There is a way to set up a grantor trust and avoid the higher-end taxation bracket. A grantor trust is a trust where for federal tax purposes (and NY state tax purposes), the grantor is treated as the owner of the whole or a part of a trust.[1] Thereby, any income from the trust passes-through to the grantor’s income and is now taxed at the individual tax rate.[2]
Rules of a Grantor Trust
Sections 671-679 of the IRS code enumerate the rules behind a grantor trust. For tax purposes, a grantor is defined as someone who either creates a trust or makes a gratuitous transfer—that is “any transfer other than a transfer for fair market value”—of property to a trust.[3] The rules dictate that a grantor (or grantor’s spouse)—or in some cases an unrelated person as discussed below—must retain certain control over the trust. Any of the below powers over a portion of the entire trust would allow that part of the trust to be considered a grantor trust.
Setting-Up a Trust as a Grantor Trust
As mentioned, setting up a trust as a grantor trust allows for pass-through taxation, guaranteeing lower rates for many taxpayers such as those who are married filing jointly, when compared with the trust tax rates. There are various strategies in how to trigger the grantor trust rules, with the following two being the most common.
Requisite Tax Forms
Generally, Form 1041 should be filed, indicating a grantor trust. Where a grantor trust is only part of the trust, both trusts should be checked off.[13] No dollar amounts on the form should be filled out, rather an attachment created containing:
The IRS also allows other optional methods of filing a grantor’s return, most notable is the “Optional Method 3,” usable when a grantor’s trust is owned by two spouses, filing joint returns.[15] This optional method allows for the IRS reporting to be done via Form 1099.[16] This has an extra benefit for NY State resident grantor trusts. If a Form 1041 is filed, this triggers the filing of New York Form IT-205, however, if an optional method for federal taxation is utilized, then no filing requirements trigger.[17] Thus, filing via an optional method in lieu of Form 1041 will likely result in accounting fee savings and less paperwork.
Summary
Many grantors may realize a tax benefit by setting up their trusts as a grantor’s trust. While the Federal and NY State tax rates remain higher for trusts compared to many individual brackets, grantor trusts should be viewed as a premier savings strategy.
Call the Law Offices of Albert Goodwin at (212) 233-1233, New York estate, guardianship, wills, trust, Medicaid and probate lawyer, and make an appointment to discuss your grantor trust.
[1] 26 U.S.C § 671 (2012).
[2] Id.
[3] 26 C.F.R. § 1.671-2(E)(1), (2)(i) (2018).
[4] 26 U.S.C § 673.
[5] Id.§ 674.
[6] Id.§ 675.
[7] Id.§ 676.
[8] Id.§ 677.
[9] Id.§ 678.
[10] Id.§ 679.
[11] Id.§ 675(4)(C); See also26 C.F.R. § 1.675-1 (2018).
[12] SeeBrad Galbraith et al., Intentionally Defective Grantor Trusts Line by Line (2016).
[13] Internal Revenue Serv., Instructions for Form1041 13 (2017).
[15] Id.
[16]Id.
[17]Id.at 14.
[18]N.Y.S. Dep’t of Taxation & Fin., Instructions for Form IT-205: Fiduciary Income Tax Return5-6 (2017).