Grantor Trust Rules and Exceptions
The grantor trust rules apply only to the transfer of property from one party to another. If you have a grantor trust, you can elect for a successor trustee to take over the property in the event you pass away. The successor trustee may elect to replace the trust principal with assets of equal value. These assets are not included in the grantor’s estate and will not be subject to estate tax. There are some exceptions to grantor trust rules.
Exceptions to grantor trust rules
Exceptions to grantor trust rules can be very complicated to navigate. If you’re unsure of what a grantor trust is, read on to learn about some common situations and what to expect. A grantor trust is created with the intention of passing the assets to his children. Typically, the grantor names another person (B) as the Trustee. B has the general power of appointment over the trust assets. In the end, B relinquishes this power, but retains the right to allocate both income and principal to the children.
Exceptions to grantor trust rules do not apply to unfunded trusts. Life insurance trusts, for example, are typically funded with insurance policies. In that case, the “support” exception does not apply to trust income. In such cases, the income is needed for the beneficiary to support the trust. If an unfunded trust is set up as an entity, the grantor must use the income from the trust to support the beneficiary.
Powers of grantor
To understand the power to dispose of trust assets, you must first understand the rules that govern grantor trusts. These rules apply to powers of a trustee to make loans or use trust corpus, regardless of the interest rate or security involved. If you have a power to dispose of trust corpus, you can do so without requiring the consent of any adverse party. Powers of grantor trusts are governed by the provisions of the IRC SS672.
Generally, a grantor trust can be both a foreign person and a U.S. person. Under grantor trust rules, a foreign person can be a beneficiary of a U.S. person. This foreign person is treated as the trust’s owner if the person made gifts to the trust. In other words, the grantor trust rules apply to the foreign individual as if he or she was the grantor of the foreign trust.
Beneficiaries of grantor trust
Understanding beneficiaries of grantor trust rules is critical to a grantor’s overall tax plan. Historically, the IRS used this type of trust to combat abusive practices, but taxpayers have begun to use these types of trusts for other purposes as well. A grantor trust can be used for asset protection or succession planning, among other things. To determine if you should use a grantor trust, read the IRS publication SS672.
Revocable trusts are generally not taxable, but most grantor trusts are considered irrevocable for federal estate and gift tax purposes. Because of this, the IRS considers such trusts a part of the grantor’s estate for tax purposes. If the grantor dies with a non-irrevocable grantor trust, however, the tax basis of the asset will be stepped up.
Tax basis of trust assets
A grantor trust may not have income tax considerations. In addition to the grantor trust income tax rules, other types of trusts must meet special requirements to own S corporation stock, including making a timely election as a qualified subchapter S trust or electing small business trust. A grantor trust will generally be taxed on all FAI, including capital gains, in the same year.
A highly appreciated asset may result in a substantial gain. Let’s assume that the grantor gifts a trust with 50,000 shares of stock. At the time of the gift, each share of stock is valued at $100, giving the grantor a basis of $20 per share. Some years later, the grantor dies and the stock is worth $250,000 per share. The grantor has an unrealized gain of $4 million when he made the gift, but it is worth $11.5 million at the time of his death.
In the context of a grantor trust, an adverse party is a person who has a beneficial interest in the trust and will be affected by the exercise or non-exercise of that power. For example, if Aunt Ethel’s jailbird step-nephew Jim-Bob is named as the trustee of the trust, Anthony would be an adverse party. If she exercises her power to appoint the income, Anthony would lose out.
If the grantor has a pool of rest-of-life beneficiaries, the adverse parties are those individuals who consent to receive distributions of the trust’s principal. The trust rules provide that only the parties with tacit consent are allowed to control the distribution of accumulated capital gains. In some cases, an adverse party may elect to distribute the trust prior to the grantor’s death. The rules are designed to make the estate tax-efficient for beneficiaries.
Revocable trusts as grantor trusts
Revocable trusts as grantor trust types are commonly used in estate planning. These trusts allow the grantor to keep control of the assets they place in the trust while transferring them out of his or her legal ownership. Some people believe that this arrangement allows them to avoid paying taxes on the income they derive from the trust assets, but in fact the IRS requires trust owners to pay taxes on that income, not the trust itself. Revocable trusts are flexible, however, and the grantor can change the trustee or beneficiaries at any time.
In addition to the revocability of a revocable trust, the IRS also treats these types of trusts as disregarded entities, so the grantor does not have to file a Form 1041. Instead, he or she will report the income from the trust on his or her personal tax return, which will be filed as a Schedule K-1. A verified copy of the trust instrument is also required.