What’s the difference between a grantor and non-grantor trust?

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Trusts can be classified in a number of different ways. The terms grantor and non-grantor trust are related to the status of the trust as a taxable entity. We have elsewhere explained that In California a trust is not an entity that can be represented by legal counsel, this is true, but for income tax purposes, trusts and estates can be taxable entities distinct from the grantor and the beneficiaries.

The Internal Revenue Code (IRC) sections 671 – 679 aka. ‘grantor trust rules’ elaborate when grantors and others are treated as substantial owners. This is essentially the case when in an inter vivos trust the grantor retains certain interests and powers. A grantor who retains an unrestricted power to revoke or amend the trust will be considered as the trust’s owner and taxed on the trust’s income. Such trusts are called grantor trusts.

In contrast, a non-grantor trust is a taxable entity where the taxes are allocated between the entity and the beneficiaries according to subchapter J of the IRC. The beneficiaries of non-grantor trusts are responsible for paying taxes on the distributions they receive, and the trust pays tax only on any income accumulated but not distributed. In essence, the primary function of subchapter J is to ensure that trust income is either to the entity or the beneficiaries but not both.

Unlike individual taxpayers, however, trusts are taxed under a ‘compressed’ rate schedule, this means tax progression is faster which resulting in a significantly higher tax for the trust. Estate and trust tax rates for 2021 are as follows:

If taxable income is:The tax is:
Not over $2,65010 percent of taxable income
Over $2,650 but not over $9,550$265 plus 24 percent of the excess over $2,650
Over $9,550 but not over $13,050$1,921 plus 35 percent of the excess over $9,550
Over $13,050$3,146 plus 37 percent of the excess over $13,050

Advanced topic: What is an ‘intentionally defective grantor trust’ (IDGT) and how does it work as an estate planning tool?

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