What are the Grantor Trust Rules?

The grantor trust rules are guidelines within the Internal Revenue Code, which outline certain tax implications of a grantor trust. Under these rules, the individual who creates a grantor trust is recognized as the owner of assets and property held within the trust for income and estate tax purposes.

Understanding Grantor Trust Rules

The grantor trust rules allow grantors to control the assets and investments in a trust. The income it generates is taxed to the grantor at his or her tax rate rather than to the trust itself. In this regard, grantor trust rules offer individuals a certain degree of tax protection because tax rates are generally more favorable to individuals than they are to trusts

Grantors can also change the beneficiaries of a trust along with the investments and assets within it. They can direct a trustee to make alterations as well. Grantors can also undo the trust whenever they please as long as they are deemed mentally competent at the time the decision is made. This distinction makes a grantor trust a type of revocable living trust. However, the grantor is also free to relinquish control of the trust making it an irrevocable trust. In this case, the trust itself will pay taxes on the income it generates and the it would require its own tax identification number (TIN).

The IRS defines eight exceptions to avoid triggering the grantor trust status. For example, if the trust has only a single beneficiary who is paid the principal and income from the trust. Or, if the trust has multiple beneficiaries who receive the principal and income from the trust in accordance with their share holding in the trust.

Key Takeaways

  • A grantor trust is a trust in which the individual who creates the trust is owner of the assets and property for income and estate tax purposes. Grantors trust rules are rules applied to different types of trusts.
  • All grantor trusts are revocable living trusts, while the grantor is alive.
  • Intentionally defective grantor trusts are trusts in which the grantor is responsible for paying taxes on trust income but those assets are not counted towards an owner's estate.

How Grantor Trust Rules Apply to Different Trusts 

Grantor trust rules also outline certain conditions when an irrevocable trust can receive some of the same treatments as a revocable trust by the Internal Revenue Service (IRS). These situations sometimes lead to the creation of what are known as intentionally defective grantor trusts. In these cases, a grantor is responsible for paying taxes on the income trusts generate, but trust assets are not counted toward the owner's estate. Such assets would apply to a grantor's estate if the individual runs a revocable trust, however, because the individual would effectively still own property held by the trust. In an irrevocable trust, property is basically transferred out of the grantor's estate and into a trust, which would effectively own that property. Individuals often do this to ensure property is passed down to family members at time of death. In this case, a gift tax may be levied on the property's value at the time it's transferred into the trust, but no estate tax is due upon the grantor's death. 

Grantor trust rules also state that a trust becomes a grantor trust if the creator of the trust has a reversionary interest greater than 5% of trust assets at the time the transfer of assets to the trust is made. A grantor trust agreement dictates how assets are managed and/or transferred after the grantor's death. Ultimately, state law determines if a trust is revocable or irrevocable as well as the implications of each. 

Examples of Grantors Trust Rules

Some of the grantor trust rules outlined by the IRS are as follows:

  • The power to add or change beneficiary of a trust
  • The power to borrow from the trust without adequate security
  • The power to use income from the trust to pay life insurance premiums
  • The power to make changes to the trust's composition by substituting assets of equal value