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Trust Law/Level V · Tax and legacy/5.1 Estate and gift tax/Lesson 5

Grantor trusts and why defective can be useful

How the US grantor trust rules can tax a trust’s income to its creator even when the trust is outside the creator’s estate, and why planners sometimes design that result on purpose.

Education, not legal advice. Trust law changes from country to country and state to state, and the right structure depends on your situation. Anything you sign should be drafted or reviewed by a qualified lawyer where you live.

The lean path

The cheapest, lowest-tax, simplest and most private route the law allows, best first. Each step names the rule it rests on and the condition that keeps it lawful.

  1. For an estate under the 2026 basic exclusion of $15,000,000, a defective grantor trust adds cost without saving federal estate tax; assets kept until death get a stepped-up basis under IRC §1014, which out-of-estate grantor-trust assets do not (Rev. Rul. 2023-2).
  2. Where estate tax is a real cost, the grantor paying the trust’s income tax shifts wealth tax-free, as Rev. Rul. 2004-64 says it is not a gift; the trust must not require reimbursement, or the whole trust returns to the estate under §2036.
  3. A nonfiduciary swap power under IRC §675(4)(C) creates grantor status cheaply and lets the grantor buy back low-basis assets with cash or high-basis assets before death, so they get a §1014 step-up; each swap must be of equal value (Rev. Rul. 2008-22).
  4. If paying the trust’s tax becomes a burden, the grantor can release the power that causes grantor status; the trust then files Form 1041 and reaches the 37% bracket above $16,000 of 2026 taxable income, so distributing income to lower-bracket beneficiaries may cost less.

MaterialsThe text of IRC §§671–679, the grantor trust rules, free on law.cornell.eduRev. Rul. 2004-64, on paying a grantor trust’s income tax, in Internal Revenue Bulletin 2004-27, free on irs.govLesson 5.1.3, on what brings trust assets back into an estate, and lesson 5.1.7, on the history of the rules

Wonder

  1. Why would anyone choose to pay income tax on a trust’s income?
  2. Which powers make a trust a grantor trust without pulling it back into the estate?
  3. Can the trust repay the grantor for the tax, and what happens if it must?

Explore

  1. After Helvering v. Clifford (1940) taxed a grantor on the income of a short-term trust he controlled, Treasury issued regulations and Congress wrote the grantor trust rules into the Internal Revenue Code of 1954 (lesson 5.1.7). Today they are IRC §§671–679. If the grantor keeps certain interests or powers, or in some cases the grantor’s spouse holds them, the grantor is treated as owner of that part of the trust for US federal income tax: its income, deductions and credits go on the grantor’s own return, even though the trustee holds legal title.
  2. Income tax and estate tax use different tests. The estate tax asks whether the settlor kept interests or powers described in IRC §§2036 and 2038 (lesson 5.1.3); the grantor trust rules ask different questions. Because the lists do not match, a trust can be a completed gift outside the settlor’s estate while its income is still taxed to the settlor. Planners call this an intentionally defective grantor trust (IDGT). ‘Defective’ is a planners’ term, not a statutory one: the trust is deliberately treated as the grantor’s for income tax only.
  3. A common trigger is a power to reacquire trust property by substituting other property of equivalent value, held in a nonfiduciary capacity without the consent of a fiduciary (IRC §675(4)(C)). Revenue Ruling 2008-22 held that such a power does not by itself bring the trust into the settlor’s estate, where the trustee must make sure the property swapped is of equal value. Other triggers include a power to borrow trust property without adequate interest or security (§675(2)) and income that may be paid to the grantor’s spouse (§677(a)). Whether a power is really held in a nonfiduciary capacity can be a question of fact.
  4. Why would a settlor want this? The settlor pays income tax on income that builds up in the trust for the beneficiaries. Revenue Ruling 2004-64 held that the grantor’s payment of that tax is not a gift to the beneficiaries, because the grantor is paying the grantor’s own legal obligation. The payments reduce the settlor’s estate while the trust’s assets grow without paying their own income tax. Grantor status also means a sale of assets between the settlor and the trust is not recognized for income tax (lesson 5.1.6).
  5. Rev. Rul. 2004-64 also addressed reimbursement. If the trust terms or state law require the trustee to reimburse the grantor for that income tax, the grantor has kept a right to have trust property pay the grantor’s own obligation, and the full value of the trust is included in the grantor’s gross estate under IRC §2036(a)(1). A discretionary power for an independent trustee to reimburse does not by itself cause inclusion, but it can if combined with an understanding between grantor and trustee, a power for the grantor to become trustee, or state law letting the grantor’s creditors reach the trust.
  6. Grantor status can end. If the grantor releases the power that causes it, the trust becomes a separate taxpayer for later years, filing its own returns and paying tax at the compressed trust brackets; grantor status also ends at the grantor’s death. The design has costs and limits: the grantor keeps paying tax on income they do not receive, assets outside the estate get no stepped-up basis at death (Rev. Rul. 2023-2), and with the 2026 basic exclusion at $15,000,000 per person, many families face no federal estate tax. This lesson describes how the design works; it does not suggest using it.

Key facts

  • Helvering v. Clifford (1940) taxed a grantor on the income of a short-term trust he controlled; the modern grantor trust rules are IRC §§671–679.
  • A trust can be outside the settlor’s estate for estate tax yet treated as the settlor’s for income tax, because the two taxes use different tests.
  • A nonfiduciary power to reacquire trust property by substituting property of equivalent value makes the grantor the owner under IRC §675(4)(C).
  • Rev. Rul. 2004-64: a grantor’s payment of income tax on grantor trust income is not a gift to the trust’s beneficiaries.
  • Rev. Rul. 2004-64: a required reimbursement of that tax brings the full trust into the grantor’s estate under §2036; a discretionary one by an independent trustee does not by itself.
  • Grantor status ends if the grantor releases the power that causes it, or at the grantor’s death; the trust then pays its own income tax.

Exercise nine, six, three, one

9CollectList up to 9 powers or terms in a trust you are reading about (some lists are shorter), such as who is trustee, who may receive income, whether anyone can swap assets or borrow from the trust, whether the grantor can be reimbursed for tax, and who can release a power.
6ClusterSort them into 6 categories: trustee powers, beneficiary rights, substitution powers, borrowing powers, reimbursement terms, and terms you are unsure about.
3DistillReduce the 6 categories to 3 groups: terms that may make the trust a grantor trust for income tax, terms that may bring it into the estate for estate tax, and terms you would ask a tax adviser about.
1CrystallizeWrite 1 sentence explaining, in your own words, how a trust can be outside a person’s estate yet still have its income taxed to that person.

Fact check

Dates, figures and claims checked against the published sources listed below.

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