Volume 23 Issue 6 -- November/December 2011
While most tax professionals are familiar with handling tax reporting for a typical revocable trust that is treated as a grantor trust for tax purposes, tax reporting for irrevocable grantor trusts can be more complicated.
A common misconception goes something like this: “Irrevocable grantor trusts, you say? I did not know there was such a thing!”
Yes, there are such things. A number of estate planning devices, like life insurance trusts, grantor retained annuity trusts (GRATs), and sales to intentionally defective grantor trusts (IDGTs) commonly employ trusts that are irrevocable but treated as grantor trusts for income tax purposes.
How can an irrevocable trust be a grantor trust, you may ask?
Clever estate planners exploit differences between the income tax rules and the gift and estate tax rules by using irrevocable trusts that are respected for gift and estate tax purposes but that contain special provisions that cause the trust to be disregarded (i.e., treated as a grantor trust) for income tax purposes.
A common strategy used to produce this result is to include a trust provision giving the grantor the power, exercisable in a non-fiduciary capacity, to substitute for trust assets other assets having an equal value. Under IRC § 675, this makes the trust a grantor trust for income tax purposes. Occasionally, other trust provisions are employed to produce the same result.
Why intentionally create something that is “defective”? The reason is that an irrevocable trust with such provisions will be treated as a completed transfer for gift and estate tax purposes but be disregarded for income tax purposes. In other words, the grantor will be taxed on all of the trust income, even though the transfer to the trust is respected for gift and estate tax purposes. We will not ask whether this is the way the law should work.
In some cases, a person other than the creator of the trust can be treated as the “grantor” or owner of the trust, so long as the person has one or more of the powers that trigger grantor trust status. Here, the term “grantor” means any person treated as the owner of the trust for income tax purposes.
In any event, many practitioners are now being confronted by irrevocable trusts that are designed to be treated as grantor trusts for income tax purposes. How are the income and expenses for such a beast reported?
The answer depends upon a number of factors, such as whether the entire trust is a grantor trust, whether the grantor is a trustee of the trust, and whether there are multiple grantors. IRS regulations specify a basic rule for grantor trust reporting and then provide a number of different options.
The basic rule (subject to a number of exceptions which we will ignore) is that items of income and deduction attributable to any portion of a trust that is treated as owned by the grantor are not reported by the trust on its own income tax return (Form 1041) but are shown on a separate statement to be attached to that form. In other words, the trust obtains a taxpayer identification number (TIN) and completes only the entity part of the return and then sets forth all income and expenses on an attachment to the 1041.
There are, however, several optional methods. First, if the trust has only one person treated as a grantor, then the trust may furnish the name , the TIN for the grantor, and the address of the trust to all “payors” during the taxable year. For this purpose, spouses filing a joint return are treated as one person. A “payor” is anyone who is required to provide information reporting (such as a 1099 or K-1) to the trust.
Under this option, if the grantor is also a trustee, no further reporting is required, and no 1041 is needed. If the grantor is not a trustee, then the trustee must provide a detailed statement to the grantor showing all items of income, deduction, and credit of the trust for the year, providing the information necessary to take the items into account in computing the grantor's taxable income, and informing the grantor that the items and other information shown on the statement must be included in the grantor’s own tax return. In order to take advantage of this option, however, the regulations require that the trust obtain a W-9 from the grantor.
Under a second option, the trust may use the trust’s own TIN for all accounts and all payors of income and then prepare timely 1099’s to report all significant categories of trust income. If the grantor is not a trustee, the trust must then provide the grantor a statement and the information referred to above. In that case, the trust does not file a 1041.
When there are multiple “grantors,” the trust must use its own TIN and then prepare 1099s for the grantors along with a statement and the information referred to above.
There are special rules for changing from one reporting method to another.
If you need assistance in grantor trust reporting, please contact Tax & Business Professionals.
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