October 5, 2017
By: Edward B. Becker
A grantor trust is a type of trust under which the tax law considers the trust assets as still owned by the transferor for income tax purposes. As such, (i) all of the income and deductions are taxed to the transferor on the transferor's income tax return and (ii) transactions between the transferor and the trust are disregarded for income tax purposes and therefore does not cause recognition of any income or capital gains taxation. Grantor trusts play a key role in estate planning as they can be structured to exclude their assets from the transferor's taxable estate, even though the transferor is still considered the owner for income tax purposes; as such, the trust grows "tax-free" outside of the transferor's estate because the transferor can cover the income tax out of his or her other assets. The effect is to reduce the transferor's estate while growing the trust.
It is worth noting, however, that if the trust is structured as a grantor trust and the tax burden on the transferor becomes too great grantor trust status could be "toggled off" by removing the powers that caused it to be a grantor trust. Conversely, it is often possible to restructure existing non-grantor trusts and cause them to be treated as grantor trusts on a going forward basis.
Grantor trust status can be achieved by including certain provisions in the trust instrument that the tax law provides will cause the trust to be taxed as a "grantor trust". One of the more popular triggering provisions is a power in the transferor; a so-called "swap power".
Due to a rise in income tax rates and an increasing estate tax exemption, income tax considerations are becoming more of a focal point in the design and implementation of an estate plan. As a result, the actual exercise of the swap power is becoming more prevalent. Assets owned by the transferor at death obtain a step-up in basis to the assets' fair market value, thus reducing any capital gains tax, while assets gifted to a grantor trust retain the transferor's basis. The swap power thus enables the transferor to substitute, prior to death, the transferor's own high-basis assets for low-basis assets held by the grantor trust. After the swap, the low-basis assets will be owned by the transferor and will be stepped-up upon the transferor's death.
Importantly, the assets that are exchanged via the swap power must be of equivalent value as of the date of substitution. If the value of the reacquired property turns out to be less than the value of the assets transferred to the trust, the transferor will have made a gift to the trust of the difference in value.
The characterization of trusts for income tax purposes has always been an important consideration in creating a trust, and various powers have been utilized when grantor trust status has been desired. These provisions have not, however, always been incorporated in a thoughtful manner and with an expectation that they might actually someday be used to obtain a future tax advantage. Under the current federal tax landscape the utilization of some of these powers, like the swap power, may provide a meaningful benefit. If a trust does not currently contain such powers consider decanting or modifying the trust to provide such flexibility.