8. How might the flexibility of irrevocable grantor trusts factor into planning?

An irrevocable grantor trust is a trust created and funded during life in which the grantor retains an element of control over the assets, which results in taxation of the trust income and calculation of related deductions and credits on the grantor’s individual income tax return. The assets of the trust are not taxed as part of the grantor’s estate, and the payment of income taxes on behalf of the trust further reduces the grantor’s estate without gift tax consequences.

In addition, there is flexibility if the payment of income taxes on behalf of the trust becomes too burdensome. First, if the trustee has the discretion to reimburse the grantor for income taxes paid, the trustee can reimburse the grantor without the assets of the trust being included in the grantor’s estate. However, if the trustee is required to reimburse the grantor or has a prearranged agreement to do so, the assets of the trust are likely includible in the grantor’s estate. Second, the trust agreement may allow the grantor to make a change to the powers the grantor retained and effectively “turn off ” the grantor trust status. This would cause the trust to pay its own income tax liability from trust funds.

Carefully consider state income tax elections that allow the payment of state income taxes via an entity owned by the trust instead of by the grantor, as the grantor may then be treated as making a gift if they reimburse the trust.

Planning point: Be aware that if the trustee is required to reimburse the grantor or has a prearranged agreement to do so, the assets of the trust are likely includible in the grantor’s estate.