One of the more important issues in trust law is whether any particular trust is considered to be 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 a trust in which the individual who created and funded the trust remains in control of it. For tax purposes, non-grantor trusts can be more beneficial 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 of the Internal Revenue Code. 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 and definite standard exists limiting the ability of the trustee to make distributions from the trust. This is commonly known as the "HEMS" exception, since this standard allows distributions to be made for health, education, maintenance or support.
- Another exception exists if a trust has multiple beneficiaries who each receive distributions of income and principle on a pro rata (or proportional) basis.
- If a trust has only one beneficiary, income and principal must be paid on a consistent schedule to that beneficiary for the trust to qualify as an exception.
- Lastly, an exception exists if neither the grantor nor the grantor's spouse are a trustee, and if a majority of the trustees are not in a subordinate position to the grantor's.
Reference: Wealth Management (June 19, 2018) "The Perils and Pitfalls of Grantor Trust Triggers."