One of the most vexing aspects of estate planning is how a trust is taxed. This article is intended to briefly introduce one of the most common types of trusts, the grantor trust, as well as outline the common income tax reporting options for grantor trusts.

Grantor trusts refer to trusts that are income taxed to the “grantor” for federal income tax purposes pursuant to Internal Revenue Code (“IRC”) Sections 671 through 677. Grantor trusts are used primarily for lifetime estate planning, such as a revocable living trust, and gift, asset protection, and charitable planning.

The most common types of grantor trusts are:

• Trusts that are revocable during the lifetime of the grantor.
• Grantor Retained Annuity Trusts (“GRATs”).
• Grantor Retained Unitrusts (“GRUTs”).
• Spousal Lifetime Access Trusts (“SLATs”).
• Most Nevada Self-Settled Spendthrift Trusts (Asset Protection Trusts).
• Intentionally Defective Grantor Trusts (i.e. gift trusts that are designed as grantor trusts).

The “grantor” of a trust is defined in Treas. Reg. 1.671-2(e)(1), as follows: “. . . a grantor includes any individual to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer . . . of property to a trust.”

In addition to making a gratuitous transfer to the trust, in order to qualify as trust as a “grantor trust,” the grantor must also hold one or more rights or powers in the trust that create “ownership” for income tax purposes under IRC Sections 671 through 677. Those rights and powers generally include:

• Power to revoke the trust. IRC 676.
• Grantor retained a reversionary interest in the trust greater than 5%. IRC 673.
• Power in grantor or non-adverse party to control timing of beneficial interest without the approval of any adverse party. IRC 674(a) and (d).
• The grantor retained the right to receive income distributions. IRC 677.
• The trust makes payments of insurance premiums on the life of the grantor using trust income. IRC 677.
• The power to add beneficiaries. IRC 674.
• The grantor retains the right to substitute property for equivalent value. IRC 675(4).
• The trustee is able to enter into transactions with the grantor for less than adequate and full consideration. IRC 675(3).
• The grantor retains the power to borrow without adequate interest or security. IRC 675(2).

Note that the grantor is treated as holding any power or interest the grantor’s spouse has in the trust. IRC 672(e). In other words, even if the grantor does not have any of the rights or powers listed above, but the grantor’s spouse holds the power, the trust is still treated as a grantor trust to the grantor.

Filing Income Tax Returns. The Internal Revenue Service provides four (4) methods in reporting income from a grantor trust:

• Option 1 – No Tax Identification Number (“TIN”). A grantor trust that is wholly owned does not need to apply for a TIN nor file an annual IRS Form 1041. However, the trustee must provide a statement that: (1) shows all of the income, deductions, and credits; (2) explains why the grantor is taxed on the income; and (3) informs the grantor that they must report the income on their personal income tax returns. Thus, no IRS Form 1041 tax return is required. The grantor must give the trustee a signed form W-9 to use this reporting method.
• Option 2 – TIN obtained and the trust only has one (1) grantor. The trustee must supply the IRS and the grantor with a 1099 reporting the income. No IRS Form 1041 is required for the trust. The trustee must also provide the grantor a statement that: (1) shows all of the income, deductions, and credits; (2) explains why the grantor is taxed on the income; and (3) informs the grantor that they must report the income on their personal returns.
• Option 3 – TIN obtained and more than one (1) grantor. The reporting is the same as Option 2, only the trustee must provide the statement to each grantor.
• Option 4 – TIN obtained and one (1) or more grantors. The trustee files an IRS Form 1041 tax return and provides a statement to the grantors that the trust is wholly owned by more than one (1) grantor that has obtained a TIN. The trustee must supply the grantors with a statement that: (1) shows all of the income, deductions, and credits; (2) explains why the grantor is taxed on the income; and (3) informs the grantor that he or she must report the income on their personal returns.