Non-Grantor Trust: What It Is & How It Works

A non-grantor trust can be a fantastic estate planning tool for high-net-worth individuals, including internationals in the US. It shifts both assets and tax obligations away from the trust creator, but is a non-grantor trust the right option for you?

There are unique advantages and disadvantages for wealth preservation to consider, which we'll break down in this guide.

What Is a Trust?

A trust puts your money or property in someone else's hands to manage for the people you choose.

It's essentially a container that holds valuable items, such as money, property, investments, or business interests. The person who creates and funds the trust is called the grantor or settlor.

Research shows that approximately 85% of successful business owners have outdated estate plans. This interesting statistic demonstrates the importance of understanding tax and estate planning to maximize the wealth you pass down to your future generations or loved ones.

Grantor Trusts

A grantor trust is a common type of trust arrangement. In this setup, the person who creates the trust (the grantor) maintains significant control over the assets and remains responsible for paying the income tax on any taxable income the trust generates.

Basically, you still own what's inside the trust, but you've organized the trust assets differently for various planning purposes.

What Is a Non-Grantor Trust?

A non-grantor trust operates as a completely separate entity from its creator for income tax purposes. When you create a new non-grantor trust, you're essentially creating a new taxpayer.

The trust itself becomes responsible for paying taxes on any income it generates, and you relinquish certain controls over the assets.

For example, if you place a rental property in a non-grantor trust, the trust – not you – would report and pay taxes on the rental income.

Grantor vs Non-Grantor Trust

As you can see, there are key differences between grantor and non-grantor trusts, mostly in the degree of control and tax consequences.

Control

With a grantor trust, you retain certain powers, such as the ability to change beneficiaries or borrow from the trust. A non-grantor trust requires you to give up these powers.

For example, let's say you create a non-grantor trust for your three children's education. With a grantor trust, you could later decide to add or remove grandchildren as beneficiaries or borrow money from the trust to handle an emergency.

With a non-grantor trust, these powers must be given up – once you name your three children as beneficiaries and establish the educational purpose, you can't change these terms or access the funds yourself.

Paying Income Tax

In a grantor trust, all income is taxed to you personally, even if the trust distributes income to other beneficiaries. A non-grantor trust files its own tax return (Form 1041) and pays taxes on undistributed income.

The Net Investment Income Tax of 3.8% still applies to non-grantor trusts if the Net Investment Income and gross adjusted income meet certain thresholds specified by the IRS. This tax applies to investment income like interest, dividends, capital gains, rental income, and other passive investment earnings.

A non-grantor trust can be valuable for high-net-worth individuals who want to reduce their tax burden while creating wealth for future generations, but make sure to consult with a qualified estate planning attorney first.

Non-Grantor Trust Pros

Non-grantor trusts have a few important advantages, both for asset protection and managing taxable income.

Income Taxation: Because a non-grantor trust is a separate tax entity, you can take advantage of tax rate differences. For example, if you're in the highest tax bracket but your beneficiaries are in lower brackets, distributing income through a non-grantor trust can help you save more on taxes.
Asset Protection: Once assets are transferred to a non-grantor trust, they're generally beyond the reach of your creditors, so your family wealth is protected.
Estate Taxes: Non-grantor trusts can help reduce estate tax exposure by moving appreciating assets out of your estate. For example, if you transfer a growing business worth $5 million to a non-grantor trust, any future appreciation happens outside your estate. If the business value doubles to $10 million, that additional $5 million in growth won't be subject to the federal estate tax at your death.

15% of people are concerned that their future heirs won't be able to pay for the taxes or maintenance of the assets they leave behind.

With these advantages, non-grantor trusts can work well for high-net-worth individuals who want to protect and efficiently transfer wealth to the next generation while minimizing their tax burden.

Related Article | Intentionally Defective Grantor Trust

Non-Grantor Trust Cons

Despite their benefits, non-grantor trusts also have drawbacks you should be aware of.

Loss of Control: Once you transfer assets to a non-grantor trust, you give up substantial control over them. Unlike a grantor trust, you can't change beneficiaries or adjust distribution terms. For example, if you place a family business in the trust and later want to change how profits are distributed among your children, you won't have that flexibility.
Taxable Transactions: Since the trust is considered a separate taxpayer with its own tax identification number, any transactions between you and the trust could trigger tax consequences. If you sell assets to the trust or receive income from trust assets, there could be unexpected tax liabilities.
Administrative Burden: You'll need to appoint a trustee (who can't be you), pay ongoing trustee fees, and maintain separate tax records. A non-grantor trust is overall generally harder to manage than a grantor trust.

Given these limitations, non-grantor trusts typically are not a good idea for individuals who need ongoing access to their assets and want to maintain direct control over their wealth.

If you anticipate needing to make frequent changes to your estate plan as family circumstances evolve, consider setting up a grantor trust instead.

Incomplete Non-Grantor Trust

An incomplete non-grantor (ING) trust is a unique kind of non-grantor trust. The transfer to the trust is considered incomplete for gift tax purposes (meaning no gift tax is triggered), but the trust is still treated as a separate taxpayer for income tax purposes.

This structure is popular with residents of high-tax states who want to minimize state income taxes.

More Trust Options | Spousal Lifetime Access Trust

Foreign Non-Grantor Trust

A foreign non-grantor trust is established outside the US, with the trust creator giving up control of the assets for US tax purposes. These trusts can help with estate planning, asset protection, and tax planning.

They're particularly useful for people who are planning to immigrate to the US because setting up the trust before becoming a US resident can help minimize future tax obligations.

FAQs

What Is the Difference Between a Grantor and a Non-Grantor Trust?

The main difference lies in who's responsible for the taxes and who controls the trust. In a grantor trust, you (the person who created the trust) are responsible for paying taxes on trust income and typically maintain certain controls over the trust assets. With a non-grantor trust, the trust itself is a separate taxpayer, and you give up significant control over the assets.

Is a Non-Grantor Trust a Simple Trust?

A non-grantor trust can be either simple or complex. These are two different classifications that depend on how the trust distributes income.

A simple trust must distribute all its income annually and can't make distributions from the principal. A complex trust has more flexibility. It can accumulate income, make discretionary distributions, or distribute principal. Most non-grantor trusts are set up as complex trusts because they offer more flexibility.

Who Pays Taxes on a Non-Grantor Trust?

The tax responsibility in a non-grantor trust is shared between the trust and its beneficiaries. The trust pays taxes on any income it retains, and the beneficiaries pay taxes on any income distributed to them. In other words, if a trust earns $100,000 and distributes $60,000 to beneficiaries, the beneficiaries pay taxes on their $60,000, and the trust pays taxes on the remaining $40,000.

Who Is the Owner of a Non-Grantor Trust?

Technically, no one person "owns" a non-grantor trust – it's a separate legal entity that owns itself. The trustee manages the trust assets for the benefit of the beneficiaries but doesn't personally own them. The person who created the trust (the grantor) has given up ownership rights, and the beneficiaries have a right to benefit from the trust but don't directly own the assets.

Can an Irrevocable Trust Be a Non-Grantor Trust?

Yes, most non-grantor trusts are actually irrevocable trusts. In fact, for a trust to qualify as a non-grantor trust, it typically needs to be irrevocable. This means once you set it up, you can't change your mind and take the assets back or make major changes to the trust terms.

Can a Spouse Be a Beneficiary of a Non-Grantor Trust?

Yes, your spouse can be a beneficiary of a non-grantor trust, but it needs to be drafted to avoid triggering grantor trust rules, which often happen when a spouse has too many rights or benefits under the trust.

The Bottom Line

Non-grantor trusts can have great benefits for your estate planning and tax management, but there are trade-offs in terms of control and complexity. If you don't need ongoing access to the trust assets, it could be the right option for you.

Make sure to work with experienced legal and tax professionals who can help you navigate complicated trust rules and tax treatment.