An Internal Revenue Code’s Grantor Trust Tax Rules Overview
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Grantor Trust Rules
When it comes to the US tax code (aka Internal Revenue Code), one of the most complicated aspects of US taxation under the Internal Revenue Code is the tax rules involving grantor trusts. In general, the two main categories of trusts are grantor trusts and non-grantor trusts. The distinction between these types of two trusts is very important because the tax implications for these two different types of trusts differ extensively. From a baseline perspective, with a grantor trust, the grantor is taxed on the income. A very simplified example would be a US person who has a US Trust with a US Property inside of it that generates income. The grantor is responsible for the income and tax reporting for that rental property. With a non-grantor trust, the initial grantor or settler is not considered the owner of the trust and therefore is not subject to US tax on the income — but rather the trust and/or beneficiaries that receive distributions are required to deal with the tax headaches. This of course becomes infinitely more complicated when it involves a foreign grantor trust, but let’s stay focused on the basics of the Grantor Trust Tax Rules.
Taxation of a Grantor Trust
The taxation of a grantor trust is relatively straightforward; usually, the grantor is responsible for the taxes. The reason for this is to avoid a situation in which income is being assigned to beneficiaries (who are typically in a lower tax bracket) and then who transfer the money back to the grantor– and the IRS loses out on tax. That is because the beneficiaries are typically taxed at a lower tax rate, and especially with the gift and estate exclusion being so high, the IRS wants to ensure that it is not missing out on any income that it is due. Therefore the grantor tax rules require the trust grantor to be responsible for the tax.
IRC 671-679 Grantor Trust Rules
Internal Revenue Code sections 671 through 678 provide a tax roadmap to the grantor trust rules. Each of these code sections refers to separate powers and attributes of the federal grantor trust tax rules. Noting, that if it turns out that the trust is considered a foreign trust then Internal Revenue Code section 679 takes effect.
Grantor Trust Powers
In general, grantors have various different powers and authorities available to them as the grantor or owner of the trust. Some of the more common powers include the:
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power to withdraw income from the trust;
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the power to substitute or exchange assets within the trust, and
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the power to change the trustee and or beneficiaries of the trust.
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These powers may be limited or modified depending on the specific type of grantor trust.
Grantor Trust Participants
When it comes to understanding the type of persons that are part of the grantor trust, the internal revenue service provides a good summary detailing the different participants.
As provided by the IRS:
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Grantor
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The grantor is also known as the trustor, settlor, or founder. The grantor is the person who transfers the trust property to the trustee.
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Trustee
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The trustee is the individual or entity responsible for holding and managing the trust property for the benefit of the beneficiary. Trustees can be a corporate fiduciary or any competent individual who is not a minor. The trustee holds the legal title to the trust property. As such, the trustee has a fiduciary duty to the beneficiaries with respect to the trust property. In the event of a breach of fiduciary duty, a trustee may be held personally liable. Such breaches include failing to pay out distributions or misappropriation.
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Beneficiary
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The beneficiary is the individual or entity who will receive the benefits of the trust property. The beneficiary holds the beneficial title to the trust property. The trust document must clearly identify the beneficiary or beneficiaries.
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Simple vs Complex Trust
Two of the main categories of grantor trusts are simple trusts and complex trusts.
Simple Trust
With a simple trust, all of the income is distributed annually so that there is no additional income within the trust beyond what has been distributed – noting there are exceptions and limitations to this rule. Expanding upon the example from above, when all of the income from the rental properties is distributed from the trust, it is considered to be a simple trust.
Complex Trust
With a complex trust, the rules are a bit different. In general, a complex trust can be distinguished from a simple trust in that the complex trust is not required to distribute all of the income each year. As a result, certain income may gain or lose its status depending on what year it was distributed and whether it is the current year or prior year’s income that is being distributed out of the trust – which has tax implications associated with it. This is further complicated by the foreign grantor tax rules.
Foreign Trust vs Domestic Trust
Once it is determined that trust is considered a grantor trust, it is important to ascertain whether or not the trust would be considered a domestic trust or a foreign trust. Grantor trusts have an immediate tax implication on income generated from the trust, so whether or not the grantor is considered a US person or a foreign person is crucial. In addition, issues involving whether or not the assets in the trust are based in the US or outside of the US and/or whether or not the beneficiaries are considered US beneficiaries may result in other tax implications including the reporting requirements under Forms 3520 and 3520-A.
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