The Perils and Pitfalls of Grantor Trust Triggers

Non-grantor trusts can be beneficial to clients to lower state income taxes. Generally most trusts are non-grantor trusts, but if the grantor retains, or is deemed to retain, certain powers or interests in a trust, then the trust’s income, deductions and credits will be attributed to the grantor and the trust will be a grantor trust. Also, IRC Section 674 provides that a trust will be a grantor trust if the beneficial enjoyment of the trust property is controlled by the grantor, the grantor’s spouse and/or a non-adverse party – UNLESS an exception to Section 674 applies.

IRC Section 674(b) and (c) provide for a total of 9 exceptions, but here are the top 4 that estate planning practitioners use to avoid triggering grantor trust status.

1. HEMS. The trustee’s power to make distributions is constrained by a reasonably definite standard such as health, education, maintenance or support (HEMS) (IRC Section 674(b)(5)(A));
   
2. Pro rata shares. The trust has multiple beneficiaries, but income and principal is distributed to such beneficiaries in accordance with their respective shares (IRC Section 674(b)(5)(B));
3. Single beneficiary. The trust has only one current beneficiary, and the income and principal must be paid to such beneficiary (or such beneficiary’s estate) or to appointees designated by the beneficiary (IRC Section 674(b)(6)); and
4. No real control. Neither the grantor nor the grantor’s spouse is serving as trustee, and no more than one-half of the trustees are related or subordinate to the grantor (IRC Section 674(c)).

See Jessica Galligan Goldsmith & David Y. Choi, The Perils and Pitfalls of Grantor Trust Triggers, Wealth Management, June 19, 2018.

Special thanks to Jim Hillhouse (Professional Legal Marketing (PLM, Inc.) for bringing this article to my attention.