Trusts are some of the most useful tools available to help you build a legacy of wealth and protect assets. In addition to estate and gift taxes, income taxes are one of the main considerations for anyone creating any type of trust. The way income taxes are levied depends largely on whether the trust is a grantor trust or a non-grantor trust.
Who Is the Grantor?
Trusts are created by a person called the Grantor. You may also see the trust creator referred to as a trustor, settlor or trustmaker. All of these words are interchangeable and refer to the person who created the trust.
What Is a Grantor Trust?
Before we get to non-grantor trusts, it’s best to start with the basics of grantor trusts. Essentially, grantor trusts are living trusts, meaning they take effect while the grantor is still alive. Aside from the grantor being alive, the other key feature of a grantor trust is that the grantor maintains control over the trust in various ways. For example, the grantor might have the power to:
- Revoke the trust
- Reposition assets in and out of the trust
- Borrow from the trust without offering any collateral
- Take income from the trust or provide income to a spouse
- Add or remove trust beneficiaries
California law allows many different types of grantor trusts. The type you choose will depend on your specific wealth and estate planning goals. It’s best to discuss those goals with a qualified Los Altos estate lawyer before you make a decision, particularly when high-value assets are involved. You and your family may benefit from one or more of the following grantor trusts:
- Revocable living trust (RLT): This is the simplest type of trust, in which the grantor is usually the trustee. The trustee manages the trust assets, which are transferred from the grantor’s ownership into the trust. Since it is revocable, the details of the trust and the list of beneficiaries can be changed at any time.
- Grantor Retained Annuity Trust (GRAT): This is an irrevocable trust. You transfer assets into the GRAT and then receive annuity payments for a predetermined number of years. Anything left over after the annuity period ends goes to the beneficiaries.
- Qualified Personal Residence Trust (QPRT): This allows you to reduce taxes by transferring ownership of your house (primary or secondary home) to the trust, thus removing its value from your taxable income. The QPRT is often used by those who own a home that they want to pass on to a child on a tax-advantaged basis.
What Is a Non-Grantor Trust?
Essentially, a non-grantor trust is any trust over which the grantor retains no control. In other words, the grantor cannot change the terms of the trust, move assets into or out of the trust, change beneficiaries, or revoke the trust.
You might be wondering why anyone would create a trust if they don’t have control over it. The answer goes back to what was mentioned at the very beginning of this article: taxes.
Different Tax Treatment for Non-Grantor and Grantor Trusts
Because the grantor retains control over a grantor trust, income from the trust is taxed to the grantor. Because of this, it’s essential that you as the trust creator have enough liquid assets to pay any income tax obligations generated by the trust. You need to keep in mind, for example, the possibility that a trust asset might generate a large capital gain. This gain could come with a hefty tax bill, which you’ll need to cover.
With a non-grantor trust, the grantor doesn’t have to pay income tax on the trust income. Instead, the non-grantor trust is treated as its own entity for tax purposes. This can be attractive in certain situations. For example:
- A divorced person who is getting remarried might want to set up a non-grantor trust for children from the previous marriage and avoid paying income taxes on the trust’s assets.
- A business owner who makes too much money to qualify for the qualified business income (QBI) deduction could set up one or more non-grantor trusts to divide ownership of the business assets and the income they generate, thus enabling the owner to qualify for the QBI deduction.
- A person who owns high-value real estate, as is common in the Bay Area, could create multiple non-grantor trusts to steer clear of the $10,000 cap on state and local tax (SALT) deductions. Since each non-grantor trust is taxed separately, each trust can claim a $10,000 SALT deduction.
Get Advice on Creating or Administering a Trust in California
The choice between a grantor or non-grantor trust is a major one that requires deep thought and understanding of the ramifications that come with each type of trust. The tax advantages of a non-grantor trust may seem attractive, but those advantages could be offset by drawbacks such as lack of control and the cost of paying fees to the person or company you choose as trustee.
At the Law Office of Janet L. Brewer, we advise clients to spend time discussing your wealth and estate goals openly with us before making a decision. With more than 30 years of California estate planning experience, we can guide you toward the trusts that best fit your vision.
If you would like to discuss trust creation or need advice on administering a trust, please call 650-325-8276 or contact us online anytime. We look forward to visiting with you at our Los Altos office, by phone or by video conference.
