March 15, 2022
Many Estate Planning attorneys build estate plans around trusts. Trusts offer great flexibility both during life, for example during a period of disability, and after the death of the grantor by providing asset protection, remarriage protection, asset management, and other benefits which might not be otherwise available.
The income tax consequences of a trust depend upon whether the trust contains provisions that make it a “grantor” trust or a “nongrantor” trust. Generally, the tax attributes of a grantor trust flow through to the grantor of the trust, pursuant to Sections 671 through 678 of the Internal Revenue Code (the “Code”). Many refer to these Code Sections as the “Grantor Trust Rules” and these sections determine the income tax status of a trust. If the trust qualifies as a grantor trust under the Grantor Trust Rules, then the Internal Revenue Service disregards the trust as a separate tax paying entity.
If the grantor retains the power to revoke the trust, that’s a grantor trust according to Section 676 of the Code. The grantor reports the income from the trust on their United States Individual Income Tax Return (“Form 1040”). The trust typically uses the grantor’s social security number when establishing an account at a bank or other financial institution in the name of the revocable trust. Alternatively, the trust could use a separate taxpayer identification number for the trust. Either way, the income would flow through to the grantor’s tax return. See Treas. Reg. Section 1.671-4. Assuming the trust uses the grantor’s social security number for tax reporting, when the financial institution issues a Form 1099 or any other tax document, it would do so using the grantor’s social security number.
Revocability alone does not determine grantor trust status. In fact, the grantor need not have a direct benefit from the trust and the trust may be classified as a grantor trust. If the grantor creates an irrevocable trust but retains certain benefits or powers under that trust, then the trust may be a grantor trust. In general terms, if the grantor retains a reversionary interest of more than five percent of the value of the trust, controls the beneficial enjoyment of the income or principal of the trust without the consent of an adverse party, retains certain administrative powers, such as the power to substitute property of equivalent value for the property in the trust, or receives income from the trust, then that’s a grantor trust. Grantor trust status may be beneficial because it allows the grantor to benefit another individual, such as a child or grandchild, while maintaining the tax liability without the payment of the tax being considered an additional gift by the grantor.
The Code classifies any trust that is not a grantor trust under the Grantor Trust Rules as a nongrantor trust and considers such trust its own taxpaying entity. The trustee files a separate income tax return detailing the income, deductions, credits, and tax liability for the trust on the United States Income Tax Return for Estates and Trusts (“Form 1041”). The nongrantor trust obtains a taxpayer identification number for use in reporting items of income and filing its tax returns. If the trustee distributes income to beneficiaries, those distributions may carry out the taxable income of the trust. The trustee provides the beneficiaries with a Schedule K-1 detailing the trust income attributable to that beneficiary which the beneficiary includes in income on their Form 1040. The trust receives an offsetting distribution deduction on its Form 1041. The trust pays tax on any income for which it did not have an offsetting distribution deduction.
The trust reaches the top federal tax rate of 37% on income that exceeds $13,450 in 2022. Contrast that with a single individual taxpayer who reaches the top tax rate of 37% on income that exceeds $539,900 in 2022. Clearly, grantor trust status provides, among other things, tax benefits to a grantor by lowering the tax rate for income. Let’s review a quick example that illustrates that difference in real numbers.
Assume that Mila established the Mila Kunis Revocable Trust. During her lifetime, the trust incurs income of $550,000 annually. Mila includes her only source of income, the trust income, on her Form 1040 for the tax year 2022. Mila has $550,000 of taxable income. Her Form 1040 shows a liability of $166,456 after the application of the tax brackets for a single taxpayer in 2022.
Assume instead that Mila establishes the Kunis Family Trust as a nongrantor trust and names her adult children, Wyatt and Dimitri, as beneficiaries of the Trust. The trust again has taxable income of $550,000 for the year 2022. Thus, Form 1041 would show a tax liability of $201,762. This number alone demonstrates the importance of a trust distributing its income and the important distinction between grantor trust and nongrantor trust status. If the trustee distributes all the income to the beneficiaries, who have no other income, then the trust should receive a distribution deduction for the $550,000 distributed. Each of Wyatt and Dimitri would include $275,000 on their individual Forms 1040. If neither receives income from another source, then assuming each files using single taxpayer status for 2022, each child would have a tax liability of $70,021 after application of the applicable tax brackets.
As the examples above demonstrate, grantor trusts provide an opportunity to lower a trust’s total tax liability, a powerful tool in the Estate Planning arsenal. As we approach the deadline for filing our 2021 income tax returns, it’s important to review your estate plan, paying close attention to any trusts that are part of your plan. Remember that grantor trust income flows through to the grantor, whether or not the trust makes distributions to beneficiaries of the trust. Conversely, nongrantor trust income flows out to the beneficiaries, if they received appropriate distributions during the year, and the trust receives a corresponding distribution deduction. If you have questions about the operation of your trusts or the resulting tax consequences, our attorneys can guide you through this complex area of the law.
Tereina Stidd, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.