There can be much confusion between an account owner, their wealth manager, and the estate planning attorney when someone forms a trust and attempts to open a trust account at their brokerage firm or their financial institution. All of this confusion can be eliminated when the parties involved understand the Grantor Trust rules for income tax reporting.
While there are many different types of trusts, two of the most common types of trusts that individuals establish are:
- The revocable living trust (for probate avoidance purposes); and
- The irrevocable income only trust (for probate avoidance and Medicaid qualification purposes)
Other trusts formed by the wealthy for gifting purposes and to exclude assets from the taxable estate are typically not Grantor Trusts, but these types of trusts are fewer since married couples can exempt more than $10 million from the estate tax.
The one key thing that all parties should be aware is that the IRS does not require or recommend obtaining an EIN/Tax ID Number for “Grantor Trusts.” The client can use their own social security number when they open the account, because income from the account is to be reported on the individual income tax return of the Grantor (the person setting up the trust), even if the Grantor Trust is an irrevocable trust.
"Grantor trust" is a term used in the Internal Revenue Code to describe any trust over which the grantor (also called a “Settlor” or "Trustor") or other owner retains the power to control or direct the trust's income or assets. If a grantor retains certain powers over or benefits in a trust, the income of the trust will be taxed to the grantor, rather than to the trust.
All "revocable trusts" are by definition grantor trusts.
An "irrevocable trust" can be treated as a grantor trust if any of the grantor trust definitions contained in Internal Code §§ 671, 673, 674, 675, 676, or 677 are met.
If a trust is a grantor trust, then the grantor is treated as the owner of the assets, the trust is disregarded as a separate tax entity, and all income is taxed to the grantor.
26 USC 677. Income for benefit of grantor
(a) General rule:
The grantor shall be treated as the owner of any portion of a trust, whether or not he is treated as such owner under section 674, whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be—
(1)distributed to the grantor or the grantor’s spouse;
(2)held or accumulated for future distribution to the grantor or the grantor’s spouse; or
(3)applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor’s spouse (except policies of insurance irrevocably payable for a purpose specified in section 170(c) (relating to definition of charitable contributions)).
Some financial institutions have, as their policy, that if the trust is "irrevocable", the trust must get its own Tax ID#. Rather, the better policy should be that if the trust is a Grantor Trust, even if the trust is irrevocable, then the Grantor who is establishing the account should be able to use their own social security number on the account application, and all income should be reported to the social security number.