Grantor Trust Rules: What They Are and How They Work

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A grantor trust is a trust whose income is taxed to the person who created it, the grantor, rather than to the trust itself. The grantor trust rules are the provisions of the Internal Revenue Code (Sections 671 through 679) that decide when this happens. If the grantor keeps certain powers or benefits, the IRS treats the grantor as the owner of the trust’s assets for income tax purposes. The grantor then reports the trust’s income, deductions and credits on their personal return, even though the assets are legally titled to the trust.

Why the rules exist

The rules were written to stop income shifting. Before 1986, trusts had their own graduated tax brackets, so a high earner could move income-producing assets into trusts, have the income taxed at lower rates, and get the assets back later. In Helvering v. Clifford (1940), the Supreme Court held that a husband who placed securities in a short-term trust for his wife while keeping control was still the owner for tax purposes. Congress codified the rules in the 1954 Code. The Tax Reform Act of 1986 tightened the reversionary interest test and compressed trust brackets, so a trust reaches the top federal rate at a small fraction of the income an individual needs. Income retained in a non-grantor trust is now usually taxed more heavily than the same income on a person’s return.

How grantor trust rules work

A trust is a grantor trust, in whole or in part, if the grantor (or in some cases the grantor’s spouse) holds any of the interests or powers below.

• Reversionary interest (Section 673): the grantor can get the property or income back, and that interest is worth more than 5% of the trust portion at the time of transfer.
• Power to control beneficial enjoyment (Section 674): the grantor or a nonadverse party can decide who receives income or principal, for example by adding beneficiaries, subject to several excepted powers.
• Administrative powers (Section 675): for example, borrowing trust funds without adequate interest or security, or reacquiring trust assets by substituting property of equal value (the “swap power”) in a nonfiduciary capacity.
• Power to revoke (Section 676): the grantor can take the property back, which makes every revocable living trust a grantor trust.
• Income for the grantor’s benefit (Section 677): income may be paid to or accumulated for the grantor or spouse, or used to pay premiums on insurance on their lives.
• Section 678: a person other than the grantor, such as a beneficiary with an unrestricted right to withdraw principal, can be treated as owner.
• Section 679: a U.S. person who transfers property to a foreign trust with U.S. beneficiaries is generally treated as owner.

A “nonadverse party” is someone without a substantial beneficial interest that the power’s exercise would hurt. Powers held by such a person are often attributed to the grantor.

Grantor trust vs. non-grantor trust

In a grantor trust, the grantor pays income tax on all trust income at individual rates, whether or not anything is distributed. A revocable trust with the grantor as trustee can often use the grantor’s Social Security number. Other grantor trusts typically obtain an employer identification number and may file Form 1041 as an information return.

In a non-grantor trust, the trust is its own taxpayer with its own EIN. It files Form 1041 and pays tax on income it keeps. Income it distributes is generally deducted by the trust and taxed to beneficiaries, who receive a Schedule K-1.

Hypothetical example

Assumptions for illustration only: a trust holds a $400,000 portfolio that earns $16,000 of interest and dividends in a year, and nothing is distributed.

• If the trust is a grantor trust, the $16,000 appears on the grantor’s Form 1040, is taxed at the grantor’s marginal rate, and is paid from the grantor’s personal funds.
• If it is a non-grantor trust, the trust pays tax on the $16,000 under the compressed trust brackets, so a large share may fall into the top rate.

How the rules are used in estate planning

Because income tax ownership and estate tax inclusion follow different rules, planners can draft an irrevocable trust that is “defective” on purpose for income tax only. In an intentionally defective grantor trust, the grantor makes a completed gift (which may use gift tax exemption or incur gift tax), so the assets are generally kept out of the taxable estate. A retained power such as the swap power keeps the grantor taxed on the income.

That combination produces three effects:

1. The grantor’s tax payments reduce the grantor’s estate without counting as additional gifts (the IRS addressed this in Revenue Ruling 2004-64).
2. Trust assets grow without being reduced by income tax.
3. Transactions between the grantor and the trust, such as selling assets to the trust for a promissory note, are generally ignored for income tax purposes because the IRS treats the grantor and trust as the same taxpayer (Revenue Ruling 85-13).

What happens at the grantor’s death

Grantor trust status ends at the grantor’s death, because no living person holds the triggering powers. A revocable trust becomes irrevocable, needs its own EIN, and is taxed as a separate entity. Its assets are included in the grantor’s estate and generally receive a basis adjustment to fair market value. Assets in an IDGT that were excluded from the estate do not get that step-up, as Revenue Ruling 2023-2 confirmed, so heirs may face more capital gains tax on appreciated assets.

Limitations

• The grantor must have cash to pay tax on income they never receive. A clause letting the trustee reimburse the grantor must be drafted carefully to avoid estate inclusion.
• Grantor trust status does not by itself protect assets from creditors or remove them from the estate.
• Retained powers that trigger grantor status can also trigger estate inclusion under Sections 2036 and 2038 if the trust is drafted poorly.
• State income tax treatment of trusts varies, and state law governs whether a trust is revocable.

Grantor vs. trustee vs. beneficiary

The grantor (also called the settlor or trustor) creates and funds the trust. The trustee holds legal title and manages the assets under the trust document. A beneficiary receives distributions. In a typical revocable living trust, the grantor is trustee and lifetime beneficiary, and a successor trustee takes over at death or incapacity. Co-grantors, such as spouses funding a joint trust, are not the same as co-trustees, though they often serve as both.

FAQs

The Bottom Line

The grantor trust rules matter to anyone with a revocable living trust and to families using irrevocable trusts to move wealth out of a taxable estate. Grantor status can shrink an estate and let trust assets grow untaxed, but the grantor needs cash to pay tax on income they never receive. Careful drafting is essential, since retained powers can also pull assets back into the estate.