Trusts are useful tools for organizing, protecting, and transferring assets. For most purposes, we generally want trusts to be considered a separate entity from the settlor of the trust. And they have long been recognized as separate taxpayers under the Internal Revenue Code, with their own tax bracket structure. But sometimes we want the IRS to ignore them. We control this by using the grantor trust rules, which are now found in sections 671-678 of the Internal Revenue Code. Understanding the history of grantor trusts helps this make more sense.
The most common type of trust is the revocable living trust. In 1924, Congress enacted rules that said if you create a living trust and reserve either the right to revoke the trust or the income from the trust, then the income is taxable to you. So, for almost a century, revocable trusts have been disregarded and taxed to the individual who created the trust. But the government wasn’t satisfied with these rules. We have a progressive income tax system, which was even more pronounced back then. Clever lawyers and accountants were using trusts to shift income from people in high income tax brackets to people in low brackets.
One of the catalysts for modern-day trust rules was a case called Helvering v. Clifford, which was decided by the U.S. Supreme Court in 1940. This was before the era of the joint tax return. Mr. Clifford’s income tax rate was higher than his wife’s. So he created a trust for her benefit that lasted for five years. He then put stock that he owned in the trust. He was the trustee and had full discretion as to distributions. After five years the trust terminated, and everything came back to him. For five years he controlled everything about the stock and the distributions, but his wife was taxed with the income. This didn’t sit well with the federal government. After years of litigation, the Supreme Court said that Mr. Clifford had kept so much power over this trust that he should be treated as the owner. But the Supreme Court’s ruling was very fact-specific and wasn’t that helpful in sorting out future cases. Then there was a flood of litigation.
In order to clarify these rules, the government came up with the “Clifford” regulations in 1945. These new rules set out three additional criteria for taxing the settlor of the trust. First, if the settlor had a reversionary interest following a trust term of less than ten years. Remember that Mr. Clifford’s was five. Second, if either the settlor or a non-adverse party had a power to control the beneficial enjoyment of either the income or the principal. A non-adverse party is one who has no dog in the fight. Third, if the settlor had any of various administrative powers exercisable for his or her own benefit. The regulations also set out rules as to when someone other than the settlor was taxable on the trust’s income. In 1954, Congress codified the Clifford regulations at §§ 671 to 678 of the Internal Revenue Code.
These rules helped the government back when the highest marginal income tax rate was 91%. Uncle Sam wasn’t worried about shifting income to spouses anymore, because the joint tax return was created in 1948. Now income shifting went to children. If you were really rich in 1960 and your daughter was a school teacher, it would make sense to give her some of your stock and let her pay 20% income tax on the income instead of paying 91% yourself. But you didn’t get rich by letting other people have control – especially your children. So, you would instead create a trust for your daughter. After the Clifford rules, you had to be more careful about how you created that trust.
But now the situation has changed. The entire point of the grantor trust rules was to prevent high income taxpayers from avoiding the impact of the progressive federal income tax by creating certain types of trusts that re-allocate income. There hasn’t been a need to shift income to spouses for over 70 years. The Kiddie Tax, passed in 1986, made the shifting to children ineffective. Then taxes went down. When the grantor trust rules were first enacted, the highest federal tax rate was 91%. Now it is 37%. Capital gains treatment was also changed in 1986. The effect of all of these changes is that there is much less incentive to shift income than there was 35 or 40 years ago.
But the biggest change in the use of trusts was the compression of income tax brackets. Before 1986, the taxation of trusts and estates was similar to that of individuals. But now a trust reaches the highest tax rate at $12,500 of income, whereas an individual must make $500,000 to be taxed at that same rate. The grantor Trust rules have now been turned on their head. There are very limited circumstances in which we are trying to avoid them.
A non-grantor Trust is a taxpayer as to any income it accumulates but is just a conduit as to any income it distributes to a beneficiary. Income that is distributed is instead taxable to the beneficiary and deductible by the trust. Because a Trust is subject to taxation only to the extent the trustee accumulates income, the trustee will often avoid accumulating income unless distributing the income has consequences that are worse than paying more taxes – like paying it to a judgment creditor or losing SSI benefits. But more often, with lifetime Trusts, the goal is to ensure that trust income is subject to taxation at the settlor’s income tax rate. This often involves asset protection, capital gains, or estate tax considerations as well.
If mom owns a 500-acre farm but lives off of her social security and has little savings, she may want to protect the farm from her creditors or the costs of long-term care. She may be able to do so by transferring the farm to an irrevocable Trust. But if she has a 12% federal income tax rate, she doesn’t want the farm’s income trapped inside a trust at 37%. And she may not want to distribute the income to her daughter who is in a 32% bracket. So if her irrevocable Trust “fails” the grantor trust rules, she can allow the income to accumulate in the Trust and pay the income tax herself. Some of the things that trigger grantor trust status also trigger estate inclusion. This is important in this scenario because of capital gains. As long as the farm is included in mom’s estate, daughter gets step up in basis when mom dies. If mom inherited the farm in 1960, this step up can be important. So mom should ensure that the trust is “defective” for both income tax and transfer tax treatment.
But if mom has a taxable estate, there are other reasons to create a grantor Trust. Perhaps the value of her farm is in an area that is poised for substantial growth over the next two decades, and its value is increasing rapidly. She may now want to transfer the farm to a Trust, make sure the income is taxed back to her, and make sure that any increase in value is outside of her estate. She can do this by choosing grantor trust powers that do not cause estate inclusion. One added benefit to this is that mom can now make additional “gifts” to the trust beneficiaries without using either an annual or lifetime exclusion by simply paying the tax bill.
The moral of this story is that while a revocable Trust is always going to be taxed to the settlor, an irrevocable trust is a versatile tool that can be used to accomplish all kinds of different things. Understanding the grantor trust rules helps us create Trusts that meet your specific needs for asset protection, estate tax planning, basis adjustment, and income tax planning.