Creative Planning Techniques with Grantor and Non-Grantor Trusts

January 22, 2020

By Kurt Peterson

Presented by Austin Bramwell, Milbank LLP; S. Stacy  Eastland, Goldman, Sachs & Co.; Carlyn S. McCaffrey, McDermott Will & Emery LLP; Edwin P. Morrow, III, U.S. Bank, Private Wealth Management

A settlor of a lifetime (intervivos) trust who retains certain powers over the administration or benefits of property transferred to a trust may be deemed to continue to be the owner of that property for income tax purposes under Sections 671 through 677 of the Internal Revenue Code (“IRC”).  In the case when the settlor retains those certain powers or benefits, the income and/or capital gain generated from the property transferred to the trust will be reportable by the settlor, also now referred to as the “grantor,” on his personal income tax returns and the resulting income tax liability from that income and/or capital gain will be the grantor’s responsibility to remit to the appropriate tax commissions.  The property inside the trust will then be able to appreciate and compound the gross income earned by the property in trust without being encumbered by the income tax liability due.  The grantor will need to pay the income tax liability on the trust’s income and/or capital gain from the grantor’s other assets not held by the trust.  However, the income tax liability that is paid by the grantor due to the inclusion of the trust’s income and/or capital gain on the grantor’s personal tax returns is not considered to be an additional gift by the grantor to the trust.  Therefore, the grantor is able to further reduce the size of his gross estate by remitting the income tax liability from the grantor’s other assets and more trust property, unencumbered by any income tax liability, will pass to the trust’s beneficiaries.

There are situations when it may be more beneficial to have someone other than the trust settlor become the grantor, for income tax purposes, of the income and/or capital gain that will be generated by the property held in trust.  If among the provisions of the trust agreement, one or more of the trust beneficiaries are granted an unrestricted general power to withdraw either the trust income and/or corpus (principal) of the trust, the beneficiary holding that power to withdraw will become the owner of the trust property for income tax purposes under IRC Sec. 678.  The beneficiary of the trust with a right to withdraw the income and/or principal of the trust will only be treated, for income tax purposes, as the grantor of the trust if the provisions of the trust agreement do not also include the aforementioned grantor trust powers or benefits attributable to the settlor under IRC Secs. 673 through 677 as that would trump (override) the beneficiary’s grantor-type trust status associated with the withdrawal power under IRC Sec. 678.  These type of trusts, which obtain grantor-type trust status with respect to the beneficiary, are commonly known as beneficiary defective owned trusts (“BDOTs”).

If, pursuant to the trust agreement, the beneficiary is granted a power to: 1) withdraw the trust’s accounting income, the beneficiary will be responsible for reporting the taxable income (generally interest, dividends, etc.) generated by the property held in the trust on his personal tax returns and/or 2) withdraw the trust’s principal, the beneficiary will be responsible for reporting the taxable capital gain and loss generated by the property held in the trust on his personal tax returns.  The beneficiary’s mere possession of the right to exercise the power will trigger the grantor-type trust status with respect to the beneficiary even if the beneficiary does not exercise the power and actually withdraw either the trust income and/or principal from the trust.

BDOTs can be useful estate and income tax planning tools when the beneficiaries’ personal income tax marginal rates are lower than those of the trust’s income tax rate.  Trusts’ tax brackets on ordinary income are very condensed with trust’s paying federal tax at the top 37% income tax bracket and the 3.8% net investment income tax after only $12,950 of taxable ordinary income. Individual beneficiaries do not obtain the top 37% federal tax bracket on their personal tax returns until after they have taxable income of $518,400 or $622,050 for single or married filing jointly taxpayers, respectively.  Therefore, the BDOT can create significant income tax savings by allowing the trust to retain more assets in the trust for estate planning, creditor protection and other purposes.  The beneficiary can also exercise the right to withdrawal of a partial amount of the income and/or principal in order to reimburse themselves for the income tax liability they paid individually while keeping the balance of the remaining income in the BDOT.  The beneficiary may also wish to exercise the right to withdrawal income if the income generated during any tax year exceeds the greater of $5,000 or 5% of the value of the trust in order to ensure the asset protection of the trust is maintained.  IRC Sec. 2514 provides that the unexercised lapse of a power to withdrawal that does not exceed $5,000 or 5% of the value of the trust is not considered to be a contribution back to the trust by the beneficiary which could jeopardize the asset protection otherwise provided by the trust.

Mr. Morrow mentioned that additional income tax benefits of BDOTs’ grantor-type trust status to the beneficiary can include qualifying for the capital gain exclusion on the sale of the beneficiary’s principal residence held by the trust, obtaining certain business deductions for ownership interests in businesses that may not be deductible by a trust if the trust were not treated as a grantor-type trust, and possibly the elimination of state income taxes if the trust beneficiaries reside in a state that does not have an income tax.  Trust agreements can also include provisions that allow a trust protector to grant or remove a beneficiary’s power to withdrawal if the circumstances are or are not appropriate for a beneficiary to possess such a power at any particular time during the existence of the trust.    


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About Kurt Peterson

Kurt Peterson Tax Director provides a wide range of tax services including financial planning, income tax planning, estate planning, complex estate plan structures, retirement planning, and risk management insurance.