Understanding Grantor Trusts

By Fredrick P. Niemann, Esq. of Hanlon Niemann, a Freehold, NJ Trust Attorney

A grantor trust in estate, asset protection and benefit planning is a terrific tool. Let me explain why.

The Internal Revenue Code provides that if a trust includes language identified in Sections 671 through 679, all income from that trust will be taxed to the grantor regardless of who receives it (hint-hint). The most typical provisions in a trust that trigger grantor trust status are if the grantor retains an interest in the income or principal from the trust, the power to control who gets the income or principal, the power to revoke the trust, or the right to borrow money from the trust without adequate interest or security. Interestingly, a “grantor trust” status does not necessarily trigger the principal of the trust to be included in the estate of the grantor at death. It’s merely an income tax impact.

To determine if assets in a trust are included in the grantor’s estate at death for estate tax purposes, one must look to Sections 2035 through 2042 of the Internal Revenue Code. Inclusions are typically caused by provisions that allow the grantor the right to possess or enjoy the property of the trust or receive the income or principal of the property from the trust, or to be able to designate beneficiaries under a Last Will or Trust.

You can often create a trust to ensure that the principal of the trust is not included in the estate of the grantor, but the income tax is. The use of a “Grantor Trust” allows additional gifts by persons that are not subject to the annual gift tax exclusion. In other words, the additional income tax being paid by the grantor is money that would otherwise have been paid by the trust to beneficiaries who received the proceeds. Having the income taxes come out of the grantor’s assets, and not the trust principal, permits the additional accumulation of funds for the beneficiaries without any gift tax consequence for the grantor. Typically, irrevocable life insurance trusts are grantor trusts for income tax purposes, but are not included in the estate of the grantor at death.

So then, what is a Pure Grantor Trust? That is a term of art to describe a trust that taxes the grantor on the income (grantor trust) and ensures that the assets of the trust are included in the estate of the grantor. A Pure Grantor Trust is both a grantor trust for income tax purposes and is included in the estate of the grantor at death.

Why is this a good plan?

Because including the assets of the grantor in their estate provides for a “step up” in tax basis after death. This ensures that their heirs inherit the property at the fair market value determined at the grantor’s date of death, rather than carry-over tax basis, in which the heirs inherit the property at the cost the grantor paid for it. Unfortunately, many lawyers restrict clients to plans based on the estate tax avoidance rules. The key now is understanding when to use each type of trust.

To discuss your NJ Trust matter, please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at fniemann@hnlawfirm.com. Please ask us about our video conferencing consultations if you are unable to come to our office.