What is a Grantor Trust?

What is a grantor trust, and how can you know which type of trust to use in your personal estate planning? Grantor trusts are a valuable estate planning tool, with revocable trusts being the most common type. Grantor trusts offer significant possibilities for estate or gift tax savings.

What is a Grantor Trust?

According to the IRS, a grantor trust is one in which the grantor (the person creating the trust) retains control over the trust’s income and assets. The grantor is treated as the owner of the assets. The trust is disregarded as a separate tax entity and all income is taxed to the grantor.

All revocable trusts are by definition grantor trusts. Irrevocable trusts may be treated as grantor trusts if they meet the grantor trust rules contained in the Internal Revenue Code. In order for a trust to be treated as a grantor trust for income tax purposes, the grantor must retain these powers:

• The power to add or change the beneficiary of a trust
• The power to borrow from the trust without adequate security
• The power to use the income from the trust to pay life insurance premiums
• The power to make changes to the trust’s composition by substituting assets of equal value

Types of Grantor Trusts 

There are many types of grantor trusts to choose from. Here are a few common examples: 

Revocable Living Trust

A revocable living trust is the most common type of grantor trust. When you create a revocable living trust, you are both the grantor (aka settlor) and trustee. You then fund the trust with assets that the acting trustee will manage. The trustee will likely be you initially, and when you pass away, your named successor trustee will take over the role. Since the trust is “revocable”, you can change the terms at any time. 

Intentionally Defective Grantor Trust (IDGT)

An Intentionally Defective Grantor Trust (IDGT) is an irrevocable trust that treats the grantor as the owner of the trust assets for income tax purposes, but not for estate tax purposes. An IDGT can be useful for reducing your estate and gift tax liabilities. 

Grantor Retained Annuity Trust (GRAT)

A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust that allows you to draw income in the form of annuity payments from the trust assets for a set number of years. After the annuitization period ends, any remaining trust assets would be passed on to the trust beneficiaries. 

Qualified Personal Residence Trust (QPRT)

A Qualified Personal Resident Trust (QPRT) is an irrevocable trust into which you transfer ownership of your primary home or secondary home and exclude that value from your taxable income.

Pros and Cons of Grantor Trusts

Here are some advantages of including a grantor trust in your estate plan:

• Wealth preservation: A grantor trust lets you preserve wealth while minimizing taxes for your heirs. Typically, from a tax perspective, you’ll be better off paying income tax on trust assets at your own personal tax rate instead of allowing the trust to be taxed.
• Probate avoidance: Assets held in a trust will not be subject to a long and expensive probate when the grantor passes away.
• Tax sheltering for specific assets: Certain types of trusts can shelter specific assets, like a home with a QPRT.
• Protection from creditors: A grantor trust can protect assets against creditors in a lawsuit. 
• Medi-Cal Planning: Grantor trusts can be used for long-term care planning, such as meeting the requirements to access Medi-Cal insurance. 

Here are two potential disadvantages:

• Potential income tax challenges: Establishing a grantor trust assumes that you have sufficient financial resources to pay income taxes on trust assets during your lifetime. If the trust asset increases in value significantly, you might run into problems at tax time if you lack sufficient cash to pay taxes. 
• Rules can change: If the rules for grantor trusts change, they may no longer offer the same advantages. For example, legislation was proposed in 2021 that would require trust assets to be included in a person’s taxable estate when they die. If this legislation is ever passed, grantor trusts may be considerably less beneficial and will decrease in popularity.  

Today, grantor trusts provide a wealth of benefits and play a vital role in many California estate plans. Consult an experienced estate planning attorney to see which type of trust would work best for you. If you have any questions about this topic, feel free to contact our law firm.

Law Offices of Daniel A. Hunt

The Law Offices of Daniel A. Hunt is a California law firm specializing in Estate Planning; Trust Administration & Litigation; Probate; and Conservatorships. We've helped over 10,000 clients find peace of mind. We serve clients throughout the greater Sacramento region and the state of California.