A “grantor” trust is a trust that contains certain provisions set forth in the Internal Revenue Code, which defines these types of trusts. With a carefully drafted irrevocable grantor trust, the income is imputed to you as the creator of the trust, but the trust assets are not included in your estate for estate tax purposes. In other words, as trust maker you must pay the income tax on all trust income, but trust assets will not be subject to estate tax at your death. The effect of paying the income tax is to further leverage the transfer to your beneficiaries at no additional gift tax cost.These trusts are also referred to as income defective grantor trusts. However, the "defect" is entirely intentional.
Grantor trusts are useful planning tools in several circumstances, particularly where you desire to sell appreciated assets to the trust without immediately incurring income tax. Under the Internal Revenue Code, when you sell an asset you must pay income tax on the amount above your “basis” in the property. In its most simplified sense, basis is the amount you paid for an asset when you purchased it, or if you received it by gift, it is the donor’s basis in the property.
A typical sale of appreciated property causes imposition of income tax. However, a grantor trust is treated as you for income tax purposes. Since you cannot “sell” property to yourself, a sale to a grantor trust is ignored for income tax purposes.
Significantly, the sale must be for full fair market value – a sale for less than full market value will be treated as part sale, part gift. How does the trust obtain the ability to purchase the assets? One way to accomplish this is by you making a gift to the trust followed by the trust purchasing the assets using an interest-bearing promissory note (with terms similar to a financing transaction with a third-party lender), using the minimum interest rate established by the IRS. Another method is for able beneficiaries to guarantee the payments in a commercially reasonable manner.
Another instance where a grantor trust provides planning opportunities is where you own life insurance in your name (or where an irrevocable trust owns life insurance in your name) and you desire to transfer the policy to a new irrevocable trust created for that purpose. By making the irrevocable life insurance trust a grantor trust you can sell the policy for its fair market value and avoid the problems that can occur when you transfer ownership of an existing life insurance policy.