An irrevocable trust is defined under state law while a grantor trust is a federal tax category, but there is considerable overlap between the two. Most trusts, even those considered irrevocable under state law, are considered grantor trusts by the IRS unless they meet very specific criteria.
A grantor trust, according to the IRS, is one in which the person who created the trust, or grantor, retains some control or use over the assets of the trust. By definition, all revocable trusts are grantor trusts because the grantor reserves the right to revoke the trust altogether and retake its assets. Similarly, any trust in which the grantor is a trustee is also a grantor trust. Though a trust may be irrevocable in that it cannot be modified or revoked, if the grantor retains any control over the disposition of the assets, even indirectly through a family member, it will be treated as an irrevocable grantor trust by the IRS.
Taxation of Grantor Trust
The assets of a grantor trust are not subject to probate because they are not considered the grantor's property. For federal tax purposes, however, the assets of a grantor trust are always considered the grantor’s property. During the lifetime of the grantor, any realized gains in the value of the trust is taxable on the grantor’s individual income tax return. After the grantor’s death, the trust assets are considered part of the decedent’s gross estate and are counted toward the estate tax.
An irrevocable trust under state law may be considered a complex trust, instead of a grantor trust, by the IRS. This is only possible if the trust is not considered a grantor trust under sections 671-677 of the Internal Revenue Code. These sections describe all the types of control over or use of trust assets that will render a trust a grantor trust for federal tax purposes. The assets must also have been transferred to the trust more than three years prior to the death of the grantor. If the trust qualifies as a complex trust, it is taxed as a separate entity during the grantor’s lifetime and not included in the grantor’s gross estate after death, a useful tool for preserving the value of a life insurance policy.
Defective Grantor Trusts
In some situations it can be advantageous to have an irrevocable trust that is treated as a grantor trust by the IRS. Such trusts are called "defective" because they fail to meet the requirements of a complex trust, but the defect can be used intentionally to create tax benefits. For example, sale of assets to a grantor trust does not create tax liability for the grantor because the trust is ignored for federal tax purposes. Similarly, a gift to a defective grantor trust is taxable to the grantor, which relieves the tax burden of any appreciation in value from the beneficiaries. A defective grantor trust can also be a shareholder of an S corporation.