Upstate Estate Law, P.C. Blog

Attorneys can be a strange lot.  They make up terms that nobody understands seemingly for no reason.  One such term is the intentionally defective grantor trust.  What is a grantor trust? Why would it ever be defective? And why would this be done intentionally?  Good questions all.

First, what is a grantor?  Well, a grantor is the person that sets up the trust and transfers his/her assets to it.

Second, what is a grantor trust? A grantor trust is a trust that is deemed to be owned by the grantor. This is important because it is the owner who is responsible for paying and filing the income taxes.  When the trust is a grantor trust, then it is the grantor that owns the income from the trust, and gets the benefit of the deductible expenses of the trust.  This allows the trust income tax brackets to be avoided in favor of the more favorable individual income tax brackets.  A grantor trust does not have to apply for a new taxpayer identification number because the grantor’s social security number is used.

How do you know whather a trust is a grantor trust? You determine this by reference to the trust instrument itself. What does the trust say? What powers does it grant? How is it structured? When you know this, you then take a look at the Internal Revenue Code, Sections 672 through 678. These sections are commonly known as the Grantor Trust rules.  As an example, a trust that is revocable by the Grantor is a grantor trust, and we know this by reference to IRC Section 676.  A trust that allows the Grantor to amend it to add beneficiaries (other than after adopted or born children) is a grantor trust and we know this by reference to IRC Section 674.  There are many other powers that can be granted in the trust to cause the trust to be a grantor trust.

Now that we know what a grantor trust is, why would we ever set up an intentionally defective grantor trust? An intentionally defective grantor trust is a trust that intentionally contains a provision that causes the trust to be a grantor trust.  This is done in the situation where it is desirable to structure a trust in a way that allows the trust assets to not be includible in the grantor’s estate, but still taxable for income tax purposes to the grantor.

The Irrevocable Life Insurance Trust (ILIT) is an example of an intentionally defective grantor trust.  The ILIT is an irrevocable trust that is set up to own life insurance on the life of the grantor.  The ILIT is considered the owner of the life insurance policy and pays the premiums.  The grantor has no right to revoke or alter the trust provisions.  As a result,  upon the death of the Grantor, the life insurance company will pay the benefit to the trust, and those proceeds will not be considered in calculating the estate tax owed by the Grantor’s estate.  The estate tax savings can be enormous. 

But how and why is an ILIT made intentionally defective? This is done by including certain administrative powers in the trust document so that under IRC 672-678 the trust is considered a grantor trust, while at the same time not including the powers that will cause the trust to be considered for estate tax purposes.  You can imagine it takes some experience to know which powers you can include and which powers you cannot.  The powers often included in the ILIT are the power to utilize trust corpus to pay life insurance premiums and the power of the Grantor to remove property from the trust and replace it with property of an equivalent value. 

The ILIT is a type of intentionally defective grantor trust that provides the best of both worlds, estate tax savings and income tax savings.  The ILIT causes the life insurance proceeds to be removed from the estate for estate tax purposes, yet causes the grantor to be responsible for the income and the beneficiary of the trust expense deductions, thus avoiding the trust income tax brackets in favor of the more generous individual income tax brackets.

So if you ever hear the term intentionally defective grantor trust, you now have an understanding of what a grantor is, what a grantor trust is, and why you would ever want your grantor trust to be intentionally defective.  

Like any decent lawyer, I need to add a disclaimer here: unfortunately, it is impossible to offer comprehensive legal advice over the internet, no matter how well researched or written. And remember, reviewing this website and my blogs doesn’t make you a client of my Firm: before relying on any information given on this site, please contact a legal professional to discuss your particular situation.