Many types of trusts are created with a similar goal in mind: to protect assets and the income they generate from a higher tax rate, creditors or other liabilities. A grantor trust is an example of a trust that lets the the holder (the grantor) protect the assets placed in trust by paying the tax liability on his/her personal 1040 return rather than deferring the tax liability to the trust and thereby cutting the amount ultimately paid out to the trust beneficiaries.
In the past, when income ranges within trust tax brackets were wider, this could provide tax saving opportunities if the individual’s tax bracket was higher than the trust. In other words, if the grantor held the assets personally, they would be taxed as the personal rate. However, in recent years the IRS established rules considerably slimming each trust tax bracket so the income threshold for trust-held assets to be taxed at the highest possible rate (37%) is much lower.
See the table below for the income thresholds for individuals and trusts at which income is taxed at the highest percent.
Despite the apparent tax advantages of holding assets personally rather than in this type of trust (given the above comparison), this type of trust still provides benefits that should be considered including the following.
First, the tax filing process is simpler. Although a Form 1041 still must be filed to recognize the trust, it is treated as a disregarded entity by not reporting income for tax purposes. Instead, the taxable income, deductions and credits reverts to the grantor’s 1040 return and if the trust paid income to one or more beneficiaries for the taxable year, the beneficiary(ies) also pay taxes on the income gifted them by the trust.
The following benefits also make a grantor trust valuable:
Asset Management and Control
The owner of a revocable grantor trust has considerable liberty to control the assets held within the trust including by removing assets and adding others. The grantor also has the power to change the beneficiaries, direct other trustees and even revoke the trust.
The Grantor Trust and Estate Planning
Although the grantor protects the trust assets by assuming the trust’s tax liability, any assets held in trust are not taxed to the grantor upon his or her death, thereby cutting (sometimes considerably) the amount in estate tax owed.
Additionally, one type of this trust called the intentionally defective grantor trust also can lower estate taxes by freezing certain assets in the trust that still includes income tax but not estate tax commitments. This type of grantor trust must be irrevocable to enjoy this benefit.
Asset Protection, Efficient Distribution and Privacy
One notable benefit of many trusts is the protection afforded to assets from creditors, lawsuits and other claimants, which is also true for certain grantor trusts, thereby preserving the assets for the trust beneficiaries. Assets in a grantor trust also avoid the probate process, which saves time and money when distributing assets and grants privacy since the probate process is part of the public record.
Income-Generating Trusts and Charitable Giving
Some grantor trusts pay income to the owners with one type providing charitable benefits. A grantor-retained annuity trust, for example, provides the grantor with an annuity for a specific term period with the remainder awarded to beneficiaries, thereby reducing estate taxes upon the grantor’s death. Within the trust, assets may also appreciate and pass to beneficiaries without consideration for gift taxes.
Alternatively, a charitable remainder trust or a charitable lead trust provides income to the grantor or other beneficiaries for a certain period of time, with the remainder going to a charitable group, providing additional philanthropic and tax benefits.
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Grantor trusts offer numerous management, tax and estate planning benefits by allowing the grantor to assume liability for trust-generated income and protect value of the assets for beneficiaries. Understanding your goals and the tax implications of choosing one trust over another will be crucial to helping you make the right decision.
One of CBM’s experienced accountants can help you navigate the complex area of trust and estate planning. Contact Paula Ellenberg with any questions via our online contact form.
Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from our office in Bethesda, MD.
