Grantor Trust Taxation

Tax considerations often guide the decision on whether or not to place assets in trust, and to the type of trust format used. Particularly, aspects of grantor trust taxation guide these considerations. Certain types of trust structures offer comparatively favorable grantor trust tax treatment for the grantor, whereas others are more favorable to beneficiaries.
Based on these considerations there is not a “one size fits all” solution to deciding which type of trust to use as an asset management tool. Because individual circumstances and preferences will largely dictate how assets will be transferred there is not a simple way of determining the best trust to fit an estate planning scenario.
Based on overriding asset management considerations one can view the selection of trusts as choosing the path of least resistance, that is the path which offers the least tax liability for the party who will benefit most from the assets held in trust. For example, a grantor who wishes to derive partial benefit from trust assets, and then transfer a majority of the assets to beneficiaries would likely want to select trust format that would lessen the tax burden on beneficiaries.      
Taxing Trusts and Resulting Estates
Before discussing the taxation of grantor trusts, it is important to understand how a trust and estate is created. A trust is created when the grantor transfers property to a trustee for the benefit of a beneficiary. An estate is created containing the assets and liabilities remaining upon the death of the grantor.
A trust and an estate exist as separate, legal, taxpaying entities. Therefore, income earned by the trust or estate property is income earned by the trust or estate. Tax liability, on income earned by a trust, depends on who receives or retains benefits from the trust.
Tax liability on income received by an estate depends on how the income is classified. For example, income earned by the decedent, income earned by the estate, income in respect of the decedent, or income distributed to beneficiaries will cause tax liability to vary.
Trusts and estates are taxed on an individual basis. As such, a trust or estate may benefit from tax−exempt income and may deduct certain expenses, and each is allowed a small exemption. However, an estate or trust is not allowed a standard deduction. Further, the tax brackets for income taxable to a trust or estate are much more compressed and can result in higher taxes than for individuals.
Grantor Trust Tax Rules
Establishing a grantor trust has a number of tax advantages. For example, the grantor can sell assets to the trust without recognizing the gain on the sale. The grantor can also loan money to the trust at the least the minimum IRS-prescribed interest rate. Under this type of arrangement, the interest income is not taxable to the grantor. Further the trust’s income tax, paid by the grantor, and, therefore, is not considered an additional gift to the trust. The trust assets can grow for the benefit of the beneficiaries, without the economic burden of paying income tax.
Grantor Trust Filing Requirements
Filing requirements under IRS grantor trust tax reporting requirements follow a basic rule. The rule generally states that income and deductions attributable to any portion of a trust that is treated as owned by the grantor, therefore, are not reported by the trust on its income tax return (Form 1041).
Rather, they are reported on a separate statement to be attached to Form 1041.  In other words, the trust, which should possess a taxpayer identification number (TIN) issued by the IRS completes only the entity part of the return and then reports all income and expenses on an attachment to Form 1041.
IRS grantor trust rules, provide other optional methods for reporting and filing. One of which involves a trust that has only one grantor. Under this situation, the trust furnishes the name, the grantor’s TIN, trust’s address to all “payors” during the taxable year.
If the grantor is not a trustee, then the grantor/trustee must provide a detailed statement to the grantor of income, deductions, and credits for the trust in the year to be included in the grantor’s tax return. Under this option, the trust must obtain a W-9 from the grantor.
Under a second option, the trust may use the trust’s TIN for all accounts and all payers of income and then prepare a timely Form 1099 to report all significant categories of trust income. If the grantor is not a trustee, the trust must then provide the grantor a statement. When there are multiple “grantors,” the trust must use its TIN and then prepare a Form 1099 for the grantors along with a a detailed statement to the grantor of income, deductions, and credits for the trust in the year to be included in the grantor’s tax return.
A grantor trust attorney can provide an evaluation as to whether this structure is an appropriate asset management vehicle. Counsel experienced in asset protection trusts can also provide advice regarding the tax implications and financial impact of this form of trust. Given the amount of trust arrangements available discussing these options with counsel experienced in wealth management and asset protection is an important first step in this decision-making process.