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: