WHAT IS A NONGRANTOR TRUST?

Every trust has at least one grantor, also known as the trustmaker. This is the person who creates the trust. So, the terms grantor trust and nongrantor trust can get confusing. Its helpful to understand that neither of these terms refer to the existence or nonexistence of the trustmaker. Instead, these terms have to do with the trust’s income tax liability.

Grantor Trust versus Nongrantor Trust

With a grantor trust, the trustmaker retains certain powers over the trust. This includes:

• The power to revoke (cancel) the trust

• The power to add trust beneficiaries

• The power to borrow from the trust without providing collateral

Because the trustmaker has retained some level of control over the trust and its accounts and property, all trust income is taxed to the trustmaker. The trustmaker reports the income on their own personal tax return (Form 1040 for federal income tax reporting).

But, with a nongrantor trust, the trustmaker has given up all power over the trust and has no right to any of the trust’s accounts or property. In many circumstances, the trustmaker may not even be a trust beneficiary. With regard to income taxation, this lack of control means that the trustmaker is not treated as the owner and is not taxed on any income of the trust. Instead, the nongrantor trust is a separate taxpaying entity. It has its own tax identification number and must file its own tax return (Form 1041 for federal income tax reporting). If the trust makes a distribution of taxable income to a beneficiary, then the beneficiary reports it on their own income tax return. The trust also takes a corresponding offsetting deduction on its return. If the trust receives income and doesn't make any distributions, then the trust is taxed on that income. Trust income tax rates are steep. A nongrantor trust is taxed 37% on income over $13,450. This is why its extremely important to engage in tax planning alongside your estate plan.

Benefits of a Nongrantor Trust

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

First, as explained above, the trustmaker is not taxed on the nongrantor trust’s income. This is beneficial when the trustmaker doesn't want to have any financial responsibility for the trust. For example, if they create a trust for an ex-spouse or children from a previous marriage. They may want to avoid paying future income taxes on that trust’s accounts or property.

Second, if the trust beneficiaries are in a lower tax bracket than the trustmaker, and trust income is distributed to the beneficiaries, the income is taxed at the beneficiary’s lower income tax rate. This results in the income being taxed at a lower rate than if it were taxed at the trustmaker’s (or the trust’s) tax rate.

Third, a nongrantor trust can be used as a workaround 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. As a separate taxpayer, a nongrantor trust has its own SALT deduction, apart from the trustmaker’s. 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) tax deduction. The QBI deduction allows eligible business owners to deduct the lesser of:

• 20% of their qualified business income, or;

• 20% 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 their business assets and income among one or more nongrantor trusts. When using this strategy, its important to consider how much of the trust’s income is composed of capital gains. You'll need to 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, to qualify as a nongrantor trust, the trustmaker must give up all power over the trust. They will have no right to any of the trust’s accounts or property. Some trustmakers are uncomfortable with this. Also, because the trustmaker and the nongrantor trust are separate taxpaying entities, then certain transactions are taxable events. This includes the movement of accounts, property, or income between the trustmaker and the trust. 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.

While a nongrantor trust can be beneficial in certain circumstances, there are also some drawbacks. Our experienced estate planning attorneys in Dublin, Ohio can help you determine which trust is right for you. To schedule a consultation, call us at 614-389-9711.

Interested in learning more about how estate planning and tax planning work together? Read our Consumer's Guide to Estate Planning here.

[1] Eric Reed, Trust Tax Rates and Exemptions for 2022, SmartAsset (Jul. 6, 2022), .