The Grantor Trust:
Yesterday’s Disaster, Today’s Delight,
by Virginia F. Coleman
All section references are to the Internal Revenue Code (“IRC”) unless otherwise
indicated. “IRS” refers to the Internal Revenue Service; “RSPS,” to related or sub-
ordinate party subservient to the wishes of the grantor; “GRAT,” to grantor
retained annuity trust; “QPRT,” to a qualified personal residence trust; “QSST,” to
qualified subchapter S trust; “NOL,” to net operating loss; “ESBT,” to electing
small business trust; and “AMT,” to alternative minimum tax.
A. The Way It Was
1. Traditionally, estate planners tried to avoid grantor trust status for all irrevo-
cable trusts that were intended to be completed gifts for gift tax purposes and
not part of the grantor’s estate.
a. If you accidentally triggered grantor trust status—for instance by giving a
related or subordinate trustee powers over a discretionary trust which did
not fall within section 674(b)—you would have made a major mistake.
Virginia F. Coleman is a partner in the Boston, Massachusetts, firm of Ropes & Gray. She is
a fellow of the American College of Trust and Estate Counsel and an academician of the
International Academy of Trust and Estate Law.
A complete set of the course materials from which this outline was drawn may be pur-
chased from ALI-ABA. Call 1-800-CLE-NEWS, ext. 7000, and ask for SD36. This is a revised
and updated version of an outline prepared for the 1996 Philip E. Heckerling Institute on
Estate Planning at the University of Miami, held from January 8-12, 1996.
16 ALI-ABA Estate Planning Course Materials Journal February 2000
b. Irrevocable trusts therefore typically included language to ensure that the
trust did not inadvertently become a grantor trust (e.g., a limit on the num-
ber of related or subordinate trustees to half, prohibition on buying insur-
ance on life of grantor or spouse (see §677), prohibition of loans to grantor
(see §675), etc.).
2. Grantor trust status was undesirable because typically the grantor would
have to pay income tax at a higher rate than the trust would if the income
were taxable to the trust. This larger amount of income tax more than offset
the gift tax benefit to be obtained by reason of the grantor’s payment of tax on
the income in question. For instance, if the trust would pay tax of $20 on $100
of income and the grantor would pay tax of $50, the family would be ahead
if the trust paid the tax and the grantor contributed $20 to the trust so long as
the applicable gift tax payable by the grantor on the additional $20 was less
than $30, (the additional income tax that the grantor would have to pay if the
trust income was taxable to the grantor), i.e., at a rate less than 150 percent.
B. What Changed?
1. The income tax rates changed. Historically trusts were subject to the same rate
schedule as married persons filing separately. Compression of the rates began
in 1987, and effective as of 1993, trusts became subject to the top (39.6 percent)
bracket at $7,500 of income, by comparison with $250,000 for individual tax-
payers ($125,000 for married taxpayers filing separately).
2. Now, therefore, the grantor is likely to be paying a lower tax on the trust
income than would the trust if it accumulated the income. Thus, the benefit
of the gift tax-free gift, which has always been available through the grantor
trust, is not offset by an income tax cost for the family as a whole.
3. Even if the trust income is distributed to a beneficiary who is less wealthy
than the grantor, the tax payable by the grantor if the trust is a grantor trust
may be less or at least no more than the tax that the beneficiary would pay on
the income if the trust was not a grantor trust.
a. The grantor may be subject to the AMT (maximum 28 percent).
b. The grantor may have charitable deductions or NOLs.
c. The beneficiary, if under age 14, will be subject to the Kiddie tax.
The Grantor Trust 17
C. The Way It Is Now
1. The intentional grantor trust has become one of the most popular vehicles for
“leveraged” gifts—i.e., vehicles to pass value on to the next generation out-
side the transfer tax system. The leverage occurs by reason of the fact that the
trust assets grow income tax free (like a qualified retirement plan or charita-
ble remainder trust), and distributions to a beneficiary are likewise income tax
free to the beneficiary, while the grantor’s conferring this additional benefit
through payment of the tax on the income in question is not a taxable gift
because the grantor (and not the trust or the beneficiary) is liable for the tax
under the IRC.
a. As used in this outline, the term “intentional grantor trust” means a trust
i. A grantor trust for income tax purposes;
ii. A completed gift for gift tax purposes; and
iii. A transfer which will not be included to any extent in the grantor’s
estate for estate tax purposes. Thus by definition the grantor is not a ben-
eficiary of such a trust and cannot control who will take under the trust
(except subject to an ascertainable standard).
b. Frequently the trust will be a long-term trust, to which GST exemption is
to be allocated.
2. The intentional grantor trust has other advantages as well.
a. It may hold S corporation stock and can have advantages over other trusts
which are permissible S corporation shareholders.
i. It permits considerably greater flexibility than the rigid QSST.
ii. It is not automatically taxed at the highest rate like the ESBT.
b. Caveat: upon termination of grantor trust status by reason of the grantor’s
death there is only a two-year grace period during which the trust will
continue to be a qualified shareholder. §1361(c)(2)(A)(ii). In addition, if
grantor trust status ceases during the grantor’s lifetime (such as, for exam-
ple, with a GRAT), there is no grace period at all; the ongoing trust or, if it
18 ALI-ABA Estate Planning Course Materials Journal February 2000
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The Grantor Trust 19
terminates, the remainderman, must immediately be a qualified share-
holder on some other basis or S status will be lost.
c. Grantor trust status is also extremely useful if transactions between the
grantor and the trust are contemplated and you wish these transactions to
be income tax free.
i. The IRS has consistently taken the position that income and deduc-
tions of a grantor trust will be treated as realized by the grantor directly;
thus a transaction between the grantor and a grantor trust cannot give rise
to any taxable income because it is a transaction between the grantor and
himself. Rev. Rul. 85-13, 1985-1 C.B. 184; Priv. Ltr. Rul. 95-35-026 (May 31,
1995), 95-25-032 (Mar. 22, 1995), 95-19-029 (Feb. 10, 1995), 93-45-035 (Aug.
13, 1993). Contra: Rothstein v. U.S., 735 F.2d 704 (2d Cir. 1984).
ii. Thus, for instance, a GRAT, assuming it is a 100 percent grantor trust,
may distribute in kind to the grantor, and the distribution will not give rise
to any taxable income. Priv. Ltr. Ruls. 98-38-017 (June 19, 1998), 97-36-028
(June 9, 1997), 97-35-034 (June 2, 1997), 96-25-021 (Mar. 20, 1996). Formerly,
the GRAT could borrow from the grantor to fund the annuity payment,
with no tax consequence on account of the interest payments. See Priv. Ltr.
Rul. 95-35-026 (May 31, 1995). This technique could be very useful if the
GRAT assets were not marketable, and distribution in kind was not desir-
able because of the expected growth of the GRAT assets. It has now been
effectively precluded, however, by Prop. Treas. Reg. §25.2702-3(b)(1)(i) and
3(d)(5), which prohibits use of a “debt instrument” to satisfy the “annuity
amount,” and adds this prohibition as a governing instrument require-
ment for GRATs created on or after September 20, 1999. Pre-existing
GRATs will be deemed to comply with this prohibition if no notes are used
to satisfy the annuity amount after September 20, 1999, and any note pre-
viously issued for this purpose is paid in full by December 31, 1999.
Borrowing from the grantor to pay the annuity in cash is not literally the
same as paying the annuity by a note, but it is in substance the same, and
it would no doubt be so viewed by the IRS. The IRS’s dissatisfaction with
the concept of the GRAT’s borrowing from the grantor was first evident in
Priv. Ltr. Rul. 96-04-005 (Oct. 17, 1995) in which, because of the way the
borrowing was implemented, the IRS clearly came to the correct conclu-
sion. Priv. Ltr. Rul. 96-04-005 involved multiple GRATs established by H
and W, all funded with closely held, non-dividend paying stock. Under a
prearrangement, each annuity payment was funded by a loan from the