What is a grantor?
A grantor is someone who creates a trust and transfers property to the trust.
What is a Grantor Trust?
A trust is a device where a trustee holds assets for the benefit of a beneficiary. There are all sorts of variations. A person who creates the trust and transfers the assets to the trust is the grantor. The trust could require the income to be paid to the grantor, or it could require the income to be paid to someone else. In estate planning, the term “grantor trust” means the trust’s income is taxable to the grantor, regardless of who receives it under the terms of the trust.
It is possible to create a trust requiring all income to be paid to your children and yet to be taxable on the income yourself. This trust could (under a separate and different set of rules) be a completed gift for gift and estate tax purposes. Thus the trust assets, including any accumulated income, would not be part of your taxable estate. Nor would any appreciation in the value of the assets after the time of transfer be subject to gift or estate tax.
Because of grantor trust status, you pay the income tax on the trust income instead of the children. Thus, this is not treated as a gift to the children, yet it further transfers assets to them.
The grantor will be treated as the owner of the income from the trust for income tax purposes when he or she retains certain powers or rights. For example, suppose the grantor retains the right to the income of the trust. In that case, the right to revoke or amend the trust, the right to change beneficiaries or certain other powers, the grantor will be deemed the owner of the trust for estate tax purposes as well as income tax purposes.
The powers the grantor can retain and still have the trust assets outside his estate include power to withdraw the trust assets and substitute other property of equal value.
What is a grantor tax information letter?
A grantor tax information letter, Grantor Letter or Information Sheet is a transmittal document. The grantor tax information letter is copied to the IRS. The Grantor Letter shows you as the recipient of different forms of income, and potentially having some deductible expenses.
Is a grantor letter the same as a K-1?
A grantor letter is not the same as a K-1. Partners in a real estate partnership file a K-1 annually. The partners use a K-1 to show their share of income in the real estate partnership. Although the real estate partnership sends out Schedule K-1 for Form 1065, it doesn’t pay taxes on income. It doesn’t pay taxes because the partnership is a pass-through entity. So rather than paying taxes on partnership income, each partner pays taxes on his or her share of income.
Because investors in a partnership aren’t employees, they don’t receive a W-2. Instead, investors receive a K-1. The K-1 reports partner income or loss, distributions, deductions and credits. Each partner gets a K-1 annually.
The real estate partners use the values from the K-1 to complete their individual tax returns. The deadline for filing K-1s is March 15, allowing sufficient time to file individual tax returns by the April 15 deadline.
What is a grantor letter?
The grantor letter is an itemization of expenses, depreciation, insurance, and fees from the trust. Each grantor receives a “grantor letter” when a trust is liquidated. The grantor letter also shows income or losses. It is an attachment to IRS form 1041.
Can a grantor trust make distributions?
A grantor trust can make distributions.
Are distributions from a grantor trust taxable to the beneficiary?
If the trust makes distributions to the beneficiaries during the year, those distributions may carry out the trust’s taxable income. In that case, the trust issues a Form K-1 to the beneficiary listing the taxable portion of the distribution. Then, the beneficiary includes the taxable part of the distribution in their income. The trust then takes a distribution deduction on its return. However, if the trust has income for which it didn’t offset distribution deduction, the trust itself is taxed on the income.
Does a grantor trust have to file a tax return?
Ordinarily, trusts are required to file an income tax return for each calendar year. But, for most grantor trusts, it’s optional to file an individual tax return.
How are grantor trusts taxed?
For income tax purposes, in a “grantor trust,” either the beneficiary or the grantor is deemed the owner of the losses and income of the trust. Accordingly, it must include such income and losses on their tax return. Grantor trust status can apply to either an irrevocable or a revocable trust.
Under the general rule, the trust is an information reporter. Accordingly, the trust must obtain its taxpayer identification number or TIN. But, income is not reported on the trust’s Form 1041. Instead, income is noted on an attachment to Form 1041, which also identifies the grantor as the owner of trust income.
Let me show you an example. The Jennifer Jones Trust has an income of $47,000 each year and distributes $16,000 to beneficiaries every calendar year. If the Jennifer Jones Trust is a grantor trust, the $47,000 of income gets taxed to Jennifer – the grantor – every year. When preparing Jennifer’s Form 1040, Jennifer adds the $47,000 income the Jennifer Jones Trust received for the tax year to her income. It doesn’t make any difference if the trust’s income is distributed to Jennifer or even distributed to another person; it’s still taxed to Jennifer as the grantor.
Jennifer then dies. The trust continues for her kids, Peter and Paul, as a non-grantor trust. Peter and Paul each receive $8,000 in income from the trust. In addition, they each receive a K-1 from the Jennifer Jones Trust, reflecting the $8,000 distribution to both. Each child must report the income on their own Form 1040. The trustee of the Jennifer Jones Trust will file a Form 1041 for the trust and will report $47,000 of income and $16,000 of distribution deductions.
Grantor trust tax advantages
Establishing a grantor trust has several tax advantages. For example, you can liquidate assets to the trust without realizing the gain on the sale. In addition, you can lend money to the trust. However, the trust must pay you no less than the minimum IRS-prescribed interest rate – called AFR or applicable federal rate. The good news is that you don’t have to pay tax on the interest income.
What’s more, your trust’s income tax that you pay as the grantor is not considered an additional gift to the trust. This allows the trust’s assets to grow for the benefit of the beneficiaries. And the beneficiaries don’t have to worry about paying income tax. So essentially, this is a tax-free gift.
Does a grantor trust issue K-1?
To avoid filing a Form 1099, a trustee can report income on Form K-1.
How do I enter a grantor tax letter in TurboTax?
In Turbo Tax, you need to enter the information listed in the Grantor Letter in the same places where you would enter income. You enter this information where you would enter income from sources other than a trust.
You need to treat each income and expense item as the equivalent of 1099. The name of the trust and EIN of the Trust is used the payer.
Treat:
- Dividends as if a 1099-DIV
- Interest as if a 1099-INT
- Gains and losses as if a 1099-B
Can a grantor trust have its own EIN?
A grantor revocable trust doesn’t need its own EIN. Part of the reason for this is the trust’s income is reported under the grantor’s social security number.
Grantor tax information letter vs. K-1
A grantor letter indicating the income earned by the trust is filed with the 1041. It is issued to the Grantor. This report is used to report income on the 1040.
Is a grantor trust a disregarded entity for K-1?
A grantor trust is a disregarded entity for federal tax purposes.
Does a grantor trust file a separate tax return?
A trust must file an income tax return each year, but for the majority of grantor trusts, filing a tax return is optional.
What tax form does a grantor trust file?
A grantor trust files a Form 1041. The 1041 form includes the name of the trust, tax identification number, and address.
Does an irrevocable grantor trust have to file a tax return?
When an irrevocable trust has a tax ID number, it’s required to file its own tax return. The irrevocable trust is required to file Form 1041.
Who reports the income from a grantor trust?
Grantor trusts are ignored for the purpose of calculating taxable income. However, a grantor trust is not ignored for the purpose of income reporting.
Who pays income tax on irrevocable trust?
An irrevocable trust pays income taxes on accumulated income that isn’t distributed to beneficiaries.
Do I have to pay taxes on money from an irrevocable trust?
If you are a beneficiary of an irrevocable trust, you are required to pay taxes on the distributions.
Grantor trust taxation when the grantor dies
Upon the grantor’s death grantor’s trust status terminates. All pre-death trust activity must be reported on the grantor’s final income tax return. As mentioned earlier, the once-revocable grantor trust will now be considered a separate taxpayer, with its own income tax reporting responsibility.
A-B Trust
The terms of an A & B trust provide that after the death of the person who created the trust, the assets will be split between two sub-trusts, the A Trust and the B Trust. The A Trust benefits the surviving spouse. The B Trust supposedly benefits the children. A formula is outlined in the trust to determine how the assets are split. This device is to minimize estate taxes by placing the amount upon which there is no tax in the B or children’s trust. This trust is structured so that when the surviving spouse subsequently dies, the children’s trust is not in his or her taxable estate. Everything else goes to the A Trust, which is structured to qualify for the marital deduction. The A Trust will be in the surviving spouse’s estate when he or she dies later.
By using this type of trust, parents can pass double the tax-free amount to their children. If the first to die merely left everything to the surviving spouse, then only one tax-free amount would pass to the children on the surviving spouse’s death. Everything else would be subject to tax.
Naturally, this type of device is useful only for taxable estates. And it works only if the assets are split between both spouses so that the first to die has the tax-free amount to pass to the children’s trust.
The surviving spouse can be the income beneficiary of the children’s trust.
The A Trust is often called a marital trust, and the B Trust is often called a family trust.
When the surviving spouse’s rights to the A Trust are limited to income and the estate’s executor is given an option to select how much of the trust will be used for the marital deduction, it is called a Q-Tip Trust.
2503(c) Trusts for Minors
Gifts in trust usually do not qualify for the annual gift tax exclusion unless the beneficiary has a right to withdraw the funds. Under Section 1503(c) of the Internal Revenue Code, the annual exclusion can be had without withdrawal rights. There must be a single beneficiary. The funds must be available for withdrawal by the child at age 21. The trustee must have unrestricted discretion to distribute principal and income for the benefit of the beneficiary.
If the trust continues after the beneficiary reaches 21, the gift tax annual exclusions are no longer available.
Installment Sales to Descendants
If appreciating assets are sold to children in return for an installment note, the selling parent converts his holdings from an appreciating asset to a fixed value note. The children get the appreciating asset. This technique removes the appreciation from the parent’s estate. The sale is financed with the income from the property. If cash can be realized from the property to pay the note and the note interest is at least the applicable federal rate, then this technique can be viable. Note that, like many similar techniques, it only works if the property appreciates and produces enough cash to pay the parent.
The property sold may be a minority interest in something, which qualifies for a discount when its value is determined.
The parent will realize capital gain with this technique. However, a capital gain may be avoided if the sale is made to a grantor trust. (Treated for income tax purposes as owned by the parent).
If the sale is made to the grantor trust, no gain is realized, but on the other hand, there is no step-up in basis for the trust. Instead, it takes the grantor’s basis.
Can you sell to an Irrevocable Grantor Trust?
This technique applies only to irrevocable trusts.
A grantor trust is one that is treated as owned for tax purposes by the person who created it and transferred assets to it. This person is called the grantor. If the grantor owns the trust for income tax purposes, all income of the trust (and deductions and other income tax items) is attributable to the grantor. If the grantor is treated as the owner for estate tax purposes, all trust assets are in the grantor’s estate for estate tax purposes. The rules for determining whether the grantor is the owner are different for income tax and estate and gift tax purposes. Because of this, it is possible to structure a trust that the grantor owns for income tax purposes but not estate and gift tax purposes. The income would be taxable to the grantor, but the assets would not be in the grantor’s estate.
Grantor trust status is determined by a variety of rights retained by the grantor. One, of course, is the right to the income of the trust. However, the grantor does not have to retain the income in order to be taxable on it under the income tax grantor trust rules. Therefore a grantor trust can provide that income be paid to the grantor’s children or grandchildren.
An example of a retained power that could cause a trust to be a grantor trust for income tax purposes is the power to substitute property of equal value for trust assets. Making the spouse of the grantor a beneficiary is another example (note that if the spouse dies before the grantor, this no longer applies).
With a grantor trust that is treated as owned by the grantor for income tax purposes, but not estate and gift tax purposes:
1. A grantor can sell property to the trust in a transaction that is ignored for income tax purposes because the grantor is selling property to him or herself.
2. If the property has appreciated in the grantor’s hands, there will be no recognition of gain on the sale.
3. If the property produces income in the future, that income can be paid to the grantor’s children while the grantor pays tax on it. In effect, this transfers future income to the children tax-free, and the grantor’s estate becomes that much smaller without incurring estate or gift taxes.
4. All future appreciation in the value of the property is out of the grantor’s estate.
The grantor does get something for the sale. Otherwise, the grantor would be making a gift. The grantor cannot get cash from the trust unless the trust has other assets or borrows against the property the grantor transfers. The grantor usually gets an installment note providing for payments of interest only.
To avoid a gift, the interest rate on the note must be at least the applicable federal rate periodically set by the IRS. The note usually provides for a balloon payment of all principal far in the future – often 30 years. The sale must also be for the full fair market value of the property to avoid a gift.
In effect, the grantor exchanges what may be appreciating property and all future income from it for a fixed value, fixed interest rate. This technique is said to “freeze” the value of the grantor’s interest.
Often this technique is combined with a device that will discount the value of the property the grantor sells to the trust. Family limited partnership interests are sometimes used for this purpose. However, any discounted asset could be sold – such as minority interest stock in a family corporation. (If the corporation is an S corporation, the trust must be qualified to hold it.)
A sale of the property to a grantor trust can backfire. The retained installment note can wind up being worth more than the property sold to the trust. This can happen if the trust property declines in value or if it produces less income than the interest payments on the note. No one can predict the future, but unless the grantor expects the property in question to appreciate in value and to pay more current income than the interest rate on the note, this technique should not be used.
Of course, a gift can be made to the trust instead of a sale. This works even better, but it will be subject to the gift tax.
The trust the sale is made to is usually funded with a gift of substantial assets before the sale to avoid IRS arguing that the sale is illusory because the buyer (trust) has no assets.
Disclaimer: The site is for educational purposes only, as well as to give general information. This blog is not intended to provide specific legal advice. The site should not be used as a substitute for legal advice from a licensed professional attorney in your state.
