Why should I want a “Grantor Trust” ?

A Grantor Trust is a Trust that is ignored for tax purposes. Back when Federal Income Tax Rates were much higher, wealthy individuals would establish many trusts for their descendants to push income in to the lower brackets. The trusts were designed to give the Grantor lots of power over the various trusts. Congress decided to maintain the integrity of the Federal Income Tax System by implementing the Grantor Trust Rules. If a Grantor retains certain powers over a trust, then the trust is ignored for income tax purposes. This, in effect, keeps all of the income of the various trusts that “violate” the Grantor Trust rules combined back on the Grantor’s income tax returns at the Grantor’s marginal bracket.

Back when income tax rates were much higher, the Grantor Trust rules limited the usefulness of trusts. In fact, a trust that violated the Grantor Trust rules was said to be a defective trust. A trust that did not work. If designed for income tax planning, that is correct, the trusts would no longer meet those goals.

Today, Income Tax Rates are lower. Additionally, to further limit the utility of trusts to dilute the income tax base, the tax brackets for trusts are greatly compressed. That is, a trust hits the highest income tax bracket at only around $11,000 of taxable income. This compression of the brackets makes using trusts to manipulate income tax rates unattractive. The Grantor Trust rules are actually no longer needed, but they remain in the law.

The Grantor Trust rules provide a distinct tax advantage from a gift and estate tax point of view. If a gift is made to a properly drafted trust, that trust will keep the assets of the trust out of the Grantor’s taxable estate. At the same time, the trust will be ignored for income tax purposes.

This dual tax status trust is essentially a vehicle to allow you to make a gift to your spouse, children or other beneficiaries that can grow income tax free. Income tax-free compounding is a powerful tool for the transfer of wealth.

Remember the estate tax is scheduled to return to a $1 million exemption and a 55% highest rate on 01/01/13. The assets in a properly structured Grantor Trust not only grow income tax free during the grantor’s life, but also will not be subject to an estate tax hit.

Posted by Patrick D. Newton

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