A "grantor trust" is a trust which is considered to be "owned" by the grantor (or creator) of the trust (or a beneficiary of the trust) for federal income tax purposes. When the grantor or beneficiary of a trust is treated as the "owner" of a trust (or a portion of the trust), that grantor or beneficiary must include the income, deductions, and credits of the trust (or portion of the trust) on that person’s individual income tax return, and not on the tax return of the trust.
There are a number of different ways that a trust can be a grantor trust, and all of those different ways are too numerous and complicated to be described in detail, but they represent the judgment of Congress that a grantor who has retained a certain level of control over the income or principal of a trust should be treated as the owner of that trust for income tax purposes. The simplest example is a revocable trust. If the grantor of a trust can revoke the trust, then the trust should be ignored for income tax purposes. Similarly, a beneficiary who can withdraw the income and principal of a trust should be treated as the owner of that trust.
That a revocable trust is a grantor trust does not create any opportunities for estate or gift tax planning, because the creation of a revocable trust is not a completed gift, and the trust is still part of the gross estate of the grantor for federal estate tax purposes (and also subject to Pennsylvania inheritance tax). However, there are other powers that the grantor can retain to create a grantor trust other than the power to revoke, and the IRS has issued favorable gift and estate tax rulings on the use of those powers, so a trust can be a grantor trust even when the trust is irrevocable.
The most commonly used power to make an irrevocable trust a grantor trust is for the grantor of the trust to retain the power, exercisable in an individual and not a fiduciary capacity, to reacquire the trust principal (or corpus) by substituting other property of equivalent value. If the grantor creates an irrevocable trust and retains the power (in a nonfiduciary capacity) to require the return of property held in the trust in exchange for property of equal value, the trust is a grantor trust even if the grantor has no other interest or power in the trust. And the IRS has issued public rulings (on which taxpayers can rely) holding that the retention of a power of substitution does not cause the trust assets to be included in the grantor's gross estate, and so the trust is not subject to federal estate tax at the grantor's death.
The benefit of a grantor trust comes from who pays the tax on the trust's income and gains. The IRS has ruled that, when a trust is a grantor trust, the grantor is liable for the tax on the trust’s income. Therefore, because the grantor is paying his own tax liability and not the liability of the trust, the payment of the tax by the grantor is not a gift by the grantor to the trust or its beneficiaries.
The IRS ruling is not limited to any particular kind of income and applies to both capital gains and ordinary income. It also makes no difference whether the income or gains are distributed or accumulated. This means that the grantor of a grantor trust can pay the income taxes for income paid to children and grandchildren, or accumulated for their future benefit, without making a taxable gift.
So, if a trust has $20,000 of income and would otherwise have to pay $6,444 of federal income tax to accumulate that income (at 2017 rates), but the trust is a grantor trust and the grantor pays the tax on the income, the grantor has effectively made a $6,444 gift to the trust without payment of any gift tax. The trust will continue to earn income for which the grantor will have to pay additional taxes each year, so the grantor can indirectly add substantial sums to that trust during his or her lifetime by paying the income taxes for the trust.
There may be a small income tax benefit to having income taxed to the grantor rather than the trust or its beneficiaries, because trusts reach the top income tax bracket very quickly (with only $12,500 of taxable income in 2017) and the grantor might not be in the top income tax bracket, in which case the income that would be taxed to the trust at the top rate is instead taxed at the lower rate that applies to the grantor.
In the alternative, there may be an income tax cost if the grantor is in the top income tax bracket, because then all of the income will the taxed at the top rate and the benefit of the lower income tax brackets of the trust will have been lost. However, this income tax cost is likely to be small in comparison to the gift and estate tax benefit, because the tax brackets that apply to trusts are much smaller than the tax brackets that apply to individuals, and so a trust reaches the top income tax rate very quickly. For example, in 2017, a trust reaches the top income tax rate with only $12,500 of income, and the difference between the tax on that income ($3,232.50) and the tax at the top income tax rate of 39.6% ($4,950) is only $1,717.50. So it doesn't take much of a gift tax benefit to overcome that income tax cost.
Further, if both the grantor and the trust are investing in securities that pay qualified dividends that are taxed as capital gains and not ordinary income, then the difference between the income tax payable by the trust as a separate taxpayer (non-grantor trust) and the income tax payable by the grantor will be even less.
An additional factor is that a trust accumulating income might also have to pay the 3.8% tax on net investment income under IRC section 1441, which the grantor might or might not have to pay because individuals have higher threshold amounts for that tax. So it is possible that the income tax paid by the grantor might be more than the income tax that would have been paid by the trust, while the tax on net investment income would be less, off-setting some (or all) of the income tax increase.
Webcalculators illustrates the gift tax benefit and income tax costs by calculating the income earned by a trust and comparing (a) the income taxes payable by the trust as a separate taxpayer (a non-grantor trust) and (b) the additional income taxes that would be payable by the grantor. The income tax cost is the difference between the cumulative difference in the income taxes paid by the two different kinds of trusts, plus the lost income, and the estate tax benefit is the difference between the compounded after-tax value of the two trusts.