The Magic of Grantor Trusts

An earlier article examined “grantor trusts” and how they are an income tax issue, not an estate tax issue. As that prior aerticle indicated, grantor trusts may be drafted so they are not included in the taxable estate of the grantor for estate tax purposes, yet they are still taxed to the grantor for income tax purposes. These “intentionally defective grantor trusts” can be very powerful estate planning tools.

Let’s look at an example of such an intentionally defective grantor trust. Let’s say the power that causes it to be a grantor trust is the power to substitute assets pursuant to Section 675(4)(C). Such a power does not cause inclusion in the taxable estate of the grantor.

Mary put $1 million of XYZ stock into the Mary Smith Irrevocable Trust, drafted with such a power of substitution. The trust is for the benefit of her children. The stock pays 7% dividends, or $70,000.  Assuming Mary and her beneficiaries are in the top income tax brackets, that $70,000 of income would incur a federal tax of 23.8% or $16,660. Since the trust is drafted as a grantor trust, that $70,000 of income would go on Mary’s Form 1040 and she would owe the $16,660 of additional tax, rather than the trust itself or the beneficiaries. This would allow the assets in the trust to grow tax-free. This is the case whether the trust distributed the income to Mary’s children, the beneficiaries of the trust, or it retained the $70,000 of income and allowed it to grow.

Years go by and Mary gets a terminal diagnosis. Let’s assume the XYZ stock increased in value to $5 million. Since it would be outside of Mary’s taxable estate in the Mary Smith Irrevocable Trust, it would not get a step-up in basis at Mary’s death. However, with the power of substitution, Mary can swap $5 million of cash for the XYZ stock worth $5 million. Since it’s a grantor trust, this exchange of assets would not trigger a taxable event. It’s like taking a dollar out of your left pocket and exchanging it for four quarters in your right pocket. Now, when Mary dies, she’ll have the XYZ stock in her taxable estate, and it’ll receive a step-up in basis, while the Mary Smith Irrevocable Trust has $5 million in cash, which won’t be included in Mary’s taxable estate.

Thus, the grantor trust which is outside the taxable estate is very powerful on two fronts.

  1. The growth of the assets in the grantor trust is not subject to gift or estate tax in the grantor’s taxable estate.
  2. The income earned by the trust is taxed to the grantor, not the beneficiaries or the trust itself. This means the grantor pays the income tax on the income earned by the trust and doing so isn’t an additional transfer by the grantor for gift and estate tax purposes.

This magic of grantor trusts is very powerful and allows assets to grow outside the taxable estate of the grantor tax-free while the grantor pays the income tax on those assets. The power of substitution is a particularly useful power to trigger grantor trust status while not causing inclusion in the taxable estate.