The Grantor Trust: Navigating the Internal Revenue Code

The Grantor Trust: Navigating the Internal Revenue Code

Internal Revenue Code Grantor Trust Tax Rules 

When it comes to the Internal Revenue Code (IRC), one of the most complicated aspects of the IRC involves the tax rules for grantor trusts. In general, the two main categories of trusts are grantor trusts and non-grantor trusts. The distinction between these two categories of trusts is very important for US tax purposes — because the tax implications for these two categories of trusts differ extensively. From a baseline perspective, with a grantor trust, the grantor is taxed on the income. A very simplified example would be a US person who has a US trust that holds US property that generates income. The grantor is responsible for the income and tax reporting for that rental property. Conversely, with a non-grantor trust, the initial grantor or settler is not considered the owner of the trust, and therefore the tax rules are different. Instead of the grantor being subject to tax on the income, rather the trust and/or beneficiaries that receive distributions are required to deal with the tax headaches. This of course becomes infinitely more complicated when it involves a foreign grantor trust, but let’s briefly go through the basics of the grantor trust.

Taxation of a Grantor Trust

While the taxation of a grantor trust is relatively straightforward, estate and tax planning can have several nuances to it and this is something to keep in mind when evaluating a trust for tax purposes. With a grantor trust, typically the grantor is responsible for the taxes. The reason for this rule is to avoid a situation in which income is being assigned to beneficiaries (who are typically in a lower tax bracket) who then transfer the money back to the grantor — and the IRS loses out on tax monies. That is because the beneficiaries are typically taxed at a lower tax rate, and especially with the gift and estate exclusion being so high, the IRS wants to ensure that it is not missing out on any income that it is due, further contributing to the tax gap. Therefore the grantor tax rules require the trust grantor to be responsible for the tax.

IRC 671-679 Grantor Trust Rules

Internal Revenue Code sections 671 through 679 provide a tax roadmap to the grantor trust rules. Each of these code sections refers to separate powers and attributes of the federal grantor trust tax rules. 

Grantor Trust Powers

In general, grantors have various different powers and authorities available to them as the grantor or owner of the trust. Some of the more common powers include the:

      • power to withdraw income from the trust;

      • the power to substitute or exchange assets within the trust, and

      • the power to change the trustee and or beneficiaries of the trust.

These powers may be limited or modified depending on the specific type of grantor trust.

Grantor Trust Participants

When it comes to understanding the type of persons that are part of the grantor trust, the internal revenue service provides a good summary detailing the different participants.

As provided by the IRS:

      • Grantor

        • The grantor is also known as the trustor, settlor, or founder. The grantor is the person who transfers the trust property to the trustee.

      • Trustee

        • The trustee is the individual or entity responsible for holding and managing the trust property for the benefit of the beneficiary. Trustees can be a corporate fiduciary or any competent individual who is not a minor. The trustee holds the legal title to the trust property. As such, the trustee has a fiduciary duty to the beneficiaries with respect to the trust property. In the event of a breach of fiduciary duty, a trustee may be held personally liable. Such breaches include failing to pay out distributions or misappropriation.

      • Beneficiary

        • The beneficiary is the individual or entity who will receive the benefits of the trust property. The beneficiary holds the beneficial title to the trust property. The trust document must clearly identify the beneficiary or beneficiaries.

Foreign Trust vs Domestic Trust

Once a trust is determined to be a grantor trust, it is important to ascertain whether or not the trust would be considered a domestic trust or a foreign trust. Grantor trusts have an immediate tax implication on income generated from the trust, so whether or not the grantor is considered a US person or a foreign person is crucial. In addition, issues involving whether or not the assets in the trust are based in the US or outside of the US and/or whether or not the beneficiaries are considered US beneficiaries may result in other tax implications including the reporting requirements under Forms 3520 and 3520-A.

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