A grantor trust enables its creator (the grantor) to retain certain powers or ownership benefits, causing the trust’s income and assets to be treated as owned by the grantor for income tax purposes. This means the grantor pays income taxes on the trust’s earnings, even if the trust is irrevocable and the assets in the trust are structured to bypass the grantor’s estate at death, thereby avoiding estate taxes.

Key features of an irrevocable grantor trust

  • Income taxation: All income, deductions, and credits flow through to the grantor’s personal tax return.
  • Estate planning tool: These trusts are often used to remove assets from the grantor’s estate for estate tax purposes.
  • Flexibility: The grantor can retain powers, such as the ability to substitute assets.

The power of substitution with a grantor trust

Substitution is one of the powers that can cause a trust to be classified as a grantor trust under Internal Revenue Code Section 675(4)(C). It allows the grantor to exchange an asset they own with one held by the trust as long as the assets are of equivalent value. This power must be exercisable in a nonfiduciary capacity without the approval or consent of the trustee.

The substitution power, therefore, enables the grantor to manage or optimize the trust’s holdings. Assets inside an irrevocable grantor trust do not receive a step-up in basis at the grantor’s death, so embedded capital gains are reduced by swapping high-income-tax basis assets into the trust. Likewise, by swapping low-basis assets out of the trust, those assets can get a step-up in basis from inclusion in the grantor’s estate.

This strategy can be used with any type of irrevocable grantor trust. Here’s a practical example of how the power of substitution works in a grantor trust:

Bob creates an intentionally defective grantor trust and funds it with shares of a privately held company valued at $5 million. The trust is structured to be a grantor trust for income tax purposes but excluded from Bob’s estate for estate tax purposes. Bob retains the power of substitution, meaning he can swap assets of equivalent value with the trust.

A few years later, Bob wants to reduce future capital gains for his heirs. The shares in the trust have appreciated significantly, but Bob owns municipal bonds with a high cost basis and similar market value. Bob exercises the power of substitution, removing the appreciated company shares from the trust and replacing them with municipal bonds of equal value.

Why this is beneficial:

  • The appreciated shares are now back in Bob’s estate and will receive a step-up in basis upon his death, reducing capital gains tax for heirs.
  • The high-basis municipal bonds are now in the trust, so they will not trigger significant capital gains, even though they do not receive a step-up in basis at Bob’s death.
  • Bob pays income tax on the trust’s earnings until his death, allowing the trust to grow without being reduced by income tax payments, further benefiting the beneficiaries.

While an irrevocable grantor trust can be a good tax planning strategy thanks to the power of substitution, it must be tailored to your unique financial needs. If you have any questions about this topic or any other planning needs, please contact your Cerity Partners advisor or request an introduction.

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