This is part one of a three-part series on taxation of trusts. The first part reviews how a person can be “intrinsically possessed” of trust, in another meaning, what is commonly known among estate planning attorneys or trust and estate attorneys as “grantor credit.” It will also consider the advantages of using grantor credit. The second article in the series will examine the Taxpayer Identification Number that trusts, including donor trusts, must use. The third article in the series will look at taxes NonTrust the giver.
Grantor credit is “substantially owned” by a person under code sections 671 et seq. The combined power that makes the trust the trust of the grantor is the retention of the power to withdraw the trust under Section 676. The revocable trust is the taxable income of the grantor and is also included in the grantor’s estate for estate tax purposes. However, the trust does not need to be included in the taxable estate of the grantor to be the grantor’s trust. A trust can be called what is generally known, albeit puzzling, as “intentionally defective” giver credit. In fact, there is absolutely nothing “flawed” in such confidence. They are excluded from the estate for estate tax purposes, but are taxable to the grantor for income tax purposes.
For example, if the grantor retains the power to substitute other assets of equal value to the assets of the trust, it is the grantor’s trust, pursuant to Section 675(4)(c).
Grantor credit can provide many advantages. The first is simplicity from an income tax perspective. The grantor credit does not need to file its own income tax return but can report the income on the grantor’s taxpayer identification number. Second, income from the grantor’s trust is taxed, whether or not it is distributed to the grantor. This may seem like a drawback, but it’s a huge advantage if the grantor is trying to remove value from their taxable property. The assets in the fund are allowed to grow tax-free because the grantor pays taxes on the income of the fund. It is important to note that the payment of taxes by the grantor is not considered a gift by the grantor, but rather a legal obligation of its own.
Let’s look at a quick example. Mary created a fund and contributed $1,000,000 to the fund. The fund has $50,000 of taxable income and no distributions per year. Taxable income of $50,000 is taxed on Mary’s income tax return. Mary pays the tax she owes on her $50,000 income, which comes out to $20,000. Mary pays the tax authorities $20,000 of her own money, without reducing the fund’s assets. When Mary pays the $20,000, she does not give an additional gift to the fund.
A grantor credit allows assets to grow tax-free, like a Roth IRA. This increased compound strength is a very strong advantage of the donor’s trust. The next article in the series will examine tax reports for trusts. In other words, what is the tax identification number and address provided by the trustee to the bank or brokerage firm?
Stephen C. Hartnett, JD, LLM
American Academy of Estate Planning Lawyers, Inc.
9444 Balboa Street, Suite 300
San Diego, CA 92123
Phone: (858) 453-2128