Grantor Trusts in New York

Understanding Grantor Trusts

A grantor trust is primarily a federal income-tax classification. The Internal Revenue Code contains a series of rules that determine when the creator of a trust, commonly called the grantor, is treated as the owner of all or a portion of the trust for federal income-tax purposes. These rules are principally found in Internal Revenue Code §§ 671 through 679.

When the grantor is treated as the owner of a portion of the trust, the tax items attributable to that portion generally flow through to the grantor rather than being taxed to the trust as a separate taxpayer. This leads to an important distinction.

A trust can be irrevocable and still be a grantor trust. Likewise, the fact that a trust is treated as a grantor trust for income-tax purposes does not, by itself, determine whether its assets will be included in the grantor’s taxable estate. Income-tax ownership and estate-tax ownership involve different provisions of federal tax law. Understanding that distinction is essential when evaluating more sophisticated trust strategies.

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How Grantor Trust Taxation Works

The grantor trust rules determine who is treated as owning trust property for federal income-tax purposes.

When the grantor is treated as the owner, the applicable trust income, deductions, and credits are generally reported by the grantor. The trust may still exist as a separate legal arrangement with its own trustee, beneficiaries, assets, and distribution provisions. Its tax treatment, however, can differ substantially from that of a non-grantor trust.

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Powers That Can Create Grantor Trust Status

Federal law identifies various powers and interests that can cause the grantor to be treated as the owner of trust property for income-tax purposes. These can include certain powers to control beneficial enjoyment, particular administrative powers, certain powers to revoke the trust, and circumstances in which trust income may be distributed or applied for the benefit of the grantor or the grantor’s spouse. The precise result depends on the particular power and the requirements of the applicable Internal Revenue Code provision. Grantor trust status should therefore be determined from the actual trust terms and applicable tax law rather than from the name given to the trust.

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Reporting Income From a Grantor Trust

When a trust is wholly treated as owned by the grantor, federal tax regulations permit specialized reporting methods for the trust’s income. Depending on the circumstances, the trustee may use the grantor’s taxpayer identification information or follow one of the alternative reporting methods permitted by Treasury regulations. Form 1041 may also be involved depending on the trust and the reporting method being used. The important point for the client is that creating a trust does not necessarily cause the trust itself to bear the income-tax burden. With a grantor trust, the grantor may continue reporting and paying tax on the trust’s taxable income even though the trust legally owns the assets.

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Revocable and Irrevocable Grantor Trusts

Grantor trust status is sometimes confused with whether a trust is revocable or irrevocable. They answer different questions.

Revocability concerns the creator’s legal ability to revoke or modify the trust. Grantor trust status concerns who is treated as the owner of trust property for federal income-tax purposes.

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Revocable Living Trusts

A revocable living trust is generally treated as a grantor trust because the creator retains the power to revoke the trust and recover the trust property. During the creator’s lifetime, income generated by the trust assets is therefore generally reported as the creator’s income for federal tax purposes. This is one reason transferring an investment account or residence to an ordinary revocable living trust generally does not create a new income-tax regime during the creator’s lifetime.

The trust can nevertheless serve important non-tax purposes, including management of trust assets during incapacity and probate avoidance for assets properly transferred to the trust.

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Irrevocable Grantor Trusts

An irrevocable trust can also be a grantor trust. The trust may be irrevocable in the sense that the grantor cannot simply revoke it and reclaim the assets, while other retained powers or provisions cause the grantor to remain the owner for federal income-tax purposes. This combination can be intentionally incorporated into advanced estate planning. For example, an irrevocable trust may be structured so that a completed gift has occurred for federal gift-tax purposes while the grantor remains responsible for income tax generated by the trust property. That result illustrates why “irrevocable,” “completed gift,” “grantor trust,” and “excluded from the taxable estate” should not be treated as interchangeable concepts. Each requires its own legal and tax analysis.

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Grantor Trusts in Estate and Gift Tax Planning

Grantor trust status can be intentionally used as part of sophisticated wealth-transfer planning. One potential advantage arises from the grantor continuing to pay income tax attributable to trust assets. If an irrevocable trust owns appreciating investments and the grantor pays the income tax attributable to the trust, trust assets do not have to be reduced by that tax payment. This can allow more property to remain invested for the trust beneficiaries. IRS Revenue Ruling 2004-64 addresses the estate and gift tax consequences of a grantor paying income tax attributable to an irrevocable grantor trust. The IRS concluded that the grantor’s payment of income tax attributable to trust income is not itself treated as an additional gift to the trust beneficiaries under the circumstances addressed by the ruling. However, the ruling also explains that provisions requiring the trust to reimburse the grantor for those taxes can create estate-tax concerns. The drafting of tax-reimbursement provisions therefore deserves careful attention.

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Transactions Between a Grantor and a Grantor Trust

Grantor trust status can also affect transactions between the grantor and the trust. In Revenue Ruling 85-13, the IRS concluded that a grantor treated as the owner of the entire trust is not recognized as engaging in a sale with a separate taxpayer when transacting with that trust for federal income-tax purposes. That principle has become important in certain advanced estate-planning strategies involving sales or exchanges between a grantor and an irrevocable grantor trust.

These transactions are substantially more sophisticated than creating an ordinary living trust and require careful estate, gift, income-tax, valuation, and administrative planning.

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Intentionally Defective Grantor Trusts

The term “Intentionally Defective Grantor Trust,” commonly abbreviated IDGT, is often encountered in discussions of advanced estate planning. The word “defective” can be misleading. It generally refers to a trust intentionally designed so that the grantor is treated as the owner for federal income-tax purposes while the trust is intended to achieve different treatment for federal estate and gift tax purposes. The “defect” is therefore intentional tax design rather than an accidental flaw in the document. An IDGT may be used in connection with lifetime gifts, sales of appreciating assets, business interests, or other wealth-transfer strategies. The objective can be to transfer future appreciation to beneficiaries while allowing the grantor to continue bearing the income-tax burden associated with trust property. Whether a particular strategy accomplishes that objective depends on the trust provisions, assets transferred, valuation, transaction structure, administration, and applicable tax law. An IDGT is not appropriate merely because someone wants to reduce taxes. It is an advanced planning technique generally considered in the context of substantial estates or assets with meaningful appreciation potential.

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Changing or Ending Grantor Trust Status

Grantor trust status does not necessarily remain unchanged throughout the entire existence of a trust. A trust may cease to be a grantor trust because a power terminates, a trust provision changes, the grantor dies, or another event changes the application of the federal grantor trust rules. The transition from grantor trust to non-grantor trust status can have important tax and administrative consequences. For example, a trust that previously reported income through the grantor may become responsible for its own federal income-tax reporting. The trust may need its own taxpayer identification number and may become subject to the income-tax rules applicable to estates and trusts. The death of the grantor can be a particularly significant transition point. Grantor trust status attributable to powers held by the grantor generally cannot simply continue on the same basis after the grantor’s death. The trust may continue as an irrevocable trust for beneficiaries, but its income-tax reporting and other tax consequences can change. These issues should be anticipated when the trust is drafted and administered rather than addressed only after grantor trust status has ended.

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Grantor Trust FAQs

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Is a Grantor Trust the Same as a Revocable Trust?

No.

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A revocable living trust is generally a grantor trust during the creator’s lifetime, but the terms describe different characteristics. “Revocable” describes the creator’s ability to revoke the trust and recover the property. “Grantor trust” describes how the trust is treated for federal income-tax purposes. Certain irrevocable trusts can also be grantor trusts when the trust provisions cause the grantor to be treated as the owner under federal tax law. A trust must therefore be analyzed separately for revocability, income-tax treatment, gift-tax consequences, and estate-tax treatment.

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Who Pays the Income Tax on a Grantor Trust?

The person treated as the owner of the trust or the relevant portion of the trust generally reports the applicable trust income, deductions, and credits for federal income-tax purposes. In many cases, that person is the individual who created and funded the trust. This can occur even when the trust is irrevocable and the grantor cannot simply withdraw the trust assets.

The income-tax obligation should therefore be considered before an irrevocable grantor trust is funded, particularly when the trust is expected to generate substantial taxable income.

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Can an Irrevocable Trust Be a Grantor Trust?

Yes.

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An irrevocable trust can be structured so that the grantor remains the owner for federal income-tax purposes even though the trust cannot simply be revoked. This is an important feature of certain advanced estate-planning strategies.

The federal grantor trust rules examine specific powers and interests rather than merely asking whether the trust document is labeled “revocable” or “irrevocable." As a result, an irrevocable trust may be a grantor trust for income-tax purposes while having different consequences for estate and gift tax purposes.

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What Is an Intentionally Defective Grantor Trust?

An Intentionally Defective Grantor Trust is generally an irrevocable trust intentionally designed to produce grantor trust treatment for federal income-tax purposes while pursuing different estate and gift tax objectives. The word “defective” does not mean the trust was drafted incorrectly. Instead, the trust deliberately contains provisions that trigger grantor trust status.

Depending on the strategy, this can allow the grantor to pay income taxes attributable to trust assets while the assets and future appreciation are being held for beneficiaries. IDGT planning is highly technical and should be coordinated with the client’s broader estate, gift, income-tax, and asset-transfer planning.

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Does a Grantor Trust Avoid Estate Taxes?

Not necessarily.

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Grantor trust status by itself does not determine whether trust property will be included in the grantor’s taxable estate.

A revocable living trust is generally a grantor trust, but assets in an ordinary revocable trust are generally included in the creator’s gross estate for federal estate-tax purposes. An appropriately structured irrevocable grantor trust may produce a different estate-tax result. The answer depends on the powers and interests retained by the grantor and the federal estate-tax provisions applicable to those rights. For this reason, a trust should never be described as providing estate-tax savings merely because it qualifies as a grantor trust.

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Related Resources

Revocable Living Trusts in New York

Learn why revocable living trusts are generally treated as grantor trusts during the creator’s lifetime and how they fit into a broader estate plan.

Irrevocable Trusts in New York

Learn why an irrevocable trust can have different income-tax, estate-tax, asset-protection, and beneficiary-planning consequences depending on how it is structured.

Generation-Skipping Trusts in New York

Learn how multigenerational trusts can be coordinated with federal estate, gift, and generation-skipping transfer tax planning.

Qualified Personal Residence Trusts in New York

Learn how a specialized irrevocable trust can be used to transfer a residence as part of federal estate and gift tax planning.

High Net Worth Estate Planning in New York

Learn how trusts, lifetime gifts, business interests, estate taxes, and advanced wealth-transfer strategies can be coordinated for substantial estates.

 

Sources & Legal References

Internal Revenue Service — Internal Revenue Code § 671, Trust Income, Deductions, and Credits Attributable to Grantors and Others as Substantial Owners

https://www.law.cornell.edu/uscode/text/26/671

Internal Revenue Service — Internal Revenue Code § 672, Definitions and Rules

https://www.law.cornell.edu/uscode/text/26/672

Internal Revenue Service — Internal Revenue Code § 673, Reversionary Interests

https://www.law.cornell.edu/uscode/text/26/673

Internal Revenue Service — Internal Revenue Code § 674, Power to Control Beneficial Enjoyment

https://www.law.cornell.edu/uscode/text/26/674

Internal Revenue Service — Internal Revenue Code § 675, Administrative Powers

https://www.law.cornell.edu/uscode/text/26/675

Internal Revenue Service — Internal Revenue Code § 676, Power to Revoke

https://www.law.cornell.edu/uscode/text/26/676

Internal Revenue Service — Internal Revenue Code § 677, Income for Benefit of Grantor

https://www.law.cornell.edu/uscode/text/26/677

Internal Revenue Service — Revenue Ruling 85-13, Transactions Between a Grantor and Grantor Trust

https://www.irs.gov/pub/irs-tege/rr85-13.pdf

Internal Revenue Service — Revenue Ruling 2004-64, Grantor Payment and Reimbursement of Income Taxes

https://www.irs.gov/pub/irs-drop/rr-04-64.pdf

Internal Revenue Service — Instructions for Form 1041, U.S. Income Tax Return for Estates and Trusts

https://www.irs.gov/instructions/i1041

Electronic Code of Federal Regulations — 26 CFR § 1.671-4, Grantor Trust Reporting

https://www.ecfr.gov/current/title-26/section-1.671-4