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Benefits of Grantor Trusts in New York

There is a way to set up a 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 or the entire trust would allow that part of the trust to be considered a grantor trust.

  • Reversionary interest: A grantor retains a reversionary interest in the corpus or in the trust’s income where such interest is valued at more than 5% of the entire trust corpus.[4]
  • Power to control beneficial enjoyment:Subject to the exceptions in the statute, this power is where“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.”[5]
  • Administrative powers: Some administrative powers either by the grantor or non-adverse party such as: Power to deal for less than adequate and full consideration; Power to borrow from the trust without security; Borrowing of the trust funds; and most importantly as is discussed below are the general powers of administration.[6] Grantor trust designation is triggered when one who possesses said power can exercise them without fiduciary’s consent.
  • Power to revoke: Subject to the reversionary interest limitation, a power to revoke is to have “power to revest in the grantor title to such portion is exercisable by the grantor or a non-adverse party.”[7]
  • Income for benefit of grantor: This rule triggers when a grantor or a non-adverse party can use the trust’s income to distribute, accumulate, or apply to a life insurance policy—for the grantor or the grantor’s spouse.[8] An important note is that the rule triggers because a grantor or a non-adverse party can do so; they do not have to actually follow through.
  • Other Rules: Other, less common rules include certain situations when a trust is owned by a third party[9], and when a person transfers property to a foreign trust.[10]

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.

  • Substitution Power: One of the powers to trigger a grantor trust is an administrative power. Within that, there is a general “power to reacquire the trust corpus by substituting other property of an equivalent value.”[11] This administrative power to substitute, seems to be the most popular power to allocate when setting up a trust. This power must be held in a non-fiduciary capacity either by the grantor or by a non-trustee, non-adverse third-party. The proper verbiage indicating said power should be added during the trust formation.
  • IDGT: Another popular (and some view the “better”) way to trigger grantor trust benefits is through what is nicknamed “Intentionally Defective Grantor Trusts” or “IDGTs”. Here, a grantor sets up a grantor trust and sells assets to the trust in exchange for a promissory note. This sale and interest on the note are ignored for income tax purposes and the assets are now reallocated from the grantor’s estate to the trust.[12]

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 name, identifying number, and address of the person(s) 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. Report the income in the same detail as it would be reported on the grantor’s return had it been received directly by the grantor; and
  • Any deductions or credits that apply to this income. Report these deductions and credits in the same detail as they would be reported on the grantor’s return had they been received directly by the grantor[14]

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.

[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).

[14]

[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).