The IRS And Abusive Trust Arrangements: Non-Grantor Trusts

• Published date: 07 February 2023
• Subject Matter: Corporate/Commercial Law, Tax, Income Tax, Tax Authorities, Trusts
• Law Firm: Freeman Law
• Author: Mr Matthew Roberts

Under federal tax law, there are significant differences between grantor and non-grantor trusts. Grantor trusts are treated as disregarded entities. In layman's terms, this means that the grantor (i.e., the creator or the settlor) and the grantor trust are one and the same. Accordingly, if the trust generates income, that income is generally reported on the grantor's income tax return. Conversely, if a trust is characterized as a non-grantor trust, the grantor is not subject to income tax'rather, the trust or the trust beneficiary (assuming the beneficiary is different from the grantor) become subject to income tax on the trust's activities.

Because the grantor trust rules are complex, third parties often mislead taxpayers into believing that they can be easily avoided. Taxpayers should be particularly cautious of these types of claims, or any blanket claim that federal income tax may be avoided altogether through the usage of a trust. Indeed, the IRS and the federal courts have routinely struck down these types of arguments, resulting in significant penalties and interest to taxpayers.

The Grantor Trust Rules

Sections 671 through 679 of the Internal Revenue Code of 1986, as amended, contain the grantor trust rules. Very generally, these rules apply if the grantor retains certain rights over property that is transferred to trust. A common application of the grantor trust rules occurs when a grantor establishes a trust but retains the right to revoke it.¹ Because the grantor has the right to retain the benefit of the trust property through the simple act of revocation, the grantor continues to be treated as the owner of the trust's assets for federal income tax purposes. Although there are additional grantor trust rules, the takeaway is that if these rules apply, the grantor'and not the trust or trust beneficiary'is subject to income tax on the trust's activities.²

Substance Over Form

To try to avoid the grantor trust rules, tax promoters commonly incorporate language into trust documents that provide that the settlor or grantor is a third party and not the taxpayer. In these instances, the third party generally makes a nominal contribution to the trust and then "resigns" or removes himself or herself altogether from the trust. Thereafter, the taxpayer contributes more significant assets to the trust. The tax promoter's purpose in using a third-party settlor here is clear: it is an attempt to distance the taxpayer from application of the grantor trust...