One of the more important issues in trust law, is whether any particular trust is considered a grantor or non-grantor trust for tax purposes. The differences between the two are set forth in the Internal Revenue Code and can be rather complicated.
A grantor trust is one in which the person who created and funded the trust remains in control of it. For tax purposes, non-grantor trusts are normally better, since they can be used to lower state income taxes.
Qualifying as a non-grantor trust requires that the grantor and the grantor’s spouse do not have beneficial enjoyment of trust property under Section 674. However, there are some very important and useful exceptions to that rule, as Wealth Management discusses in “The Perils and Pitfalls of Grantor Trust Triggers,” including:
- A reasonable definite standard limits the ability of the trustee to make distributions from the trust. This is known as the “HEMS” exception, since the standard can be health, education, maintenance or support.
- If a trust has multiple beneficiaries who each receive distributions of income and principle on a pro rata basis, it is an exception.
- If a trust has only one beneficiary, income and principle must be paid on a definite schedule to that beneficiary for the trust to be an exception.
- Neither the grantor nor the grantor’s spouse are a trustee, nor are more than 50% of the trustees in a subordinate position to them.
Reference: Wealth Management (June 19, 2018) “The Perils and Pitfalls of Grantor Trust Triggers.”