Grantor trusts are groovy. They have so many potential benefits that they are the cornerstone of many, maybe even most estate plans. Grantor trusts let you transaction business with your trust without triggering gain for income tax purposes. Rev. Rul. 85-13. So, you can sell your family business or rental real estate to the trust and pay not capital gains tax. Why would you want to do that? Because the trust, if structured and operated to be outside of your estate, can grow those assets outside of your estate meaning no estate tax. There are many nuances, implications and considerations with using grantor trusts, but that is not our topic for here. One of the tax consequences of a grantor trust is that you as the person setting up the trust (called the “settlor, “trustor” or “grantor”) report on your personal income tax return. That means you get to pay the income tax on income earned by the trust and perhaps remaining inside the trust. This one little oddity can be one of the most powerful forces in estate planning over time. Over the years your paying income tax on trust income makes the trust grow outside of your estate as if it were income tax free. That can result in powerful compounding. Your paying income tax over all those years on income you do not get reduces your estate for estate tax purposes. That can be a good thing from an estate tax planning perspective.
I Do not Love This Arrangement!
So, after many years of paying income tax on income you’re not getting, and your kid who is the beneficairy of the trust and all your largesse still forgetting your birthday, you grow less enthused about this tax benefit when you die. What might you do to defray that tax burden that is no longer giving you smiles? Several ideas to discuss with your planning team (CPA, wealth adviser, insurance consultant, estate planning attorney) are briefly explained below. This is really complex stuff and has potentially huge and adverse implications to your planning or even to your current bill to the IRS. So, proceed really cautiously. Very carefully review the consequences, and in particular potential tax or legal issues of any action you are considering and especially the loss of the benefits of your trust being a grantor trust, before doing anything. Losing the grantor trust benefits could be a whopping mistake depending on the growth of your estate, future tax law changes (less predictable than weather forecasts) and so on. If after that analysis you want to proceed, then review all the options your advisor team can think of. The ideas below might help them get started on this. Many of the options below may not be available to you, or even if available may have negative repercussions. So this is really a brainstorming checklist for you to chew over with your advisers.