Grantor vs non-grantor trusts

Trusts for the benefit of family members are typically classified as grantor trusts or non-grantor trusts. The main difference between these is how assets held within the trust are taxed. The criteria below can be used to determine which trust type is optimal to help a grantor reach their planning goals.

Grantor trusts

A grantor trust is a trust that is retained by the grantor for income tax purposes. Any taxable income or capital gains generated by a grantor trust is reported on the grantor’s tax return and the grantor is responsible for paying these taxes. Common types of grantor trusts include revocable living trusts and Grantor Retained Annuity Trusts (GRATs).

Intentionally-defective grantor trusts

An intentionally-defective grantor trust (“IDGT”) refers to a trust that is classified as a grantor trust for income tax purposes, however the assets in the trust typically benefit individuals other than the grantor, such as family members.
They function as grantor trusts for income tax purposes, but non-grantor trusts for estate tax purposes.
IDGTs are often funded with irrevocable gifts or with the remainder interest from GRATs or other wealth transfer strategies.

Benefits of planning with IDGTs

• Transferring assets to IDGTs removes assets from the grantor’s taxable estate.

• Assets held in the IDGT grow unencumbered by income taxes (because the taxes are being paid by the grantor), which increases the trust’s after tax growth potential.

• Taxes due from the IDGT are paid by assets on the grantor’s balance sheet, further reducing the grantor’s taxable estate.

• Grantor trusts can be converted into non-grantor trusts, allowing for the grantor to stop paying taxes on an IDGT. However, once grantor status has been turned off, it is difficult to change back.

• A grantor can substitute assets from their balance sheet for assets held within a grantor trust without income tax consequences.
  Learn more about asset substitution

Drawbacks to planning with IDGTs

• Income generated by an IDGT is subject to state income tax, so if the grantor lives in a high income tax state, they may pay more in taxes than they would in the case of a non-grantor trust.

• An IDGT typically cannot be used to multiply the exclusion of capital gain on qualified small business stock.
  Learn more about QSBS

Non-grantor trusts or “taxable trusts”

A non-grantor trust, sometimes known as a taxable trust, refers to a trust that is a separate taxable entity from the grantor.
A non-grantor trust pays its own taxes.

Benefits of planning with non-grantor trusts

• Transferring assets to a non-grantor trust removes assets from the grantor’s taxable estate.

• A non-grantor trust can be structured to be domiciled in states other than the grantor’s state of residence, including states with favorable tax treatment and trust rules.

• As a separate taxpaying entity, a non-grantor trust can be used to multiply the exclusion of capital gain on qualified small business stock.
  Learn more about QSBS

Drawbacks to planning with non-grantor trusts

• Assets held in non-grantor trusts are subject to taxes based on the trust tax brackets, which are significantly compressed compared to individual tax brackets. The estimation of potential tax burden often requires analysis from a tax professional.

¹ Assets held in IDGTs and taxable trusts can be includable in a grantor’s taxable estate depending on the trust’s structure, such as if the grantor is the primary beneficiary of the trust, or if certain actions are taken.

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Luminary does not provide legal or tax advice. Consult with your legal and tax professionals prior to making any estate planning decisions.