided into two categories: grantor trusts or nongrantor trusts. The party responsible for the income-tax obligations differs according to the type of trust. Dive into the questions and answers below to learn about the differences and the potential income-tax advantages and disadvantages.
Q. What is a grantor trust?
A. A grantor trust allows the grantor to maintain control of the income, assets, and investments in the trust. Revocable living trusts, grantor-retained annuity trusts, intentionally defective grantor trusts, and irrevocable life insurance trusts are all examples of grantor trusts. The grantor of the trust retains the ability to remove trust assets, change the trust beneficiaries, and manage the trust investments as well as borrow from the trust.
Q. How is the income of a grantor trust taxed?
A. A grantor trust is treated as a disregarded entity for income tax purposes. This means that the grantor reports on their individual tax return any taxable income or deductions that are earned by the trust. For example, if a grantor trust is funded with interest-producing assets that generate $20,000 in income during a tax year after deducting the costs to manage the assets, the income and the deduction can be claimed on the grantor’s individual tax return. No trust tax return needs to be filed.
Q. What are some advantages of a grantor trust?
A. A grantor trust provides several benefits to the grantor and the trust’s beneficiaries, including the following:
- The beneficiaries are relieved of any income-tax burden incurred on the trust assets, permitting the assets to grow tax-free.
- The grantor’s payment of the trust’s income-tax liability is not treated as a taxable gift by the grantor, which preserves the grantor’s applicable federal gift tax exemption amount.
- The grantor’s payment of the trust’s income-tax liability reduces the size of the grantor’s estate, which in turn reduces the grantor’s exposure to federal estate taxes at death.
Learn more about this topic by watching our on-demand webinar, Fiduciary Income Tax Considerations in Drafting Trusts.
Q. What are some disadvantages of a grantor trust?
The main disadvantage of a grantor trust is that the grantor must pay income tax on the income accumulated in the trust, a situation that the grantor may sometimes prefer to avoid. For example, a grantor trust may not be the best option if the grantor has set up the trust for an ex-spouse or for another beneficiary for whom the grantor does not wish to bear the income-tax burden.
Q. What is a nongrantor trust?
A. A trust for which the grantor is not considered the owner of the trust’s assets is called a nongrantor trust. For example, revocable living trusts are grantor trusts while the grantor is living but become nongrantor trusts upon the grantor’s death. Because the grantor is not considered an owner of the assets held in a nongrantor trust, the grantor gives up the control to direct the management of the assets, including the right to amend or revoke the trust. The grantor cannot be a trustee or a beneficiary of a nongrantor trust.
Q. How is nongrantor trust income taxed?
A. A nongrantor trust is treated as an independent tax-paying entity. The trustee files a separate tax return to pay the tax on trust-generated income that is not distributed to beneficiaries. If income is distributed to a beneficiary during the tax year, the beneficiary receives a Schedule K-1 that reports the income received, and the beneficiary reports the income tax on the distribution on their personal return. The trust does not get a deduction for distributions made to beneficiaries.
For income tax purposes, nongrantor trusts can be classified as either simple or complex. A simple trust requires mandatory distributions of all income during the taxable year, and the beneficiary of a simple trust will be responsible for the tax on the income distributed to them during the tax year. A complex trust gives the trustee discretion to make distributions to beneficiaries, and the trustee can make distributions that are stipulated in the trust agreement. If the trust agreement does not require the trustee to make mandatory distributions of all of the income in the trust, the trust will be responsible for paying income tax for the income that remains in the trust, and a beneficiary will report on their individual return the income tax on any distributions they received during the tax year.
Q. What are some advantages of a nongrantor trust?
A. First, the trust’s income is not taxed to the grantor. This is beneficial for a grantor who does not wish to pay income tax on behalf of a beneficiary such as an ex-spouse. In addition, the beneficiary’s income-tax rate will probably be much lower than the trust’s tax rate, so there is income tax savings when the income is distributed to the beneficiaries.
Q. What are some disadvantages of a nongrantor trust?
A. When the trust beneficiaries receive distributions from the trust and the assets are out of the grantor’s control, the assets are not protected from the beneficiaries’ creditors. Although the income distributed to the beneficiaries will probably be taxed at a lower rate than the trust’s tax rate, subjecting the assets to a beneficiary’s creditors can be undesirable if the beneficiary has creditor issues. In addition, the grantor no longer has control over the trust assets and loses the ability to manage the assets, to amend or revoke the trust, to borrow from the trust, or to be named a beneficiary or trustee of the trust.Q. How do you determine which type of trust is best for a client?
A. It is imperative to first determine the client’s goals for creating the trust and their tolerance for incurring income tax obligations on behalf of the trust beneficiaries. It is also crucial to fully understand the income tax implications of the trust and to draft the trust accordingly. It is vitally important to remain updated on the laws that affect the fiduciary income taxation of trusts, as they change frequently. Some changes could occur soon. Watch for new developments on legislative proposals related to net investment income tax and section 199A qualified business income.