When is a Non-Grantor Trust Preferable?

Grantor trusts became one of the most commonly used tools for estate tax planning beginning with the enactment of the Tax Reform Act of 1986 (P.L. 99–514), which substantially reduced the increases in federal income tax rates. Two major perceived benefits have been (1) to allow the trust to grow free of income taxes because the income of the trust is attributed to the grantor1 and (2) the ability of the trust’s grantor to sell appreciated assets to the trust without a gain or other income recognition in exchange for a note. This note typically has interest at the applicable federal rate, and this interest is not taxed as income. Instead, the position of the Treasury and the Internal Revenue Service (IRS) is that the grantor will continue to be treated as the owner of the trust assets for federal income tax purposes.2

Grantor trusts also offer other benefits. For instance, the grantor, or the grantor’s spouse under Section 1041, can buy low basis assets from a grantor trust before death and achieve an automatic (commonly called a “tax-free”) change in basis upon death. Moreover, a grantor trust whose grantor is a U.S. individual taxpayer is automatically a qualified S corporation shareholder.3