One of the most useful estate planning tools is a trust, which can be used to create a legacy of wealth and protecting assets. One question to consider when creating one is whether a grantor or non grantor trust is more appropriate. A non grantor trust is any trust that is not a grantor trust. That distinction may seem simplistic but it matters from a tax perspective when shaping an estate plan. Understanding the difference between the two is important when deciding which type of trust to form.
Estate planning can be complicated so working with a financial planner can help ensure your arrangements best suit you and your beneficiaries.
What Is a Non Grantor Trust?
To understand non grantor trusts it’s helpful to have some background on what a grantor trust is and how it works. A grantor trust allows the grantor, i.e. the person creating the trust, to maintain certain powers of the trust. For example, that might include the power to:
- Revoke the trust
- Substitute assets in the trust
- Borrow from the trust without providing collateral or security
- Distribute trust income to oneself or to a spouse
- Add or remove beneficiaries from the trust
Regardless of the scope of powers involved, what’s unique about grantor trusts is their tax treatment. With this type of arrangement, the trust grantor is responsible for paying income tax on the trust assets. Any income the trust generates or receives is taxable to the grantor, who reports it on their personal tax return.
A non grantor trust is any trust that is not a grantor trust. This kind of trust affords no control or powers to the grantor. That means they’re unable to revoke or change the terms of the trust or make changes to trust beneficiaries.
In terms of taxation, the lack of control means that a non grantor trust is treated as a separate tax entity. The trust itself is required to pay taxes on any income that’s received and file a tax return using a tax identification number.
Non Grantor Trust Advantages
Creating a non grantor trust can offer certain tax benefits to the trust grantor. First, the grantor wouldn’t have to pay tax on the trust income. This might be an advantage in a situation where the grantor prefers to assume no further financial responsibility for the trust or its assets. For example, if you’re divorced and getting remarried, you may set up a non grantor trust for a former spouse or children from that marriage to avoid paying income tax on assets held in the trust.
There can also be positive tax implications if the trust beneficiaries are in a lower tax bracket than the grantor. When trust income is distributed to beneficiaries in a lower tax bracket, it may be taxed at a lower rate than it would if the grantor were being taxed.
You may consider creating a non grantor trust if you run a business. The qualified business Income (QBI) deduction allows eligible taxpayers to deduct up to 20% of qualified business income as well as 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. This deduction is phased out business owners once they reach certain income thresholds.
So where does a non grantor trust fit in? For tax purposes, non grantor trusts are treated as separate entities. If you own a business and your income is above the allowed threshold to qualify for the QBI deduction, you could establish one or more non grantor trusts as a work-around. Essentially, by dividing ownership of business assets and its associated income, it may be possible to qualify for the 20% deduction.
Finally, non grantor trusts can be useful for high income taxpayers or individuals who own high value property. The Tax Cuts and Jobs Act (TCJA) placed a $10,000 cap on state and local tax (SALT) deductions. If your state and local tax liability is above the threshold, you could use one or more non grantor trusts to distribute assets and maximize tax benefits. Since non grantor trusts are recognized as separate entities for tax purposes, they enjoy a $10,000 SALT deduction limit all their own.
Non Grantor Trust Disadvantages
There are some potential drawbacks associated with non grantor trusts. First, as the trust grantor you lack control of what happens with trust assets. With a grantor trust, on the other hand, you’d still have certain powers you’d be able to exercise.
Next, its important to consider how any transactions between yourself as the grantor and the trust may be taxed. Generally, certain interactions, including the movement of assets or income between the two, is taxable since you and the trust are two separate entities. This difference may create tax liability on either side when conducting certain transactions.
Finally, there’s the cost and setup involved in establishing a non grantor trust. You’ll need to choose someone to act as the trustee, as grantors cannot be the trustee of a non grantor trust. This individual or entity is typically entitled to be paid a fee for overseeing and administering the trust, which is drawn from trust assets.
Incomplete Non Grantor Trusts
An incomplete non grantor (ING) trust is a type of trust that’s used for asset protection. This type of trust is often used by individuals who live in states with high income tax rates or no state income tax at all. For example, if you live in a state that has higher income tax rates you could establish an incomplete non grantor trust, then fund it using appreciated assets that have a low tax basis. If the trust is established in a state that has lower income tax rates or no state income tax, this could reduce the grantor’s tax bill when selling those assets later.
Incomplete non grantor trusts can also make it possible to transfer ownership of assets to the trust without paying gift tax. This would also convey the other tax benefits associated with non grantor trusts. Whether it makes sense to establish an incomplete non grantor trust can depend on the tax rules where you live. Talking to an estate planning attorney or tax professional can help you decide if it’s a suitable option for managing assets.
Bottom Line
Non grantor trusts can be useful in a variety of situations from a tax and estate planning perspective. The most important thing to know about them is how they’re treated for tax purposes. Also, keep in mind that they don’t offer the same degree of control and decision-making as grantor trusts.
Tips for Estate Planning
- Consider talking to a financial advisor about various tax planning strategies you may incorporate into your financial plan. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor, get started now.
- Grantor and non grantor trust define how a trust is taxed. But there are other characteristics of trusts that are important to understand. For example, whether a trust is revocable or irrevocable matters for tax and estate planning. A revocable trust can be changed after the fact while an irrevocable trust cannot. It’s also helpful to understand different types of trusts that may be useful in estate planning. For example, a testamentary trust can be used to transfer assets in accordance with a last will and testament while a special needs trust may be established on behalf of a special needs dependent. An estate planning attorney can help with deciding which type of trust might fit your situation.
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