Establishing a grantor trust, sometimes called an intentionally defective grantor trust, has a number of tax advantages at the federal level and is incorporated into many effective estate planning strategies. Generally, under federal grantor trust rules, the grantor of a trust is treated as the “owner” of the trust income for income tax purposes. As a result, all items of income, deductions, and credits are taxed to the owner. This is advantageous for a number of reasons. Specifically, assets grow tax free, preserving more wealth for the beneficiaries while also removing assets from the grantor’s estate. This ultimately reduces estate taxes due on the value of the transferred asset as well as on any future appreciation of this asset.
Further, the grantor can loan money to a grantor trust and despite having to pay a minimum IRS prescribed interest rate, known as the Applicable Federal Rate, the interest income is not taxable. The Applicable Federal Rate is fixed for the entire note term at the lowest rate allowed under the law. The grantor can also sell assets to the trust without recognizing a gain on the sale because he is selling assets to himself. Essentially, the trust assets can grow for the benefit of the beneficiaries and the trust’s income tax, paid by the grantor, is a tax free gift.
Fortunately, the vast majority of states honor the federal grantor trust rules. However, Pennsylvania does not follow federal grantor trust rules. Unless the grantor trust is revocable, Pennsylvania law imposes the fiduciary income tax on grantor trusts according to the same personal income tax rules that apply to irrevocable trusts. The beneficiaries of the trust, not the grantor, are taxed on all income distributed to them, credited to them, or required to be distributed to them. The trust must pay tax on all income not distributed to the beneficiaries. If assets are sold to the trust by the grantor there is a taxable transaction. Also, estimates must be made in the first year of the trust when the beneficiaries do not know the amount of income the trust will produce.
A grantor trust is a great tool to assist clients in migrating wealth from one generation to the next. Many states, not just Pennsylvania, have the opportunity to change their trust taxation rules year to year. Therefore, grantor trust rules should be examined regularly at both the federal and state level to avoid unintended income, gift, and estate taxation. Schneider Downs’ experienced estate planning professionals would welcome the opportunity to discuss various planning strategies concerning the divergent treatment of grantor trusts under Pennsylvania state law.
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