Trusts have served as integral tools in tax planning for numerous decades, offering various advantages such as:

1. Reducing income tax liability
2. Diminishing estate tax liability
3. Bypassing probate
4. Shielding assets from creditors
5. Dictating posthumous wealth utilization

Despite their widespread utility, the term “trust” encompasses a diverse range of trust types, causing many individuals to feel overwhelmed and hesitant to explore their options. While delving into every trust type may seem daunting, we can simplify your tax and estate planning decisions by elucidating a fundamental aspect.

Irrevocable vs. Revocable Trusts

Before delving into the nuanced topic of Grantor and Non-Grantor trusts, it’s crucial to address another pivotal distinction: revocable and irrevocable trusts. A revocable trust allows the Grantor to revoke or significantly alter it at any time, with no real transfer occurring initially. Consequently, revocable trusts are typically exempt from gift tax upon establishment but are included in the decedent’s estate upon death.

Conversely, an irrevocable trust provides the grantor with limited or no ability to alter its terms substantially. Often employed as an “estate freeze,” irrevocable trusts subject transferred assets to gift tax at inception, enabling them to appreciate in value without being included in the taxable estate upon the grantor’s demise.

Understanding Grantor & Non-Grantor Trusts

All trusts fall into either the grantor or non-grantor category. Let’s begin by examining grantor trusts and their characteristics.

Grantor Trust Overview

Establishing a grantor trust allows retention of specific powers and rights over trust assets, often involving administrative control as a trustee or through enumerated grantor powers. While not equivalent to direct asset ownership, a grantor trust enables actions such as:

1. Controlling the use of trust assets
2. Determining the timing of income or principal distribution
3. Modifying trust beneficiaries
4. Exchanging personal assets with trust assets
5. Borrowing from the trust
6. Using trust assets as collateral
7. Adjusting trust terms

Grantor Trust Taxation

Income Tax

For income tax purposes, grantor trusts are disregarded entities, attributing trust earnings directly to the grantor. This approach facilitates tax advantages, including the ability to swap assets without incurring capital gains tax and ensuring trust appreciation without significant tax depletion.

Estate Tax

Revocable grantor trusts are typically included in the decedent’s estate, necessitating the creation of an irrevocable grantor trust to remove assets from the estate. The emergence of “Intentionally Defective Grantor Trusts (IDGTs)” has allowed for the creation of grantor trusts not included in the estate upon the grantor’s death.

Gift Tax

Upon establishing an irrevocable trust, initial asset transfers incur gift taxes. However, these gifts can often be absorbed by the individual’s lifetime estate and gift tax exemption. Ongoing gift tax obligations are minimal, provided that annual exclusion gifts do not increase. The grantor’s income tax payments on trust earnings are not considered gifts to beneficiaries, allowing the trust assets to grow tax-free.

Additionally, ongoing funding of the trust with annual exclusion gifts is feasible without further gift taxes, provided the trust is structured to grant beneficiaries the right to claim the gift amount, converting future interest into present interest (referred to as a “Crummey Trust”). This tax-efficient strategy remains applicable until the temporary estate tax exemption amount halves in 2026.

Choosing the Right Trust Structure

Determining the appropriate trust structure is crucial in aligning with your estate planning goals. Let’s explore the considerations for using a Grantor Trust and a Non-Grantor Trust.

Opting for a Grantor Trust

Grantor trusts are commonly established with the primary objective of removing assets from one’s estate, facilitating their growth for the future benefit of children or grandchildren. By retaining some control over trust assets, individuals can actively manage their wealth during their lifetime. It’s important to note, however, that this control comes with the responsibility of handling the annual income tax obligations associated with trust earnings.

Understanding Non-Grantor Trusts

In contrast, a non-grantor trust involves relinquishing control over trust assets. A trustee is appointed to administer the trust according to its documented terms, assuming a fiduciary duty to prioritize the best interests of beneficiaries. It’s crucial to refrain from acting as the trustee for a non-grantor trust, as this would reclassify it as a grantor trust.

Typically, the trust document, specifying when and how distributions occur and to whom, remains unalterable. Nevertheless, most trust documents grant trustees certain powers over trust assets. These powers may include borrowing money, selling trust assets, or investing in new types of property, provided such decisions align with the beneficiaries’ best interests.

Tax Implications of Non-Grantor Trusts

Income Tax

Distinguishing itself from a grantor trust, a non-grantor trust is treated as a distinct entity for tax purposes. This results in the trust obtaining its own taxpayer identification number (EIN or TIN). The trust is responsible for reporting all earnings and income on its annual income tax return, specifically federal form 1041. Unless these earnings are distributed, they are subject to taxation within the trust. Distributed earnings, however, become part of the beneficiary’s taxable income.

Careful consideration of these trust structures and their respective tax implications is essential in making informed decisions aligned with your overarching estate planning strategy.

As mentioned earlier, trust income tax brackets are much more condensed than individual tax brackets, which means trusts reach their maximum marginal tax rate more quickly than individuals. Here is a comparison of trust tax rates and individual income tax rates:

Ordinary Income Tax Brackets(2022)

	Trusts/Estates	Individuals (Single Filer)
10%	$0 – $2,750	$0 – $10,275
12%		$10,275 – $41,775
22%		$41,775 -$89,075
24%	$2,750 – $9,850	$89,075 – $170,050
32%		$170,050 – $215,950
35%	$9,850 – $13,450	$215,950 – $539,900
37%	$13,450	$539,900 +

 

Strategic Considerations for Non-Grantor Trusts

Due to the substantial tax rates applied to trusts, meticulous planning is essential, especially for non-grantor trusts. These trusts are often structured to empower trustees to make discretionary distributions to beneficiaries. Rather than retaining earnings within the trust, subjecting them to high tax rates, trustees can opt to distribute these earnings to beneficiaries by the end of the tax year. Such distributions typically adhere to ascertainable standards, such as addressing health, education, maintenance, or support needs. This approach, common in tax planning, can prove advantageous when beneficiaries find themselves in lower tax brackets than the trust, benefiting all parties involved.

While this strategy is prevalent, trustees must exercise caution, as they are obligated to act in the best interests of beneficiaries. Distributing earnings solely to reduce overall tax liabilities might contravene fiduciary duties if the trust’s original intent was not to burden beneficiaries with taxable income at a specific point in their lives. Additionally, if the trust lacks proper drafting, permitting fully discretionary distributions beyond ascertainable standards, it may lead to unforeseen tax consequences.

Navigating Estate and Gift Tax Implications

Estate Tax

Establishing an irrevocable non-grantor trust ensures that the trust’s assets remain outside your estate, unless specified otherwise. However, a tax code provision subjects transfers made within three years of the decedent’s death to estate tax. Individuals advanced in age or facing terminal illnesses should explore various options beyond a non-grantor trust.

Gift Tax

The gift tax ramifications of an irrevocable non-grantor trust align with those of an irrevocable grantor trust. Contributions to the trust upon its funding are subject to gift tax, diminishing your $12,060,000 lifetime estate and gift tax exemption. Leveraging annual exclusion gifts through well-drafted Crummey trusts is still viable for an irrevocable non-grantor trust.

Determining the Appropriate Trust

Choosing between a grantor or non-grantor trust is a decision requiring careful consideration, ideally with guidance from a tax advisor. Beyond this fundamental choice, several crucial questions must be addressed:

1. Do I prefer a revocable or irrevocable trust?
2. What types of assets should be placed in the trust?
3. Who are the designated beneficiaries?
4. Is a charitable allocation within the trust desired?
5. How long should the trust endure after my passing?
6. Should the trust be established during my lifetime or at death?
7. Can a reliable trustee be identified?
8. Which attorney should draft the trust documents?

Navigating these tax planning decisions may seem intricate, but seeking assistance from a KBCPA tax advisor can help streamline the process and ensure informed choices align with your financial goals.