What it means
A trust is a legal arrangement in which one person, the trustee, holds assets for the benefit of others, called beneficiaries. The grantor is the person who creates the trust and puts assets into it.
Normally a trust is taxed as a separate taxpayer, but the grantor trust rules switch that off when the grantor has kept enough control or benefit. The rules list the situations that trigger this treatment.
Typical triggers include the power to revoke the trust and take the assets back, a right to get the assets back at some point, the ability to decide who enjoys the income, certain administrative powers such as swapping assets of equal value, and income that can be used for the grantor or the grantor's spouse. If any one of these applies, the grantor is treated as owning the relevant part of the trust.
The practical result is that the income, deductions and credits of the trust show up on the grantor's own return. A revocable living trust, which many people use to avoid probate, is almost always a grantor trust, so it usually changes nothing about the owner's yearly tax filing.
This is why many simple trusts need no separate tax bill of their own. Advisers also use the rules on purpose.
An intentionally defective grantor trust is built so that the assets are outside the grantor's estate for estate tax, while the grantor still pays the income tax on the trust's earnings. Because the grantor pays that tax from personal funds, the trust assets can grow undiminished, which works like an extra gift that does not count against gift limits.
The detail matters a great deal, and the rules are technical. A single power written into the trust document can change who pays the tax, so trust drafting is a job for a qualified lawyer and tax adviser, and anyone relying on this entry should seek professional advice.
The tax rates and thresholds involved are set by law and change over time.
In practice
Real-world examples.
Example
A founder sets up a revocable trust to hold her house and brokerage account so her family can avoid a lengthy probate process. Because she can cancel the trust at any time, it is a grantor trust, and she reports all the income on her own tax return as before.
Example
A business owner expecting his company's value to rise sells shares to an intentionally defective grantor trust for his children. He pays the income tax on the trust's share of the company's profits each year, so the trust keeps all the cash and the future growth stays outside his taxable estate.
Example
A tax accountant reviewing a new client's file finds a trust with a clause that lets the creator substitute assets of equal value. She tells the client that this single power makes the trust a grantor trust, so the trust's income must be reported on the client's personal return.
Formula
Calculation
Income tax paid by grantor = Trust taxable income x Grantor's tax rate
Suppose a grantor trust holds investments that produce $200,000 of taxable income in a year, and, for illustration, the grantor's combined tax rate on that income is 30%. The grantor pays 200,000 x 0.30 = $60,000 of tax from personal funds. The trust keeps the full $200,000 of income, so its assets grow by $200,000 instead of 200,000 - 60,000 = $140,000 if the trust had paid the tax. The $60,000 of tax paid by the grantor is effectively an additional transfer to the beneficiaries, made without using any of the grantor's gift allowance.Case study
Seen in the real world.
Halvorsen Logistics is an illustrative, fictional family company owned by Anna Halvorsen. She transferred a minority stake worth $2,000,000 to a trust for her two children, set up as a grantor trust under the advice of her lawyer.
Over the next five years the company paid out $300,000 a year to the trust in dividends. Anna paid the income tax on those dividends herself, which came to about $60,000 a year at her assumed rate of 20%, and the trust kept the whole $300,000 to reinvest.
After five years the trust held roughly $300,000 more than it would have if it had paid its own tax, since 5 x $60,000 equals $300,000 of tax that Anna covered. The illustrative lesson is that the tax rules turned her tax payments into a quiet way of passing wealth on, but it also meant her cash outflows rose, so she had to plan for them.
Watch out
Common mistakes.
- Assuming a grantor trust avoids income tax, when the income is taxed in full but on the grantor's return instead of the trust's.
- Forgetting that retaining even one specified power can make the whole trust, or a portion of it, a grantor trust.
- Treating tax and estate rules as the same, as a trust can be a grantor trust for income tax and still remove assets from the estate for estate tax.
Questions
People also ask.
Is a revocable trust a grantor trust?
Yes, in general, because the grantor can revoke it and take the assets back, so the grantor is treated as the owner for income tax.
Can the grantor be reimbursed for the tax paid?
Sometimes the trust document allows the trustee to reimburse the grantor, but that choice has its own tax consequences and should be discussed with an adviser.
Is a grantor trust only a US concept?
The specific rules are part of the US tax code, though other countries have their own rules for taxing the person who set up a trust.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%