Editor’s note: This is part seven of an ongoing series about using trusts and LLCs in estate planning, asset protection and tax planning. The effectiveness of these powerful tools — especially for asset protection and tax planning — depends very much on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner. See below for links to the other articles in the series.
An irrevocable trust agreement must be designed, drafted and implemented to deal with two primary categories of taxes: 1) transfer taxes, such as gift and estate taxes, as well as the less common generation skipping transfer tax, and 2) income taxes, such as earned income taxes, income taxes on investment or capital gains taxes, which are income taxes on property appreciation after the property is sold or exchanged.
Either the irrevocable trust or an individual will pay taxes on all trust income. Trust income includes rents on real estate, profits produced by trust investments, the appreciation income from property sold or distributions of assets from the trust. Under the comprehensive tax rules, all trust income must be reported on either the trust income tax return (at trust tax rates) or on the tax return of the trust maker or beneficiary (at individual tax rates).
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Putting this into different words, irrevocable trusts can be set up so that the trust maker no longer pays income taxes, and the taxes are instead paid by the trust. Note that the income tax rules for non-U.S. residents and non-U.S. citizens will vary quite a bit from the income tax rules we are discussing here.
Trust tax rates are much higher than individual tax rates
Why wouldn’t everyone want to set up an irrevocable trust so that they don’t need to individually pay income taxes any longer? The reason why most taxpayers are better off to pay taxes individually rather than having a trust pay income taxes is because trust tax rates are often much higher than individual tax rates.
The higher trust tax rates are due to the fact that an irrevocable trust has only hundreds of dollars in standard deduction, and an irrevocable trust pays the highest federal tax rate after just a few thousand dollars of income. Unless the irrevocable trust maker is already paying taxes at the highest marginal individual tax rate, it is almost always less expensive for the trust maker to keep on paying the trust income taxes.
Example. A trust maker with rental properties reads that they can stop paying taxes themselves by forming a trust. The trust maker asks an attorney to set up a trust with rental property LLCs so that the trust will pay taxes, thinking that the trust and LLC structure will save a lot of taxes. When the attorney calculates how much the trust would pay in taxes compared to the trust maker paying individually, the trust would pay more than two times more taxes! The attorney advises the trust maker that instead of having the trust pay taxes, the trust maker should set up a trust with “grantor” provisions so that the trust maker will continue paying taxes at the trust maker’s lower tax rates.
The fact is that most people would save on taxes by continuing to pay income taxes on the irrevocable trust income themselves, rather than having the irrevocable trust pay the income taxes at trust tax rates. The feature in an irrevocable trust that permits the trust maker or another person to pay trust income taxes is known as “grantor trust status.”
As a general rule, if an irrevocable trust is treated as a grantor trust, this means that an individual (typically the trust maker) will be treated as the owner of the trust income or principal, and the individual needs to include on their personal tax filings all items of trust income, deductions and credits as though the individual had received them personally — even if the trust didn’t distribute the income to them personally and the income stays in trust. Where several different people are treated as owners of different parts of the trust income or principal (multiple grantors), the taxes will be allocated between the different people.
It is important to note that we are primarily discussing federal income tax here, though many (but not all) state income taxes and state capital gains taxes follow the federal income tax laws.
To be certain we are clear, I’ll again point out that trusts deal with both income taxes (including earned income, investment income, losses, deductions and capital gains income taxes), and trusts also deal with transfer taxes (estate and gift transfer taxes, as well as generation skipping transfer taxes). On the transfer tax front, a trust may be designed to exclude assets from the trust maker’s gross estate (referred to as a completed gift trust), though the very same trust can be designed so that the income of the trust is taxed to the trust maker (grantor trust status).
Grantor trust rules are part of the tax code
The grantor trust rules are part of the Internal Revenue Code (IRC), which are found in Title 26 of the United States Code, the U.S. federal laws passed by Congress. More particularly, the grantor trust rules are found in Sections 671 to 679 of the IRC. The grantor trust rules generally provide that if the trust maker (or another person) has certain powers over the trust that are found in IRC Sections 673-679, the trust income will flow through to be taxed at the trust maker’s personal tax rates — and personal tax rates are almost always lower than trust tax rates.
A few examples of the powers that a trust maker can keep over the trust, so that the trust qualifies for grantor status and trust income is taxed to the trust maker, include generally: powers to invest (IRC 673); powers to reacquire trust assets, i.e. buy back trust property (IRC 673); powers to replace the trustee (IRC 675); powers to substitute property in the trust (IRC 675); power to use trust assets (IRC 677); power to veto distributions (IRC 678).
This sample list of grantor trust rules is very incomplete, and over time, billions of people with billions of needs have created millions of trusts with endless permutations of trust powers. This has caused the IRS, lawyers and tax court judges to spend countless hours determining whether bespoke and customized trust powers will cause trust income to be taxed to a grantor (usually the trust maker) or whether it should be taxed to the trust.
Complicating the matter of grantor trusts is the fact that some of the same trust income tax grantor powers will also cause a trust to be included in the gross estate and/or taxable estate of the trust maker. Again, estate tax is a different tax regime than trust income tax. For example, the power to revoke or amend the trust, a grantor trust power under IRC 676, will also cause a trust to be included in the grantor’s gross estate under a few different sections of the IRC (IRC 2036 and IRC 2038). In other words, a trust maker who retains the power to revoke or amend a trust (a revocable trust) ensures not only that the trust income is taxed to the trust maker, but also that the trust assets will be included in the trust maker’s gross estate.
Example. A trust maker forms a trust for a beneficiary, and the trust maker retains a “reversionary interest” under IRC 673 where the trust maker (or the trust maker’s estate) has the right to get back all of the trust property after the beneficiary dies. This grantor trust power will both cause the trust maker to be treated as the grantor for income tax purposes, and the trust property will also be included in the trust maker’s gross estate. The trust maker is happy with both tax results because the trust maker’s income tax rates are lower than trust income tax rates, and the trust property will get a step-up in basis by inclusion in the trust maker’s gross estate, although the trust maker will not owe any estate tax because the trust maker has adequate exemption from estate tax so that the trust maker’s gross estate is not taxable.
People who don’t have millions in wealth won’t pay estate taxes on their gross estates anyway, so the inclusion in the gross estate caused by grantor trust powers to amend under IRC 676 isn’t a problem at all. In fact, revocable trusts are usually the most tax-efficient type of trust for most people, who pay lower taxes individually compared to the higher trust tax rates, and a revocable trust also ensures that the trust property will qualify for a step-up in basis when the trust maker dies, under the capital gains rules of IRC Section 1014.
Because revocable trusts are both income tax and capital gains tax efficient, and revocable trusts are excellent for estate planning, revocable trusts are the most common type of trust. However, revocable trusts do nothing to protect assets, and revocable trusts don’t remove assets outside of the gross estate for people who have some wealth and need to avoid the estate tax.
Example. A trust maker engages an attorney to set up an irrevocable trust with the objectives of protecting assets and to avoid estate taxes on their estate. The trust maker has low tax basis in rental properties because the rentals were purchased 30 years ago when properties were considerably less expensive. The trust maker’s gross estate ( a concept similar to total net worth) is $5 million. The attorney advises the trust maker to form an irrevocable asset protection trust to hold the LLCs. The attorney drafts the trust to include provisions so that the trust maker retains grantor powers to pay taxes on the rentals by retaining rights to borrow against the rentals. The attorney also drafts the trust with provisions so that the trust maker retains rights to use trust income. When the attorney and trust maker meet, the attorney explains that the trust powers drafted in the trust not only cause the trust maker to pay taxes on the trust income — at income tax rates much lower than the trust would pay — but the powers also cause the trust-owned rentals to be included in the gross estate of trust maker. The trust maker is surprised that the attorney didn’t draft the trust to exclude the rentals from their gross estate, thinking that because the assets are included in the gross estate, the trust maker’s beneficiaries will need to pay estate taxes. The attorney explains that even though the rental properties are included in the trust maker’s gross estate, the trust maker has significant estate tax exemption, so the beneficiaries will not owe any estate tax. More important, because the low-basis rental properties are included in the gross estate, the inclusion in the estate will qualify the low-basis rental properties for a step-up in basis to the value at the time of death. This step-up in basis will save the beneficiaries significant capital gains taxes when the trust maker dies.
Why use a non-grantor trust vs a grantor trust?
Non-grantor trusts, defined as “complex” by the IRS, are trusts that owe income tax at the trust level and do not push out income and deductions to individuals. You may be wondering — if a non-grantor trust pretty much always pays the highest marginal tax rates, why would I want anything other than a grantor trust? Here is a scenario that illustrates when it could make sense to terminate the grantor trust powers and switch a trust to non-grantor.
Example. A trust maker has high income and is currently paying the highest marginal tax rate. The trust maker previously formed a completed gift trust that is outside of the trust maker’s gross estate, and the completed gift has grantor trust income tax provisions so that the trust income flows through to the trust maker. However, the completed gift grantor trust income is being taxed to the trust maker personally at their highest marginal tax rate. Put differently, the trust maker does not save income taxes by personally paying the trust income taxes. Further, a trust maker does not need or want to spend down the trust maker’s personal assets that are included in the trust maker’s gross estate — i.e. the trust maker’s personal assets are diminishing and/or the trust maker cannot afford to keep paying taxes on behalf of the trust. Because there is not an advantage (or even what could be a disadvantage) to having the trust maker continue to pay the trust income taxes since they are taxed at the highest rate anyway, and also because there is not an advantage for the trust maker to pay trust income taxes to spend down their personal assets (gross estate), the trust maker decides to terminate the grantor trust powers.
A trust maker will need to decide on a trust income tax provision (either grantor or non-grantor) that is best suited to minimize their taxes, depending on how much the trust maker earns. Keep in mind that a trust can include a renunciation of grantor trust provisions where the trust maker pays the taxes individually and later have the trust pay the taxes rather than the trust maker (or beneficiary) if that will lower the trust’s and individual’s total income tax burden.
However, a provision that terminates the grantor trust status must not be “toggled” on and off to avoid income taxes, or the IRS will challenge the trust. Additionally, a grantor trust can include a provision to reimburse the trust maker for the taxes they pay, though such a provision can pose gift tax risks or even estate tax inclusion risks if the tax reimbursement power is mandatory.
Another advantage of grantor trusts
Another powerful advantage of grantor trusts for estate tax planning is the ability of grantor trusts to reduce any assets remaining in the trust maker’s estate by having the trust maker pay the income taxes on trust income. If the property transferred into a trust is removed from the trust maker’s estate because the trust maker gave up possession, enjoyment and control over trust assets (a completed gift), rather than having the trust pay income taxes with trust property, the trust maker can pay the taxes for the trust. Using the grantor trust provisions to have the trust maker pay taxes on the trust property is the functional equivalent of the trust maker transferring more property into the trust.
Grantor trusts have been on the “green book” tax agendas of the IRS and several U.S. presidents who are keen to take away the powerful advantages that grantor trust status provides. Keep in mind that revocable trusts are the most common type of trusts, and revocable trusts are always grantor status. No one is trying to do away with revocable trusts, and the grantor trust status that is automatically afforded to revocable trusts won’t be challenged by Congress. Rather, the IRS and some U.S. presidents have been trying to do away with grantor trust advantages when the grantor trust provisions are used by trust makers to increase the value of large, complex trusts by having the trust maker continue to pay the income taxes on the trust using the trust maker’s personal assets that are still subject to estate taxes.
As much as the news focuses on using grantor trusts to reduce the potentially taxable gross estate, non-grantor trusts have become a high priority of states with high income tax rates, such as California and New York. In these states, high-income earners have been setting up trusts in other jurisdictions with no trust tax (places like Delaware, Nevada, South Dakota or Wyoming) and making the trust “intentionally non-grantor” so that the trust pays federal income taxes but avoids the high California and New York taxes.
The trust makers also make the trust incomplete for estate tax purposes so that the trust assets are purposefully included in the trust maker’s gross estate to get a step-up in basis for capital gains tax purposes. Both California and New York have passed laws that work contrary to the federal law so that the high-income-tax states can still tax the income of the non-grantor trusts.
Grantor trust income tax provisions are powerful because they permit a trust maker to pay the trust taxes themselves — and individuals almost always pay taxes at a lower rate than a trust. Additionally, when the income tax planning afforded by grantor trusts is paired with estate tax planning, grantor trusts are a powerful mechanism to effectively reduce the trust maker’s gross estate remaining outside of the estate tax-exempt trust.
However, caution must be exercised with the grantor trust rules because they interplay very closely with the estate tax and capital gains tax rules.
My next article will focus on how grantor trust provisions can have a significant effect on whether trust assets will be included in the gross estate of a decedent for computation of estate transfer taxes, and whether it is desirable to have trust assets included in the gross estate.
Other Articles in This Series
- Part one: To Avoid Probate, Use Trusts for Estate Planning
- Part two: How Quitclaim Deeds Can Cause Estate Planning Catastrophes
- Part three: Revocable Trusts: The Most Common Trusts in Estate Planning
- Part four: With Irrevocable Trusts, It’s All About Who Has Control
- Part five: Ins and Outs of Domestic Asset Protection Trusts (DAPTs)
- Part six: Irrevocable Trusts: Less Control Equals More Asset Protection
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