Nongrantor Trusts

One classification of trusts is whether the trust is a grantor or nongrantor trust. Although every trust has at least one grantor (the trustmaker or settlor who creates the trust), the terms grantor or nongrantor are used to classify the trust’s income tax liability.

Grantor Trust versus Nongrantor Trust
With a grantor trust, the trustmaker retains certain powers over the trust, such as the power to revoke the trust, to add trust beneficiaries, or to borrow from the trust without providing collateral. Because the trustmaker has retained some level of control over the trust and its accounts and assets, all trust income is taxed to the trustmaker and is reported on the trustmaker’s personal tax return.

With a nongrantor trust, the trustmaker gives up all control of the trust and has no right to any of the trust’s accounts or assets. In many circumstances, the trustmaker may not even be a trust beneficiary. Because of this lack of control, the trustmaker is not treated as the owner and is not taxed on any income of the trust. The nongrantor trust is instead a separate taxpaying entity with its own tax identification number that must file its own tax return. If the trust makes a distribution of taxable income to a beneficiary, then the beneficiary reports the distribution on his or her own income tax return and the trust takes a corresponding offsetting deduction on its return. If the trust receives income and does not make any distributions, the trust is taxed on that income. Trust income tax rates are different than the rates for an individual. A nongrantor trust pays the top federal tax bracket rate of 37 percent on any income over $13,450.

Benefits of a Nongrantor Trust
Why would a trustmaker choose to create a nongrantor trust? A nongrantor trust has the following tax advantages:

  • First, the trustmaker is not taxed on the nongrantor trust’s income. This is beneficial when the trustmaker does not want to have any financial responsibility for the trust. For example, a trustmaker may create a trust for an ex-spouse or children from a previous marriage and want to avoid liability for income taxes on that trust’s accounts or assets.
  • Second, trust income can be pushed to beneficiaries who are in a lower tax bracket than the trustmaker or the trust. When there are trust beneficiaries who are in a lower tax bracket than the trustmaker, there will be tax savings if the income is distributed to those beneficiaries and taxed at their lower rate. Likewise, there is savings if the income is not retained in the trust and taxed at the high trust rate.
  • Third, a nongrantor trust can be used to avoid the current $10,000 state and local taxes (SALT) deduction limit. An annual itemized deduction is available for payment of state and local property, income, and sales taxes. This deduction cannot exceed $10,000, however. Because a nongrantor trust is a separate taxpayer, it has its own SALT deduction, separate from the trustmaker’s SALT deduction. A taxpayer could divide ownership of real property among one or more nongrantor trusts to maximize potential tax savings.
  • Finally, a nongrantor trust can be used to maximize the qualified business income (QBI) deduction. The QBI deduction is a tax deduction that allows eligible business owners to deduct the lesser of 20 percent of their qualified business income or 20 percent of taxable income in excess of net capital gains if their income is below the allowed threshold. If a trustmaker’s income exceeds the limits to qualify for the QBI deduction, they could divide the ownership of their business assets and income among one or more nongrantor trusts (which are separate taxpaying entities) to qualify for the QBI deduction. When using this strategy, it is important to consider how much of the trust’s income is composed of capital gains and ensure that the trust is within the same income threshold to qualify for the QBI deduction.


Downsides of a Nongrantor Trust
There are some disadvantages to nongrantor trusts. First, remember that to qualify as a nongrantor trust, the trustmaker must give up all power over the trust and have no right to any of the trust’s accounts or assets. Some trustmakers are uncomfortable with giving up control over what happens to the trust and its accounts and assets.

In addition, because the trustmaker and the nongrantor trust are separate taxpaying entities, then certain transactions, including the movement of accounts, assets, or income between the trustmaker and the trust, are taxable events. For example, if the trustmaker purchases property from a nongrantor trust that has increased in value, then the trust would have to pay tax on the gain. If, however, the trust was a grantor trust, then no gain would be realized.

Let Us Help
While a nongrantor trust can be beneficial in certain circumstances, there are also some drawbacks to using a nongrantor trust. We can help you determine whether a nongrantor trust is right for your estate planning and tax situation. To learn more, call us to schedule your appointment.