Asset Protection and Tax Planning With Grantor Trusts

Many tax planning and asset protection strategies rely on the use of Grantor Trusts to shift assets and income among family members to achieve liability protection and available tax benefits.  An understanding of how Grantor Trusts work allows for great creativity and flexibility in your asset protection planning options.

What is a Grantor Trust?

Stated briefly, a Grantor Trust is any trust in which the person establishing the trust (the “Grantor”) retains certain powers over the trust so that he or she is treated as the owner of trust property for income tax purposes.

One example of these retained powers is the right to revoke the trust, as is found in the language of most Living Trusts. If you set up a Living Trust, retaining the power to revoke the trust, this will cause the trust to be treated as Grantor Trust and you will be taxable on the income.  If you set up a trust to benefit family members or for asset protection or tax planning purpose, the question is who owns the property in the trust and who should pay the taxes on the income? Will you, as the Grantor of the trust, be responsible for the taxes? And if you’re not responsible, who is?

Asset Protection Advantages of a Grantor Trust

Asset Protection Benefits

Taking advantage of the Grantor Trust rules will be advantageous in circumstances where the primary objective of the trust is asset protection-to protect personal or business assets from lawsuit or liability risks. If asset protection, rather than tax planning, is the primary objective, then we may wish to keep the overall plan neutral from an income tax standpoint. That is to say, if we want to achieve liability protection but don’t want a change in the existing tax structure, then we would apply the Grantor Trust rules to make sure that the trust contains appropriate language to accomplish asset protection and tax neutrality.

Whether or not a Grantor Trust is appropriate for asset protection depends on the types of powers that the Grantor wishes to retain. Many of the retained powers which cause the trust to be treated as a Grantor Trust will make the trust ineffective as a tool for asset protection. We have a detailed discussion of the types of trusts used in asset protection but for now understand that a Grantor Trust can work well for asset protection and can avoid unexpected tax consequences, but the types of powers retained by the Grantor must be carefully drafted for the trust to achieve its objectives.

Estate Tax Advantages with Grantor Trusts

Some estate planning strategies will use a Grantor Trust to achieve significant tax savings by arbitraging the difference between the income tax and gift tax rules.  For instance, one popular technique is known as an Intentionally Defective Grantor Trust (“IDGT”). 

Let’s say that you own a property that has substantially appreciated in value.  If you sell the property you will have to pay taxes on the gain. If you keep the property it may continue to appreciate in value and you may have large estate taxes upon death. The property can be sold to a Grantor Trust on an installment basis for a promissory note. There are no income taxes on the sale because the Grantor Trust is ignored in this situation. For gift tax purposes however, the completed transfer may be sufficient to remove the property from your estate for estate tax purposes. The result is that valuable property is transferred to children or other family members through a trust and income taxes, as well as gift and estate taxes are avoided.

Avoiding Grantor Trust Status

In cases where we are seeking to reduce or shift taxes, we will want to draft the trust to avoid Grantor Trust status. If we don’t want he income from trust property taxed to the Grantor, we must take care to draft the trust to avoid the specific prohibited powers which would result in treatment as a Grantor Trust.

For example, there are times when we want to shift the income from particular property to a lower bracket taxpayer in order to produce an absolute tax savings. Children or other family members may be in substantially lower tax brackets and savings can be achieved through a trust where the income from rents or interest is reported on the returns of an individual other than the Grantor. This is particularly true under the revised brackets in the 2018 Tax Act.  In other situations it can be advantageous to legally shift income to the tax return of a separate taxpayer to achieve particular asset protection or business objectives. A properly drafted trust agreement addresses the issue of who we want to be the taxpayer on the income of the trust.

Designing a trust as a Grantor Trust is beneficial in certain situations for asset protection and tax planning. In other cases, purposely avoiding Grantor Trust status is the correct planning option. The choice depends on your goals and the particular circumstances of your case.