Understanding Grantor Trusts

By Ronald A. Fatoullah, Esq. and Debby Rosenfeld, Esq.

{5:35 minutes to read} People utilize trusts for a myriad of reasons.

• Some clients like the idea of all of their assets being held under one umbrella. The trust is viewed as a big envelope or bucket into which all of a person's assets are transferred; this allows for centralized asset management.

• Many people, for various reasons, wish to avoid the probate process. Transferring all of one's holdings to a trust will accomplish that.

• Others look to trusts as a way to protect some or all of their assets from certain creditors.

Regardless of the incentive for creating a trust, the term "grantor trust" is often bandied about in a way that is confusing to many. The purposes of this article are to explain what a grantor trust is and to help clarify some misconceptions.

The Internal Revenue Code of 1986 ("the Code"), as amended, provides that if a trust triggers any of the provisions that are found in Sections 671-679 of the Code, all income earned from that trust will be taxed to the grantor of the trust, regardless of who ultimately receives the income. The grantor is the person who created the trust and transferred his or her assets to the trust. Sometimes the grantor is referred to as the settlor or the creator.

In other words, if a grantor transfers assets to a trust, but simultaneously retains certain controls through various provisions in the trust, the grantor will be taxed on the trust income, even though he ostensibly transferred the assets out of his name.

If a trust provides that income and/or principal is payable to the grantor, grantor trust status will be triggered. Grantor trust status will also be triggered if the grantor has control over who receives income and/or principal, retains the power to revoke or amend the trust, or has the right to borrow funds from the trust without sufficient security or proper interest payments.

Triggering grantor trust status has ramifications with respect to the income taxation of the trust's assets. The provisions in Sections 671-679 do not have anything to do with whether the assets held by a trust are included in the grantor's estate for purposes of estate taxation. Estate tax inclusion is governed by Sections 2035-2042 of the Code. For example, if a grantor transfers his personal residence to a trust but retains the right to the possession, use and enjoyment of the premises, the property will be included in his taxable estate when he dies. Similarly, if the grantor retains the right to receive income and/or principal from the trust, the assets will be included in the grantor's estate.

When a person is interested solely in asset management during his life but does not wish to relinquish control and is not concerned about estate taxes, a revocable trust would be the preferred vehicle. With a revocable trust, the grantor can maintain complete control over the assets and will receive all of the income during his lifetime. When the grantor dies, all of the assets will be included in his estate. Conversely, when estate taxes are a concern, i.e., the individual's assets exceed $3,125,000 for New York State purposes and $5,430,000 for federal estate tax purposes, he might opt for a trust that has no estate inclusion. Clearly, with such a trust, the grantor will have very little control and no access to any income or principal.

Often, when a client is interested in preserving assets in case he requires long-term care in the future, we recommend an income-only irrevocable trust. The grantor of this trust will continue to receive the income during his lifetime. Many individuals need the income derived from their assets to live on. This type of vehicle offers a perfect compromise. Provided the trust is drafted properly, the assets will be protected (after the passage of five years), but the grantor will still enjoy the income from the trust during his lifetime.

Because all these rules may be overwhelming to a lay person, it is important to seek proper counsel when engaging in estate and elder law planning. A seasoned attorney will be able to customize a trust based on the specific needs of the individual client.

Ronald A. Fatoullah, Esq. is the principal of Ronald Fatoullah & Associates, a law firm that concentrates in elder law, estate planning, Medicaid planning, guardianships, estate administration, trusts, wills, and real estate. Debby Rosenfeld, Esq. is a senior staff attorney at the firm. The law firm can be reached at 718-261-1700, 516-466-4422, or toll-free at 1-877-ELDER-LAW or 1-877-ESTATES. Mr. Fatoullah is also the co-founder of JR Wealth Advisors, LLC. The wealth management firm can be reached at 516-466-3300 or 800-353-3775.