Up until the Tax Reform Act of 1986, grantor trust status was something to be avoided, but thanks to rulings by the Internal Revenue Service, intentionally creating a grantor trust is now an accepted estate and gift tax planning strategy. This article will explain the principles of grantor trusts, why grantor trusts are desirable, and the way that some Pennsylvania court decisions could undermine the effectiveness of grantor trusts in Pennsylvania unless the trusts are drafted to negate those decisions.
What is a Grantor Trust?
Section 671 of the Internal Revenue Code (IRC) states that, when IRC sections 672 through 679 specify that the grantor or beneficiary of a trust shall be treated as the “owner” of any portion of a trust, that grantor or beneficiary must include the income, deductions, and credits of the trust on that person’s individual income tax return, and not on the tax return of the trust. The trust is then known as a “grantor trust.” (Although the Pennsylvania Uniform Trust Act, 20 Pa.C.S. Ch. 77, refers to the “settlor” of a trust, the Internal Revenue Code refers to the “grantor,” and this article will use the term “grantor.”)
The provisions of IRC sections 672 through 679 are too complicated to be described in detail, but they represent the judgment of Congress that a grantor who has retained a certain level of control over the income or principal of a trust should be treated as the owner of that trust for income tax purposes. The simplest example is a revocable trust. If the grantor of a trust can revoke the trust, then the trust should be ignored for income tax purposes. Similarly, a beneficiary who can withdraw the income and principal of a trust should be treated as the owner of that trust.
Irrevocable Grantor Trusts
That a revocable trust is a grantor trust does not create any opportunities for estate or gift tax planning, because the creation of a revocable trust is not a completed gift, and the trust is still part of the gross estate of the grantor for federal estate tax purposes (and also subject to Pennsylvania inheritance tax). However, there are other powers that the grantor can retain to create a grantor trust even when the trust is irrevocable, and the IRS has issued favorable gift and estate tax rulings on the use of those powers.
Under IRC section 675(4), the grantor is treated as the owner of any portion of a trust over which any person (not just the grantor) has a specified power of administration that is exercisable in a nonfiduciary capacity without the approval or consent of any fiduciary. The third “power of administration” listed section 675(r) is “a power to reacquire the trust corpus by substituting other property of equivalent value.” So, if the grantor creates an irrevocable trust and retains the power (in a nonfiduciary capacity) to require the return of property held in the trust in exchange for property of equal value, the trust is a grantor trust even if the grantor has no other interest or power in the trust.
In Rev. Rul. 2008-22, 2008-16 I.R.B. 797, the IRS confirmed that the retention of a power of substitution described in IRC section 675(4) does not cause the trust assets to be included in the grantor’s gross estate under IRC section 2036 or 2038. In Rev. Rul. 2011-28, 2011-49 I.R.B. 830, the IRS went further and held that when a trust holds a policy insuring the life of the grantor, the grantor’s power of substitution for the policy is not in itself an “incident of ownership” within the meaning of IRC section 2042(2), so the power of substitution does not cause the policy to be included in the grantor’s gross estate.
These rulings confirm that the grantor of a trust can be considered the owner of the trust for federal income tax purposes even though the grantor is not the owner of the trust assets for federal estate tax purposes.
Estate and Gift Tax Advantage of Irrevocable Grantor Trusts
So an irrevocable trust that is a completed gift for federal gift tax purposes, and which is not included in the grantor’s gross estate for federal estate tax purposes, can be a grantor trust for federal income tax purposes. Which means that the income of the trust is subject to income tax at the grantor’s income tax rates and not as a separate taxpayer with its own income tax rates. Where is the tax advantage to that?
The advantage comes from who pays the tax. In Rev. Rul. 2004-64, 2004-27 I.R.B. 7, the IRS ruled that, when a trust is a grantor trust, the Internal Revenue Code makes the grantor liable for the tax on the trust’s income. Therefore, because the grantor is paying his own tax liability and not the liability of the trust, the payment of the tax by the grantor is not a gift by the grantor to the trust or its beneficiaries.
Notice that this ruling is not limited to any particular kind of income and applies to both capital gains and ordinary income, and that it does not make any difference whether the income or gains are distributed or accumulated. This means that the grantor of a grantor trust can pay the income taxes for income paid to children and grandchildren, or accumulated for their future benefit, without making a taxable gift.
So, if a trust has $20,000 of income and would otherwise have to pay $6,444 of federal income tax to accumulate that income (at 2017 rates), but the trust is a grantor trust and the grantor pays the tax on the income, the grantor has effectively made a $6,444 gift to the trust without payment of any gift tax. The trust will continue to earn income for which the grantor will have to pay additional taxes each year, so the grantor can indirectly add substantial sums to that trust during his or her lifetime by paying the income taxes for the trust.
Possible Income Tax Costs
There may be a small income tax cost to having income taxed to the grantor rather than the trust or its beneficiaries, because the grantor may be in a higher income tax bracket, but this cost may be small in comparison to the gift and estate tax benefit, particularly if the income would otherwise be accumulated, because the tax brackets that apply to trusts were greatly compressed by the Tax Reform Act of 1986, P.L. 99-514.
Before the Tax Reform Act of 1986, trusts were generally subject to the same tax rates and tax brackets that applied to married individuals filing separate returns. So, in 1985, a trust would need $84,510 of income to reach the top income tax bracket, and the tax on that income would have been $32,576. If the same income had been taxed to the grantor of the trust and the grantor had been in the top (50%) income tax bracket, the tax would have been 50% of that income, or $42,255. So putting income producing property in trust, and letting the income accumulate and be taxed at trust rates, could save about $9,679 per year in income tax compared to what the tax would have been on the income in the hands of the grantor.
Under current (2017) law, a trust reaches the top income tax rate with only $12,500 of income, and the difference between the tax on that income ($3,232.50) and the tax at the top income tax rate of 39.6% ($4,950) is only $1,717.50. And, if both the grantor and the trust are investing in securities that pay qualified dividends that are taxed as capital gains and not ordinary income, then the difference between the income tax payable by the trust as a separate taxpayer (non-grantor trust) and the income tax payable by the grantor might be insignificant.
An additional factor is that a trust accumulating income might also have to pay the 3.8% tax on net investment income under IRC section 1441, which the grantor might or might not have to pay because individuals have higher threshold amounts for that tax. So it is possible that the income tax paid by the grantor might be more than the income tax that would have been paid by the trust, while the tax on net investment income would be less, off-setting some (or all) of the income tax increase.
Calculating the possible income tax cost of a grantor trust would require a number of different assumptions, and comparing that possible income tax cost of a grantor trust to the estate tax benefit of a grantor trust is beyond the scope of this article. However, whether the grantor will pay more in income tax on the income of a grantor trust than the trust or its beneficiaries would pay on the trust’s income if the trust were not a grantor trust is a factor that should be considered when deciding whether to create a grantor trust. (The author has created an on-line calculator that compares (a) the income tax costs of a grantor trust over an accumulating trust with (b) the potential estate tax benefits. See Webcalculators at wcalcs.com.)
Pennsylvania Cases on Tax Reimbursements to Grantors
As explained above, Rev. Rul. 2004-64 held that the grantor’s payment of income taxes on the income of a grantor trust is not a taxable gift. The revenue ruling actually went further than that, holding not only that the grantor can pay the income tax, but that the grantor must pay the income tax on the trust’s income in order to keep the trust assets out of the grantor’s gross estate. According to the IRS, if the trust document (or applicable local law) required the trust to reimburse the grantor for the income tax on the trust’s income, then the trust would be used to discharge a legal obligation of the grantor and the entire value of the trust would be included in the grantor’s gross estate under IRC section 2036(a)(2).
If under state law the grantor of a trust has a right of reimbursement for income tax paid by the grantor on the trust’s income, then the estate tax benefit of the trust is lost because the trust assets will still be included in the grantor’s gross estate. Unfortunately, there are Pennsylvania cases holding that a grantor might have that right of reimbursement.
In French Trust, 23 Fid. Rep. 296, 61 D.&C. 654 (O.C. Philadelphia 1963), the grantor established an irrevocable trust to pay the income to her during her lifetime and to distribute the principal upon her death as she may direct by will. The trustees had distributed principal to the grantor in order to reimburse her for taxes paid on capital gains, and the court approved the distributions. “Equity similarly requires that although the Internal Revenue Code and Regulations impose upon the settlor-beneficiary the income tax liability on capital gains realized and retained by the trustees, the principal of the trust should be applied in relief of such tax.” 23 Fid. Rep, at 300 (emphasis an original). The court also ruled that, as a matter of administrative convenience, the measurement of the tax liability should be based upon the tax which would have been paid by the trust, rather than the tax actually paid by the grantor.
French Trust was cited and followed in Doughty Trust, 6 Fid. Rep. 2d 260 (O.C. Montg. 1985). In that case, capital gains were realized by a revocable trust shortly before the death of the grantor, but the court held that the same equitable principles applied, and the trust should reimburse the grantor’s estate for the taxes on the capital gains, because the grantor had not had an opportunity to request reimbursement prior to her death.
In Mathey Trust, 1 Fid.Rep.2d 96, 19 D.&C.3d 43 (O.C. Montg. 1981), the court approved the reformation of an irrevocable trust so as to direct distributions of principal to the grantor-beneficiary to reimburse the grantor for any federal income tax liability which may be assessed against him because of capital gains realized by the trust. The trust was created in 1955, shortly after the enactment of the Internal Revenue Code of 1954 and before regulations were issued that clarified the scope of the grantor trust rules, and the court found that it was “generally assumed among experts” that the capital gains of a trust would not be considered “accumulated income” that the grantor would have to report on his own income tax return. Because the trust was for the benefit of the grantor, and the payment of the taxes on capital gains would “result in the diminution of his personal assets and income,” the court approved the proposed reformation in order to carry out the intent of the grantor.
Mathey Trust is factually distinguishable from a trust that is intentionally a grantor trust because the grantor wants to pay the tax on the trust’s income. But arguing about the unstated intentions of the grantor is not an argument anyone should want to have with the IRS, so the safer and more prudent course is to specifically waive any right of reimbursement for income tax in the grantor trust document.
An irrevocable and yet intentionally grantor trust can have significant estate tax benefits, but a Pennsylvania grantor trust document should specify that the grantor does not want to have any right of reimbursement for income taxes paid on the trust’s income, and that the grantor waives any right of reimbursement, in order to be sure that Pennsylvania decisions such as French Trust and Mathey Trust do not apply and that the trust assets are not part of the grantor’s gross estate for federal estate tax purposes.