797 / What is a grantor trust? How is a grantor trust taxed?

A grantor who retains certain interests in a trust he creates may be treated as the “owner” of all or part of the trust and thus taxed on the income of the trust in proportion to his ownership. There are five categories of interests for which the IRC gives detailed limits as to the amount of control the grantor may have without being taxed on the trust income. These categories are: reversionary interests, power to control beneficial enjoyment, administrative powers, power to revoke, and income for benefit of grantor.¹ With respect to any taxable year ending within two years after a grantor/decedent’s death, any trust, all of which was treated under these grantor trust rules as owned by the decedent, is not required to file an estimated tax return (see Q 795).²

Reversionary Interests

Generally, a grantor will be treated as the owner of any portion of a trust in which he has a reversionary interest in either the corpus or the income, if, as of the date of inception of that portion of the trust, the value of such interest exceeds 5 percent of the value of the trust.³ There is an exception to this rule where the reversionary interest will take effect at the death before age 21 of a beneficiary who is a lineal descendant of the grantor.⁴ For transfers in trust made prior to March 2, 1986, the reversionary interest was not limited to a certain percentage, and so long as it took effect after 10 years it did not result in taxation of the grantor.⁵ Using a 6 percent valuation table, the value of the reversionary interest of a term trust falls below 5 percent if the trust runs more than about 51 years. The value of a reversion will depend on the interest rate and the valuation tables required to be used.

Power to Control Beneficial Enjoyment

If the grantor has any power of disposition over the beneficial enjoyment of any portion of the trust, and such power is exercisable without the approval of an adverse party, he will be treated (i.e., taxed) as the owner of that portion.⁶ A grantor may do any of the following without such action resulting in his being treated as the owner of that portion of the trust:

(1) reserve the power to dispose of the trust corpus by will, (2) allocate corpus or income among charitable beneficiaries (so long as it is irrevocably payable to the charities), (3) withhold income temporarily (provided the accumulated income must ultimately be paid to or for the benefit of the beneficiary), (4) allocate receipts and disbursements between corpus and income, and (5) distribute corpus by a “reasonably definite standard.”⁷ An example of a “reasonably definite standard” is found in Treasury Regulation Section 1.674(b)-1(b)(5): “for the education, support, maintenance and health of the beneficiary; for his reasonable support and comfort; or to enable him to maintain his accustomed standard of living; or to meet an emergency.” A grantor also may retain the power to withhold income during the disability or minority of a beneficiary.⁸ However, if any person has the power to add or change beneficiaries, other than providing for the addition of after-born or after-adopted children, the grantor will be treated as the owner.⁹

IRC Section 674(c) allows powers, solely exercisable by a trustee or trustees (none of whom is the grantor, and no more than half of whom are related or subordinate parties who are subservient to the wishes of the grantor), to distribute, apportion, or accumulate income to or for beneficiaries or pay out trust corpus to or for a beneficiary without the grantor being considered the owner of the trust. A related or subordinate party is a person who is not an adverse party and who is the grantor’s spouse if living with the grantor; the grantor’s father, mother, issue, brother or sister; an employee of the grantor; or a corporation or employee of a corporation if the grantor and the trust have significant voting control of the corporation.¹⁰ An adverse party is any person having a substantial beneficial interest in a trust which would be adversely affected by the exercise or non-exercise of the power the person possesses respecting the trust.¹¹

The grantor will also not be considered the owner of the trust due to a power solely exercisable by a trustee or trustees, none of whom are the grantor or the grantor’s spouse living with the grantor, to distribute, apportion, or accumulate income to or for a beneficiary as long as the power is limited to a reasonably definite external standard set forth in the trust instrument.¹² Regulations treat a reasonably definite external standard as synonymous with a reasonably definite standard, described above.¹³

Income for Benefit of Grantor

If the trust income is (or, in the discretion of the grantor or a nonadverse party, or both, may be) distributed or held for the benefit of the grantor or his spouse, he will be treated as the owner of it.¹⁴ This provision applies to the use of trust income for the payment of premiums for insurance on the life of the grantor or his spouse, although taxation does not result from the mere power of the trustee to purchase life insurance. This provision is also invoked any time trust income is used for the benefit of the grantor, to discharge a legal obligation. Thus, when trust income is used to discharge the grantor’s legal support obligations, it is taxable income to the grantor.¹⁵ State laws vary as to what constitutes a parent’s obligation to support; however, such a determination may be based in part on the background, values and goals of the parents, as well as the children.¹⁶

The mere power of the trustee to use trust income to discharge a legal obligation of the grantor will not result in taxable income to the grantor. Under IRC Section 677(b), there must be an actual distribution of trust income for the grantor’s benefit in order for the grantor to be taxable on the amounts expended.

Other Grantor Powers

A grantor’s power to revoke the trust will result in his being treated as owner of it. This may happen by operation of law in states requiring that the trust instrument explicitly state that the trust is irrevocable. Such a power will also be inferred where the grantor’s powers are so extensive as to be substantially equivalent to a power of revocation, such as a power to invade the corpus.¹⁷

Certain administrative powers retained by the grantor will result in his being treated as owner of the trust; these include the power to deal with trust funds for less than full and adequate consideration, the power to borrow without adequate interest or security, or borrowing from the trust without completely repaying principal and interest before the beginning of the taxable year.¹⁸