If you are not sure what grantor trusts are, or when they might be used, this article is for you. We’ll discuss what grantor trusts are, their most common uses, and how they can be used to help people avoid or minimize estate and gift taxes.

For most purposes, the key feature of a grantor trust (as opposed to any of several varieties of non-grantor trust) is the fact that the income earned by a grantor trust flows through to the grantor’s personal income tax return.

Why would someone want to pay tax on income that doesn’t flow to him or her?

That is the question we’ll address in this post.

(For a copy of an Advisor Guide, please click here.)

As it turns out, counter-intuitive though it may appear at first, having to pay tax on the income generated by a trust can be an advantage in estate planning.

To repeat, the key characteristic of a grantor trust is that, for federal income tax purposes, the trust’s income is taxed to the grantor, not to the trust itself or the beneficiaries (unless a grantor is also a beneficiary, in which case the income will be taxed to the grantor in the grantor’s role as grantor, not the grantor’s role as beneficiary). This differs from a non-grantor trust, in which case the trust itself or its beneficiaries are responsible for taxes on the trust’s income.

It can be helpful for advisors to be familiar with the most common types of Grantor Trusts, in order to better be able to advise their clients.

Common Types of Grantor Trusts
Several types of grantor trusts are commonly used, each with its own specific purposes and benefits:

Revocable or Living Trust: A revocable trust is a grantor trust. That is, any revocable trust will, by its nature, pass any income earned or recognized by the trust to the grantor for federal income tax purposes. Living trusts are typically used for non-tax reasons, and the grantor nature of the trust has no tax-planning significance. Click here for our post on Revocable Trusts.

Irrevocable Life Insurance Trust (ILIT): A trust designed to own life insurance policies, typically also designed to make sure that the death benefits are out of the grantor’s estate for estate tax purposes, is often called an ILIT. One design calls for the trust to be a grantor trust, and during the grantor’s life it has little income and the grantor design has limited income tax effects.

Grantor Retained Annuity Trust (GRAT): A GRAT is a type of trust specifically designed with estate planning purposes in mind. A full discussion of GRATs is beyond the scope of this post. We plan a future post to discuss GRATs in greater depth.

Intentionally [Defective] Grantor Trust: A trust may be designed as a grantor trust that takes assets out of the grantor’s estate for estate tax purposes, but leaves the income with the grantor for income tax purposes.[1]

In the early days of grantor trusts, some lawyers inadvertently drafted trusts that were considered grantor trusts, and this may be the origin of the term “defective.” The term has stuck, and is still sometimes used. Today, however, the preferred term is Intentionally Grantor trust, or simply Grantor trust.

Income Taxes
In some circumstances, a grantor trust can be used to shift the income tax burden from the trust or its beneficiaries to the grantor. This can be advantageous if, for example, the beneficiaries might be in a higher tax bracket than the grantor, or if the grantor desires to pay the income tax instead of having either the trust or the beneficiaries pay the income tax.

Trust Income Tax
If a trust is not a grantor trust, and it has only taxable beneficiaries, the trust is likely to be a complex trust. A complex trust is a taxable trust. Such trusts, as opposed to individuals, pay tax at the highest personal income tax bracket on the income over $14,450.

Thus, in most cases, a taxable trust will pay a higher total income tax on a given amount of income compared to the total amount of income tax that would be paid if the same amount of income were spread over one or more human beneficiaries.

In many estate planning situations, the desire is not to pay more income tax than necessary. Either the beneficiaries or the grantor, rather than the trust, should pay the tax, because they’ll be taxed at a lower rate than the trust would.

Why Have the Grantor Pay Income Tax on Trust Income?
If a trust is not itself to be liable for tax, then either the grantor or the beneficiaries will have to be liable.

In estate planning situations, it is often the case that the grantor is trying to remove as much value from his estate as possible, while incurring as little estate or gift tax as possible.

A grantor trust can be a way to effectively carry this out.

Consider a case in which a grantor funds a non-grantor trust with property worth exactly the amount of his remaining lifetime estate/gift tax exemption. For ease on illustration, let’s assume this amount is $10,000,000.

Again, for ease of illustration, assume the trust invests and earns exactly 5.1445% interest per year, or $514,450 of ordinary income.

At trust tax rates, the trust will owe tax at the top ordinary income tax rate, 37%, on $500,000 of income.

Compare that to a couple filing jointly in 2024, which would incur the top rate of 37% only on income above $731,000, and would pay 35% only on income above $487,000.

If the $514,450 were the couple’s only taxable income, they’d owe about $113,000 in income tax on it (assuming no state or other income taxes).

That same income, in the trust, would incur taxes of over $185,000.

The difference in this example is over $70,000, and would occur each year.

Extra Gift
Another reason for using a grantor trust, as opposed to a non-grantor (complex) trust, is to increase the effective gift.

Using the same numbers as above, if the non-grantor trust must pay tax (as opposed to the grantor absorbing the tax), the trust will have $185,000 less after the year.

So, in effect, the grantor makes an additional “gift” of $185,000 to the trust by making the trust a grantor trust. That extra $185,000 is not considered a taxable gift.

And it can be argued that the grantor provision is worth even more than that $185,000 a year. Suppose that the grantor was to have the trust pay the $185,000 of income taxes, and then the grantor would make an additional gift to make up for the $185,000 paid in taxes.

That would cost the grantor about $259,000, because the gift itself would be taxable. If the grantor has no remaining gift/estate tax exemption, to make a gift of $185,000, the giver would also have to pay a gift tax of $74,000.

Sale of Assets to an Intentionally Defective Grantor Trust
A grantor trust can be used as a buyer of appreciated assets that a grantor believes will keep appreciating. The sale of such assets to a grantor trust can remove the asset from the estate for estate tax purposes, while avoiding the recognition of capital gain.

For example, the grantor can sell appreciating assets to the grantor trust in exchange for a promissory note. The sale is not recognized for income tax purposes, and any future appreciation of the assets occurs outside the grantor’s estate, reducing future estate taxes.

The note will have to bear interest, and that interest will come back into the grantor’s estate for tax purposes.

Sale of Appreciated Assets and Avoidance of Capital Gains Tax
Consider a grantor with no remaining estate tax exemption, but with remaining appreciated assets in his estate. He wants to get the assets out of his estate but doesn’t want to incur either capital gains taxes, or estate/gift taxes.

One strategy is to use first a tax-exempt Asset Diversification Trust, and then an Intentionally Defective Grantor Trust.

The asset would be contributed to the Asset Diversification Trust. Because the Asset Diversification Trust is tax-exempt, that trust can sell the asset, and incur no capital gains tax.

The grantor owns the lead interest in the Asset Diversification Trust. The grantor then sells that lead interest to the grantor trust, for a note.

For more on this strategy, call, email, or request our Advisor Guide. Call our office at 703 437 9720, and ask for Connor or Katherine. Or, email [email protected].

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[1] Prior to the 1940s, there was no such thing as a grantor trust. The supreme court, in a decision designed to increase tax revenue, ruled (If you are not sure what grantor trusts are, or when they might be used, this article is for you. We’ll discuss what grantor trusts are, their most common uses, and how they can be used to help people avoid or minimize estate and gift taxes.

For most purposes, the key feature of a grantor trust (as opposed to any of several varieties of non-grantor trust) is the fact that the income earned by a grantor trust flows through to the grantor’s personal income tax return.

Why would someone want to pay tax on income that doesn’t flow to him or her?

That is the question we’ll address in this post.

(For a copy of an Advisor Guide, please click here.)

As it turns out, counter-intuitive though it may appear at first, having to pay tax on the income generated by a trust can be an advantage in estate planning.

To repeat, the key characteristic of a grantor trust is that, for federal income tax purposes, the trust’s income is taxed to the grantor, not to the trust itself or the beneficiaries (unless a grantor is also a beneficiary, in which case the income will be taxed to the grantor in the grantor’s role as grantor, not the grantor’s role as beneficiary). This differs from a non-grantor trust, in which case the trust itself or its beneficiaries are responsible for taxes on the trust’s income.

It can be helpful for advisors to be familiar with the most common types of Grantor Trusts, in order to better be able to advise their clients.

Common Types of Grantor Trusts
Several types of grantor trusts are commonly used, each with its own specific purposes and benefits:

Revocable or Living Trust: A revocable trust is a grantor trust. That is, any revocable trust will, by its nature, pass any income earned or recognized by the trust to the grantor for federal income tax purposes. Living trusts are typically used for non-tax reasons, and the grantor nature of the trust has no tax-planning significance. Click here for our post on Revocable Trusts.

Irrevocable Life Insurance Trust (ILIT): A trust designed to own life insurance policies, typically also designed to make sure that the death benefits are out of the grantor’s estate for estate tax purposes, is often called an ILIT. One design calls for the trust to be a grantor trust, and during the grantor’s life it has little income and the grantor design has limited income tax effects.

Grantor Retained Annuity Trust (GRAT): A GRAT is a type of trust specifically designed with estate planning purposes in mind. A full discussion of GRATs is beyond the scope of this post. We plan a future post to discuss GRATs in greater depth.

Intentionally [Defective] Grantor Trust: A trust may be designed as a grantor trust that takes assets out of the grantor’s estate for estate tax purposes, but leaves the income with the grantor for income tax purposes.[1]

In the early days of grantor trusts, some lawyers inadvertently drafted trusts that were considered grantor trusts, and this may be the origin of the term “defective.” The term has stuck, and is still sometimes used. Today, however, the preferred term is Intentionally Grantor trust, or simply Grantor trust.

Income Taxes
In some circumstances, a grantor trust can be used to shift the income tax burden from the trust or its beneficiaries to the grantor. This can be advantageous if, for example, the beneficiaries might be in a higher tax bracket than the grantor, or if the grantor desires to pay the income tax instead of having either the trust or the beneficiaries pay the income tax.

Trust Income Tax
If a trust is not a grantor trust, and it has only taxable beneficiaries, the trust is likely to be a complex trust. A complex trust is a taxable trust. Such trusts, as opposed to individuals, pay tax at the highest personal income tax bracket on the income over $14,450.

Thus, in most cases, a taxable trust will pay a higher total income tax on a given amount of income compared to the total amount of income tax that would be paid if the same amount of income were spread over one or more human beneficiaries.

In many estate planning situations, the desire is not to pay more income tax than necessary. Either the beneficiaries or the grantor, rather than the trust, should pay the tax, because they’ll be taxed at a lower rate than the trust would.

Why Have the Grantor Pay Income Tax on Trust Income?
If a trust is not itself to be liable for tax, then either the grantor or the beneficiaries will have to be liable.

In estate planning situations, it is often the case that the grantor is trying to remove as much value from his estate as possible, while incurring as little estate or gift tax as possible.

A grantor trust can be a way to effectively carry this out.

Consider a case in which a grantor funds a non-grantor trust with property worth exactly the amount of his remaining lifetime estate/gift tax exemption. For ease on illustration, let’s assume this amount is $10,000,000.

Again, for ease of illustration, assume the trust invests and earns exactly 5.1445% interest per year, or $514,450 of ordinary income.

At trust tax rates, the trust will owe tax at the top ordinary income tax rate, 37%, on $500,000 of income.

Compare that to a couple filing jointly in 2024, which would incur the top rate of 37% only on income above $731,000, and would pay 35% only on income above $487,000.

If the $514,450 were the couple’s only taxable income, they’d owe about $113,000 in income tax on it (assuming no state or other income taxes).

That same income, in the trust, would incur taxes of over $185,000.

The difference in this example is over $70,000, and would occur each year.

Extra Gift
Another reason for using a grantor trust, as opposed to a non-grantor (complex) trust, is to increase the effective gift.

Using the same numbers as above, if the non-grantor trust must pay tax (as opposed to the grantor absorbing the tax), the trust will have $185,000 less after the year.

So, in effect, the grantor makes an additional “gift” of $185,000 to the trust by making the trust a grantor trust. That extra $185,000 is not considered a taxable gift.

And it can be argued that the grantor provision is worth even more than that $185,000 a year. Suppose that the grantor was to have the trust pay the $185,000 of income taxes, and then the grantor would make an additional gift to make up for the $185,000 paid in taxes.

That would cost the grantor about $259,000, because the gift itself would be taxable. If the grantor has no remaining gift/estate tax exemption, to make a gift of $185,000, the giver would also have to pay a gift tax of $74,000.

Sale of Assets to an Intentionally Defective Grantor Trust
A grantor trust can be used as a buyer of appreciated assets that a grantor believes will keep appreciating. The sale of such assets to a grantor trust can remove the asset from the estate for estate tax purposes, while avoiding the recognition of capital gain.

For example, the grantor can sell appreciating assets to the grantor trust in exchange for a promissory note. The sale is not recognized for income tax purposes, and any future appreciation of the assets occurs outside the grantor’s estate, reducing future estate taxes.

The note will have to bear interest, and that interest will come back into the grantor’s estate for tax purposes.

Sale of Appreciated Assets and Avoidance of Capital Gains Tax
Consider a grantor with no remaining estate tax exemption, but with remaining appreciated assets in his estate. He wants to get the assets out of his estate but doesn’t want to incur either capital gains taxes, or estate/gift taxes.

One strategy is to use first a tax-exempt Asset Diversification Trust, and then an Intentionally Defective Grantor Trust.

The asset would be contributed to the Asset Diversification Trust. Because the Asset Diversification Trust is tax-exempt, that trust can sell the asset, and incur no capital gains tax.

The grantor owns the lead interest in the Asset Diversification Trust. The grantor then sells that lead interest to the grantor trust, for a note.

For more on this strategy, call, email, or request our Advisor Guide. Call our office at 703 437 9720, and ask for Connor or Katherine. Or, email [email protected].

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[1] Prior to the 1940s, there was no such thing as a grantor trust. The supreme court, in a decision designed to increase tax revenue, ruled (Helvering v. Clifford, 1940), created the concept of a trust whose income was taxable to the grantor. Congress codified the grantor trust in 1954.

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