How Does a Trust Affect My Taxes?

As Benjamin Franklin famously stated, “In this world, nothing can be said to be certain, except death and taxes.” While life may be unpredictable, establishing a grantor trust is a powerful way to ensure your wishes are honored and to shape your beneficiaries' future. This estate planning tool allows you to document your directives while maintaining flexibility to adapt to life’s changes, such as family dynamics, financial issues, divorce, elder care, and blended family challenges. However, it’s crucial to understand the tax implications associated with a grantor trust under the Internal Revenue Code.

What is a Grantor Trust?
A grantor trust is a revocable trust where the grantor (the person who creates the trust) retains certain powers, which allows them to maintain control over the trust assets. This control often includes the ability to alter the trust terms, revoke the trust, or manage the assets within it. The most common type of grantor trust is the revocable living trust, which becomes particularly beneficial during the grantor's lifetime.

Tax Treatment Under the Internal Revenue Code
One of the defining features of a grantor trust is its unique tax treatment. Under the Internal Revenue Code, a grantor trust is considered a disregarded entity for tax purposes. This means that the grantor is treated as the owner of the trust’s assets, and all income generated by those assets is reported directly on the grantor’s personal tax return.

For instance, if the trust holds investments that generate interest or dividends, these amounts must be reported as part of the grantor’s taxable income. The trust itself does not file separate income tax returns during the grantor's lifetime. This simplifies tax reporting and allows the grantor to retain all tax benefits associated with the assets, such as capital gains and deductions.

Tax Implications on Income and Capital Gains
One of the advantages of a grantor trust is that the grantor is responsible for paying taxes on the income generated by the trust. This means that any earnings, such as interest, dividends, or rental income, are taxed at the grantor’s individual tax rate. Importantly, because the grantor is still considered the owner of the trust assets, any capital gains from the sale of those assets are also taxed to the grantor.

If the grantor sells an asset held within the trust, the gain or loss from that sale is reported on their personal tax return. However, if the trust holds appreciated assets, there may be potential tax benefits upon the grantor’s death. Under current tax laws, a step-up in basis may apply, meaning that the assets' value is adjusted to their fair market value at the time of death. This can significantly reduce capital gains taxes for the beneficiaries if they decide to sell the assets after inheriting them.

Conclusion
Understanding the tax consequences of a grantor trust is essential for effective estate planning. As with any financial decision, it's wise to consult with an experienced estate planning attorney or tax advisor to ensure that a grantor trust aligns with your financial goals and overall estate strategy. Consult with our estate planning attorneys—Nick Goedde, Daniel Kloos, or Russell McLaughlin—to explore your options.