How Does a Grantor Trust Work?
Trusts are one of the most important and versatile estate planning tools. They can provide potential tax advantages and protection from creditors while efficiently managing your assets. There are many different types of trusts, each with its own advantages and disadvantages. It's important to discuss which type of trust is right for you with an experienced estate planning attorney.
Within the past few decades, grantor trusts have become increasingly popular. A grantor trust is a revocable trust in which the grantor (the person who created the trust) retains control over the assets put into trust. This means the trust is not taxed, instead, the grantor is taxed for the assets. By definition, all revocable trusts are grantor trusts, but not all grantor trusts are revocable. What this means is according to the IRS revocable trusts are considered grantor trusts and can be altered at any time, however, if a grantor trust meets certain IRS guidelines it will be irrevocable and can never be altered.
Types of Grantor Trusts
There are different types of grantor trusts that best serve estate plans in different ways. Deciding which grantor trust is right for you may hinge on your financial needs and goals.
Revocable Living Trust
A revocable living trust is most likely the simplest of the grantor trusts. Under this type of trust, you name a trustee (they can be yourself or someone else) to manage the trust and the assets you put in it.
Grantor Retained Annuity Trust (GRAT)
A Grantor Retained Annuity Trust (GRAT) is irrevocable, and cannot be changed after it is established. A GRAT is very beneficial as it allows you to gain income from your assets and is a way to gift large sums of money without paying large taxes.
A GRAT works by establishing the trust for a short period of time (usually 2-5 years) and funding it with any assets you would like to be passed onto beneficiaries. During the period the trust is active you will receive annuity payments from the trust. The total of the annuity payments is more than or equal to the original value, plus interest. Once the trust has ended the remaining value is passed on to the beneficiaries tax-free. If the trust creator dies before all annuity payments are made, then the trust is considered part of the estate. It is then subject to estate taxes. A GRAT may be useful for wealthy families who have a larger amount of assets that they plan to pass on to the next generation.
Qualified Personal Resident Trust (QPRT)
A qualified personal residence trust is an irrevocable trust designed to hold you house and reduce your tax burden.
Within the terms of the trust, the grantor retains the right to reside in the home for a specific number of years (term). As a result, the taxable value of the gift to the trust can be discounted under federal tax law. The longer the term, the greater the gift’s valuation discount. When the term ends, the grantor’s right to live in the home ends, and the trust beneficiaries (usually, the grantor’s children) receive the home either outright or at a time dictated by the trust. If the grantor wishes to continue to live in the home, they can rent it at fair market value, which allows them to make additional transfers of cash to the trust, tax-free, for the benefit of the beneficiaries.
Those with a high net worth who will be facing high estate taxes upon death may want to consider using a QPRT in their estate planning.
Intentionally Defective Grantor Trust (IDGT)
An intentionally defective grantor trust is an irrevocable trust. This type of trust treats you as an asset owner for income tax purposes but not for estate tax. Under an IDGT an asset will exist separately from your estate once you pass. It’s important to consult with an experienced estate planning attorney before drafting a IDGT.
Benefits of Grantor Trusts
Grantor trusts are great tools for minimizing taxes for yourself and your beneficiaries. They allow you to pay taxes at your own personal rate instead of the trusts’. This can save you and your beneficiaries a significant amount of money in the long run.
Another benefit of grantor trusts is that they can be used to protect assets from creditors. If you are worried about your beneficiaries becoming involved in lawsuits, bankruptcies, messy divorces, etc., a grantor trust can help. Once an asset is placed in a grantor trust it becomes separate from your estate. Creditors cannot go after assets in a grantor trust to satisfy debts.
Grantor trusts can also help you avoid probate altogether. Probate is the legal process of distributing your assets after you die. It can be expensive and time-consuming. By using a grantor trust you can avoid this process entirely as the trustee can simply distribute assets to beneficiaries without going through the probate court.
There are many different types of grantor trusts and each has its own set of benefits and drawbacks. Deciding which type of trust is right for you will depend on your specific financial needs and goals. It is best to speak with an experienced estate planning attorney to see if a trust is the right addition to your estate plan. Contact our office at (614) 389-9711 to schedule a consultation.
Want to learn more about how to integrate trusts into your estate plan? Read our Consumer's Guide to Estate Planning in Ohio here.