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The Benefits of Grantor Trusts in New York
Federal and New York State income tax rates for trusts are higher than many individual brackets. A grantor trust is the way to avoid the higher-end bracket. It is a trust in which, for federal and New York State income tax purposes, the grantor is treated as the owner of all or part of the trust (26 U.S.C. § 671). Any income from that part of the trust passes through to the grantor and is taxed at the grantor’s individual rate rather than the trust rate. This page explains which powers make a trust a grantor trust, the two most common ways to set one up, and the tax forms involved.
The Grantor Trust Rules
Sections 671 through 679 of the Internal Revenue Code set out the grantor trust rules. For tax purposes, a grantor is anyone who either creates a trust or makes a gratuitous transfer of property to it, meaning “any transfer other than a transfer for fair market value” (26 C.F.R. § 1.671-2(e)(1), (2)(i)). The rules require that the grantor, the grantor’s spouse, or in some cases an unrelated person retain a certain kind of control over the trust. Any one of the following powers over a portion of the trust makes that portion a grantor trust.
| Power retained | What triggers grantor trust status | Code section |
|---|---|---|
| Reversionary interest | The grantor keeps a reversionary interest in the corpus or in the trust’s income worth more than 5% of the entire trust corpus. | 26 U.S.C. § 673 |
| Power to control beneficial enjoyment | Subject to the exceptions in the statute, “the beneficial enjoyment of the corpus or the income therefrom is subject to a power of disposition, exercisable by the grantor . . . without the approval or consent of any adverse party.” | 26 U.S.C. § 674 |
| Administrative powers | The grantor or a non-adverse party holds a power to deal with the trust for less than adequate and full consideration, a power to borrow from the trust without security, has actually borrowed trust funds, or holds the general powers of administration discussed below. Status is triggered when the holder can exercise the power without a fiduciary’s consent. | 26 U.S.C. § 675 |
| Power to revoke | Subject to the reversionary interest limitation, a “power to revest in the grantor title to such portion is exercisable by the grantor or a non-adverse party.” | 26 U.S.C. § 676 |
| Income for the benefit of the grantor | The grantor or a non-adverse party can distribute or accumulate the trust’s income for the grantor or the grantor’s spouse, or apply it to a life insurance policy on either of them. The rule is triggered because they can do so; they do not have to actually do it. | 26 U.S.C. § 677 |
| Other, less common rules | Certain situations in which a trust is treated as owned by a third party, and transfers of property to a foreign trust. | 26 U.S.C. §§ 678, 679 |
Setting Up a Trust as a Grantor Trust
Because a grantor trust gives pass-through taxation, it guarantees lower rates for many taxpayers, such as those who are married filing jointly, when compared with the trust tax rates. There are various ways to trigger the grantor trust rules deliberately; these two are the most common.
The substitution power
Among the administrative powers in § 675 is a general “power to reacquire the trust corpus by substituting other property of equivalent value” (26 U.S.C. § 675(4)(C); see also 26 C.F.R. § 1.675-1). This power of substitution appears to be the most popular one to build in when a trust is set up. It must be held in a non-fiduciary capacity, either by the grantor or by a non-trustee, non-adverse third party, and the language granting it should be added when the trust is formed.
The intentionally defective grantor trust (IDGT)
Another popular route, which some regard as the better one, is the trust nicknamed an intentionally defective grantor trust. The grantor sets up a grantor trust and sells assets to it in exchange for a promissory note. The sale and the interest on the note are ignored for income tax purposes, and the assets are moved out of the grantor’s estate and into the trust (see Brad Galbraith et al., Intentionally Defective Grantor Trusts Line by Line (2016)).
The Tax Forms
Generally a Form 1041 is filed, indicating that the trust is a grantor trust; where only part of the trust is a grantor trust, both boxes are checked. No dollar amounts are entered on the form itself. Instead an attachment is prepared showing the name, identifying number and address of the person or persons to whom the income is taxable; the income of the trust that is taxable to the grantor or another person under sections 671 through 678, reported in the same detail as it would be on the grantor’s own return had it been received directly; and any deductions or credits that apply to that income, again reported in the same detail as on the grantor’s return (Instructions for Form 1041 (2017), at 13).
The IRS also allows optional methods of reporting a grantor trust. The most notable is “Optional Method 3,” available when the trust is owned by two spouses who file joint returns; it allows the reporting to be done on Form 1099 instead. This has an extra benefit for New York State resident grantor trusts. Filing a Form 1041 triggers the filing of New York Form IT-205, but if an optional federal method is used, no New York filing requirement is triggered (Instructions for Form IT-205 (2017), at 5–6). Filing under an optional method in place of Form 1041 will therefore usually mean lower accounting fees and less paperwork.
Summary
Many grantors can realize a tax benefit by structuring their trusts as grantor trusts. As long as federal and New York State tax rates remain higher for trusts than for many individual brackets, the grantor trust should be viewed as a premier savings strategy. If you would like to discuss whether your trust should be a grantor trust, call us at 212-233-1233 or email [email protected].
About the Author
Albert Goodwin Esq. is a licensed New York attorney with over 18 years of courtroom experience. His extensive knowledge and experience make him well-qualified to write authoritative articles on a wide range of legal topics. He can be reached at 212-233-1233 or [email protected].
