Grantor Trust Rules

The grantor trust rules are Internal Revenue Code sections 671 through 679, subpart E of the trust taxation chapter. Their effect is stated by section 671: where the code specifies that the grantor or another person is treated as the owner of any portion of a trust, that portion's items of income, deduction and credit are included in computing that person's own taxable income and credits. The Instructions for Form 1041 put the consequence plainly: "In general, a grantor trust is ignored for income tax purposes and all of the income, deductions, etc., are treated as belonging directly to the grantor."

Section 671 also draws a boundary that is easy to miss. No item of a trust is taxed to the grantor merely because of dominion and control under the general definition of gross income; only the specific triggers in subpart E do it. A trust is a grantor trust because it matches one of the enumerated descriptions, not because it feels like the settlor still runs it.

The seven triggers, and what each one actually reaches. Section 673 applies where the grantor holds a reversionary interest in the income or corpus worth more than 5% of that portion at the time it was created. Section 674 applies where beneficial enjoyment is subject to a power of disposition held by the grantor or a nonadverse party, subject to a long list of exceptions. Section 675 covers administrative powers, including the power to deal with trust property for less than adequate consideration, the power to borrow without adequate interest or security, actual unrepaid borrowing by the grantor, and, at section 675(4)(C), a power exercisable in a nonfiduciary capacity "to reacquire the trust corpus by substituting other property of an equivalent value." Section 676 applies where the grantor can revoke. Section 677 applies where income is or may be distributed to the grantor or the grantor's spouse, or held for future distribution to them. Section 678 treats a person other than the grantor as owner where that person holds a power exercisable solely by themselves to vest the corpus or income in themselves. Section 679 reaches a United States person who transfers property to a foreign trust with a United States beneficiary.

Section 672 supplies the vocabulary the other six run on, defining adverse party, nonadverse party and related or subordinate party, and attributing to the grantor any power or interest held by the grantor's spouse. The spousal attribution is why giving a power to a husband or wife rather than to oneself does not avoid the rules.

The status is measured in portions, not in whole trusts. Section 671 repeats "any portion" throughout, and the Instructions for Form 1041 tell a filer to check both boxes where only part of a trust is a grantor type trust, indicating "both grantor trust and the other type of trust, for example, simple or complex trust." One trust can therefore have some of its income on the grantor's Form 1040 and the rest on its own Form 1041 in the same year.

Section 678 is the trigger that catches people out, because it has nothing to do with the settlor. Its own heading is "Person other than grantor treated as substantial owner," and it reaches anyone with a power exercisable solely by themselves to take the property, or who has partially released such a power and kept controls that would have caught a grantor. Section 678(b) gives way where the grantor is already treated as the owner under another section, so the two do not both apply to the same portion. Section 678(c) carves out a trustee's power merely to apply income toward supporting someone they are obliged to support, except to the extent it is actually so applied, and section 678(d) excuses a power renounced or disclaimed within a reasonable time.

Reporting is where the rules become visible, and much of the time there is nothing to see. Treasury regulation 1.671-4, headed "Method of reporting," provides that items attributable to a grantor-owned portion are not reported by the trust on Form 1041 but are shown on a separate statement attached to it. Where the whole trust is owned by one or more grantors, the trustee may instead use one of the regulation's optional methods, furnishing the grantor's taxpayer identification number to payors or issuing the grantor a statement, so that no Form 1041 is filed at all. That is why the trust behind a routine revocable living trust never generates a tax return, and why the tax return is a poor way to find out whether a trust is a grantor trust.

Nothing here is about the estate tax, and conflating the two is the standard error. Grantor trust status turns on subpart E; estate inclusion turns on sections 2036 through 2038 and their neighbors. A trust can be a grantor trust and outside the estate, or a non-grantor trust and inside it. The deliberate use of a swap power under section 675(4)(C) to produce the first combination has its own name and its own entry. The grantor is also not always an individual planning an estate: a rabbi trust holding deferred compensation is a grantor trust of the employer, so the trust's income is taxed to the employer rather than to the participants. That its assets must stay reachable by the employer's creditors is a separate requirement, and it is the condition that preserves the participants' deferral.

1. Read the instrument for retained powers and benefits, and for powers held by the grantor's spouse, which are attributed to the grantor.

2. Test the trust, portion by portion, against sections 673 through 679. Only those descriptions matter; general control does not.

3. Where a portion is owned by the grantor or another person, that portion's income, deductions and credits go on the deemed owner's own return.

4. Report it under Treasury regulation 1.671-4: as a statement attached to a Form 1041, or under an optional method where the whole trust is grantor-owned and no Form 1041 need be filed.

5. Test estate inclusion separately. It is a different question with different statutes.

A hypothetical showing the portion rule. The Nakamura Trust holds two assets: a bond portfolio producing $30,000 of interest a year, and a rental property producing $50,000 of net rent. The instrument gives the settlor a power, exercisable in a nonfiduciary capacity, to reacquire the bond portfolio by substituting property of equivalent value. It gives no power at all over the rental property.

Section 675(4)(C) makes the settlor the owner of the bond portion only. So $30,000 of interest is reported on the settlor's own Form 1040 and is taxed at the settlor's rates. The $50,000 of rent belongs to the trust, which reports it on Form 1041 and is taxed on it at the compressed estate-and-trust rates unless it distributes. The return itself shows the split, because the filer checks both grantor trust and the trust's other classification.

Pros

• Where the whole trust is grantor-owned, the tax reporting is simple: the income appears on a return the grantor was filing anyway.

• The grantor's own rate brackets are far wider than the compressed estate-and-trust brackets, so income taxed to the grantor is usually taxed less heavily.

• Transactions between the grantor and a wholly grantor trust are between one taxpayer and itself, which removes a layer of income tax friction.

• Status can be engineered deliberately, in either direction, because the triggers are specific rather than open-ended.

Cons

• The grantor pays tax on income they may never receive, and where the trust is irrevocable they cannot simply stop.

• The triggers are easy to fire by accident, so a trust drafted for non-tax reasons can produce an unintended tax result.

• Because the status can attach to a portion, the analysis is not a single yes or no and often needs the instrument read line by line.

• The status can change over time as powers lapse or are released, which moves the tax between parties without any transaction taking place.

• Nothing about the status tells anyone whether the assets are inside or outside the estate.