In recent years, grantor trusts have been a popular method used by taxpayers in an effort to protect some of their property from estate taxes. This strategy was especially popular in 2012, as Congress had not yet acted to extend the sunsetting $5M lifetime exemption, which was then slated to return to $1M.
Recently, some practitioners have advocated for turning grantor trusts into non-grantor trusts, citing the $11M lifetime exemptions, the income tax burden on the grantor, and potential income tax savings, among others. While toggling non-grantor status can be an advantageous move in specific circumstances, it may not always be the most tax-efficient path in the long run.
If the trust owns interests in a closely-held business, this change can be particularly complicated. The following is a breakdown of three issues business owners may face when converting a grantor trust to a non-grantor trust:
- Trust income is subject to narrower trust income tax brackets
Universally, federal income tax brackets for trusts are much narrower than individual income tax brackets. This causes income in trusts to be taxed at a higher tax rate much sooner than if it were taxed at individual rates. For example, in 2018, a married couple filing joint begins taxed at the highest tax rate (37%) after reaching $600,000 of income; in comparison, trusts start paying at the top tax rate (also 37%) after reaching only $12,500 of income. Thus, except for those grantors who are taxed at the highest tax rate, switching from a grantor to a nongrantor trust will likely result in trust income being taxed at a higher tax rate.
- Trust eligibility to be an S corporation owner
Additional implications exist if the trust owns S corporation stock. A corporation can only become and remain an S corporation if it makes a valid S election and maintains its eligibility. Only allowing stock to be owned by permissible shareholders is one of the rules required to receive and maintain S corporation status. A grantor trust is a permissible shareholder, mainly because it is treated as the grantor, who, as an individual, is a permissible shareholder. Non-grantor trusts are not permissible shareholders unless the trust makes an election to be either a Qualified Subchapter S Trust (QSST) or an Electing Small Business Trust (ESBT).
While both QSSTs and ESBTs are eligible S corporation shareholders, the rules for each are very different. A QSST must follow two primary requirements: 1) Only one beneficiary of the trust; 2) All income must be distributed to the beneficiary at least annually. If an existing trust wishes to make a QSST election but has multiple beneficiaries, the trust can divide trust assets into separate shares inside the trust, which then would be a permissible S corporation shareholder under § Regs. Sec 1.1361-1(j)(3).
An ESBT may have multiple beneficiaries but it can be more complicated than a QSST. Trust income is not required to be distributed to beneficiaries, and income distributions are usually left to the discretion of the trustee. An ESBT has at least two sections—one consisting of the S corporation stock and a non-S corporation section—and it may also have a grantor section. Different tax rules apply to each section, but the S corporation section is taxed at the highest tax rate on ordinary income (currently 37%).
Deciding whether to elect to be a QSST or an ESBT will be at least partially determined by the structure of the trust and the settlor’s intent. While this election is important, it is not permanent; a QSST can later convert to an ESBT and vice versa.
- The applicability of the net investment income tax (NIIT) to trust income
The net investment income tax (NIIT) is a 3.8% tax on portfolio income and income from a passive trade or business. Individuals are subject to the same NIIT on passive investments, but the tax does not apply if the taxpayer materially participates in the trade or business. For a trust to materially participate in a trade or business, the trust’s trustee must be deemed to materially participate in business operations. The beneficiary’s activity in the trade or business is currently irrelevant for NIIT purposes. In cases where the grantor materially participates in the business but the trustee does not, a change to non-grantor status will cause the trust to incur an additional tax liability of 3.8% NIIT.
Changing the status of a grantor trust can result in many tax consequences, some of which may require the trust to pay more income taxes than if the income were taxed on the grantor’s tax return. Each of the three potential issues addressed in this article can be solved with careful planning and competent advising.
If you have questions regarding how changing a grantor trust to non-grantor status will impact your income and estate taxes, call John Ure or one of our experienced estate tax advisors today at 301.231.6200.