grantor trust

Can you provide an example of when a grantor trust may be desirable? Is there a downside to these trusts?

“Grantor trust" is an income tax classification for a trust that is, wholly or in part, disregarded for income tax purposes; in other words, the property transferred by the grantor to the trust is treated to some extent as still being owned by the grantor for income tax purposes. The portion of the trust property that is treated this way is determined by the grantor's interest in or control over the trust. For example, a grantor's interest in trust income may cause the trust to be a grantor trust as to ordinary income (interest and dividends), but the grantor may not have sufficient power over trust principal to cause the trust to be a grantor trust as to capital gains (which result from the sale of principal). The grantor's retained powers or interests that cause the trust to be treated as a grantor trust for income tax purposes may also cause the trust property to be treated as owned by the grantor for gift and estate tax purposes. If this occurs, trust property is included in the grantor's gross estate for the federal estate tax. This is not always the case, and grantor trusts (“defective grantor trusts") are often intentionally drafted that cause the trust property to be treated as owned by the grantor for income tax purposes, but not owned by the grantor for federal gift and estate tax purposes. This distinction can allow the grantor to pay the income tax on trust income enjoyed by the trust beneficiaries and, under current federal income and gift tax laws, avoid having the payment of that income tax being treated as a gift by the grantor

The consequence of grantor trust status, that the income of the trust assets is taxed in the grantor's income tax return, can be undesirable if the tax would have been less if the income had been taxed in the trust or taxed to the beneficiaries receiving distributions. However, because the marginal brackets applicable to trusts are quite compressed (in 2008, a trust's taxable income in excess of $10,700 was taxed at the 35% bracket), accumulated income of trusts of even moderate size will often be taxed at the highest income tax bracket, and there will be no effective tax disadvantage of using a grantor trust.

Stephen F. Lappert, Partner, Trusts and Estates Department, Carter Ledyard & Milburn LLP, New York, NY