Every trust has at least one grantor, also known as the trustmaker, i.e., the person who creates the trust. So, it can be confusing when terms like grantor trust and nongrantor trust are used. It is helpful to understand that neither of these terms refers to the existence or nonexistence of the trustmaker (the person who created the trust), but are terms that have to do with the trust’s income tax (typically not estate or gift tax) liability.
Grantor Trust versus Nongrantor Trust
With a grantor trust, the trustmaker retains certain powers over the trust, such as the power to revoke (cancel) the trust, the power to add trust beneficiaries, and the power to borrow from the trust without providing collateral. Because the trustmaker has retained some level of control over the trust and its accounts and property, all trust income (whether ordinary or capital gains income) is taxed to the trustmaker, who reports the income on their own personal tax return (Form 1040 for federal income tax reporting).
On the other hand, with a nongrantor trust, the trustmaker has given up all power over the trust and has no right to any of the trust’s accounts or property. In many circumstances, the trustmaker may not even be a trust beneficiary. With regard to income taxation, this lack of control means that the trustmaker is not treated as the owner and is not taxed on any income of the trust. Rather, the nongrantor trust is a separate taxpaying entity with its own tax identification number that must file its own tax return (Form 1041 for federal income tax reporting). If the trust makes a distribution of taxable income to a beneficiary, then the beneficiary reports the distribution on their own income tax return and the trust takes a corresponding offsetting deduction on its return. If the trust receives income and does not make any distributions, and therefore does not have any offsetting deductions for distributions, then the trust is taxed on that income. Trust income tax rates are steep: a nongrantor trust reaches the top federal tax bracket rate of 37 percent on income over $13,450.
Benefits of a Nongrantor Trust
Why would a trustmaker choose to create a nongrantor trust? A nongrantor trust has the following tax advantages:
- First, as explained above, the trustmaker is not taxed on the nongrantor trust’s income. This is beneficial in circumstances where the trustmaker does not want to have any financial responsibility for the trust. For example, a trustmaker may create a trust for an ex-spouse or children from a previous marriage and want to avoid paying future income taxes on that trust’s accounts or property.
- Second, if the trust beneficiaries are in a lower tax bracket than the trustmaker and trust income is distributed to the beneficiaries, the income is taxed at the beneficiary’s lower income tax rate. This results in the income being taxed at a lower rate than if it were taxed at the trustmaker’s (or the trust’s) tax rate.
- Third, a nongrantor trust can be used as a workaround to avoid the current $10,000 state and local taxes (SALT) deduction limit. An annual itemized deduction is available for payment of state and local property, income, and sales taxes. This deduction cannot exceed $10,000, however. As a separate taxpayer, a nongrantor trust has its own SALT deduction, apart from the trustmaker’s SALT deduction. A taxpayer could divide ownership of real property among one or more nongrantor trusts to maximize potential tax savings.
- Finally, a nongrantor trust can be used to maximize the qualified business income (QBI) deduction. The QBI deduction is a tax deduction that allows eligible business owners to deduct the lesser of 20 percent of their qualified business income or 20 percent of taxable income in excess of net capital gains if their income is below the allowed threshold. If a trustmaker’s income exceeds the limits to qualify for the QBI deduction, they could divide the ownership of their business assets and income among one or more nongrantor trusts (as separate taxpaying entities) to qualify for the QBI deduction. When using this strategy, it is important to consider how much of the trust’s income is composed of capital gains and ensure that the trust is within the same income threshold to qualify for the QBI deduction.
Downsides of a Nongrantor Trust
There are some disadvantages to nongrantor trusts. First, remember that to qualify as a nongrantor trust, the trustmaker must give up all power over the trust and have no right to any of the trust’s accounts or property. Some trustmakers are uncomfortable with giving up control over what happens to the trust and its accounts and property. In addition, because the trustmaker and the nongrantor trust are separate taxpaying entities, then certain transactions, including the movement of accounts, property, or income between the trustmaker and the trust, are taxable events. For example, if the trustmaker purchases property from a nongrantor trust that has increased in value, then the trust would have to pay tax on the gain. If, however, the trust was a grantor trust, then no gain would be realized.