Trusts and Estates - Grantor Trusts

A grantor trust may occur when the grantor:
1) Derives benefits from the income,
2) Retains the power to revoke the trust,
3) Retains power over beneficial enjoyment,
4) Is able to exercise certain administrative powers over the trust’s operation, or
5) Retains a reversionary interest in either principal or income.

Adversity: Even if the grantor retains a power or right listed in #1 through #4 above, he/she is not considered the owner if an adverse party must consent to the grantor’s exercise of control. An adverse party is a person who has a substantial beneficial interest in the trust and who would be adversely affected by the exercise or nonexercise of the grantor’s power. [IRC §672] Trust beneficiaries are generally adverse parties; however, a beneficiary who has a right to only a portion of a trust’s income or principal is only an adverse party as to that portion. A remainder beneficiary is generally not adverse to a power over income. Income beneficiaries are generally adverse to distributions of principal only during the term of their interests. See Reg. §1.672(a)-1 for examples. A grantor is also treated as owner of the trust if one of the powers listed in #1 through #4 above is given to a nonadverse party. A grantor is considered to have retained any power or interest given to a spouse for transfers to trust after 3/1/86. [IRC §672(e)] 

Income Benefit: A grantor is taxed on income that can be distributed to the grantor or spouse, that can be held or accumulated for future distribution to the grantor or spouse, or that can be used to pay premiums on policies insuring the life of the grantor or spouse. [IRC §677]

Revocable Trust: Gives the grantor the power to end all or part of a trust and take back the property. The grantor is treated as owner of the trust to the extent of that power. [IRC §676]

Beneficial Enjoyment: A grantor who retains the power to control who receives income or principal from a trust is generally treated as the owner of the trust. [IRC §674] A grantor is also considered the owner if unlimited powers are given to a relative or subordinate of the grantor. Limited powers can be given without causing the trust to be treated as a grantor trust.

– Power to distribute principal to trust beneficiaries limited by a reasonably definite standard can be retained by the grantor or given to any other person. [Reg. §1.674(b)-1]
– Power to distribute, apportion, or accumulate income limited by a reasonably definite standard can be given to any trustee other than the grantor or spouse. The power must be exercisable without consent of any other person. [Reg. §1.674(d)-1]
– Unlimited discretionary power over principal or income can be given to an independent trustee who is not a relative or subordinate of the grantor as defined in IRC §672(c). Power must be exercisable without consent of any other person. [Reg. §1.674(c)-1] The grantor is taxed if any person has the power to add beneficiaries (other than children born or adopted after the creation of the trust) or to make distributions to a person who is not a trust beneficiary. If a grantor retains a power to remove, substitute, or add trustees so that a power would no longer meet the criteria in the regulations, the grantor is treated as owner of the trust. [Reg. §1.674(d)-2] A reasonably definite standard is one that is clearly measurable and allows the holder to be held legally accountable. The standard must be stated in the trust instrument. 

Administrative Power: If the grantor or a nonadverse party has the power to purchase principal for less than adequate consideration or to borrow funds without adequate interest or security, the grantor is considered the owner to the extent of the power. [IRC §675]

Reversionary Interest: Income from property transferred to a trust after March 1, 1986, is taxable to the grantor unless the value of the grantor’s reversionary interest on the date of the transfer is not more than 5% based on IRS valuation tables. [IRC §673] For trusts established on or before March 1, 1986, a grantor with a reversionary interest was treated as owner if the trust term lasted no more than ten years. If the trust term was expected to last more than ten years, the grantor was not taxed on the trust income.

• Established on or before 3/1/86,
• Irrevocable for at least ten years and one day,
• Income allocable to accounting income is taxable to the income beneficiaries,
• Income allocable to principal is taxable to the grantor,
• Any accumulated accounting income must eventually be distributed to the income beneficiaries,
• Death of an income beneficiary before the end of the term does not change the tax treatment of the trust income.

Person Other Than Grantor Treated As Owner: A person other than a grantor may also be considered the owner of all or part of a trust if he/she: (1) has an exclusive power to vest principal or income in himself/herself, or (2) previously released such a power and retained one of the rights which would cause the trust to be taxed to a grantor [IRC §678]. This rule does not apply to a power over income if the grantor is treated as the owner.

A grantor trust generally stops being a grantor trust when the grantor dies (unless there are multiple grantors). Income earned through the date of death is reported following the reporting requirements for grantor-type trusts. After-death income generally must be reported by the trust on Form 1041, even if the trust was not previously required to file a separate return because the grantor was taxed on all income. A decedent’s grantor trust may be treated as part of the estate for federal income tax purposes. The election must be made by the trustee and the personal representative of the estate by the due date for the estate’s first year return. If no estate tax return is required, the election is effective for two years after the date of decedent’s death. The election applies to trusts treated as grantor-type trusts because of a power held by the decedent; trusts treated as grantor trusts because of a power held by a nonadverse party do not qualify.