A grantor or trustmaker is the person who funds a trust, so how can you have a trust without a grantor? It is confusing, but the terms grantor trust and nongrantor trust refer to the trust’s income tax, not the existence or lack thereof of a trustmaker.
The Difference Between a Grantor Trust and a Nongrantor Trust
A key difference between grantor and nongrantor trusts is whether the trustmaker retains control over the trust’s accounts and properties.
The trustmaker retains certain rights and power over the grantor trust and its accounts and properties, and therefore, all trust income is taxed to the trustmaker.
The trustmaker will report the income from the trust on their personal tax form.
For federal income tax reporting, this is Form 1040.
In a grantor trust, the trustmaker retains the power to:
- Revoke or cancel the trust
- Add trust beneficiaries
- Borrow from the trust without providing collateral
With a nongrantor trust, the trustmaker has given up all power and control over the trust and its accounts and properties.
The trustmaker may not even be a beneficiary of the trust.
Because the trustmaker has no power over the trust, the trustmaker is not considered the trust owner and, therefore, is not taxed on any of the trust’s income.
A nongrantor trust is a separate taxpaying entity. The trust has its own tax identification number and must file its own tax return.
If the trust disperses a taxable payment to a trust beneficiary, the beneficiary must report the distribution on their income tax return.
The trust then makes a corresponding offsetting deduction on its return.
However, if the trust receives income and does not disperse it to the beneficiaries, it cannot take an offsetting deduction and must report the income on its tax return.
This can have significant financial implications, as trust income tax rates are steep.
For example, a trust reaches the top federal income tax bracket of 37% with income over $13,450.
Benefits of a Nongrantor Trust
Here are some of the potential advantages of a nongrantor trust:
The trustmaker is not responsible for the nongrantor trust’s income taxes.
In some cases, people want to establish trusts but want to ensure that they do not have any future financial responsibility for the trust.
For example, suppose you want to establish a trust for an ex-spouse or children from a previous marriage, but you want to ensure that once you fund it, you will not have any future financial responsibility for the trust’s income taxes.
When a nongrantor trust is ideal
Suppose your trust beneficiaries are in a lower income tax bracket than you or the trust.
Then the trust income will be distributed and taxed at the beneficiary’s lower income tax rate.
A nongrantor trust can be used as a workaround to avoid the current $10,000 state and local taxes (SALT) deduction limit.
The SALT deduction allows you to deduct payments for state and local property, income, and sales taxes.
Since the trust is a separate taxpayer from the trustmaker, a nongrantor trust has its own SALT deduction.
A taxpayer could divide property ownership among several nongrantor trusts to maximize their potential tax savings.
Qualified Business Deduction
A nongrantor trust can also be used to maximize the qualified business income (QBI) deduction.
The QBI deduction is a deduction that allows 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.
For example, suppose the trustmaker’s income exceeds the set threshold for the QBI deduction.
In that case, they could divide their ownership in their business income and assets among multiple nongrantor trusts to stay under the threshold and qualify for the QBI deduction.
It is essential 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.
If you plan on using this strategy, talk to your estate attorney.
Drawbacks of a Nongrantor Trust
Here are some potential drawbacks of a nongrantor trust:
- The trustmaker must give up all power over the trust and the right to its accounts or property.
- Because the trustmaker and the nongrantor trust are separate tax entities, certain transactions such as moving accounts, property, or income between the trustmaker and the nongrantor trust are taxable events.
For example, if you, as the trustmaker, purchase property from the nongrantor trust and the property has increased in value, then the trust would have to pay tax on the gain.
This is not the case with a grantor trust.
If you are considering a nongrantor trust, contact The Katzner Law Group to discuss the advantages and disadvantages.
We can help you determine whether a nongrantor trust is the best option for your estate and income tax planning needs.