Every trust has a grantor. So why are some trusts called “grantor trusts” and others called “non-grantor trusts”? The phrase “grantor trust” is actually referring to an IRS term that means the grantor of the trust is treated as the owner of trust property for income tax purposes. For example, Grantor has a grantor trust that holds some investment property. The income that the investment property makes is passed onto the grantor instead of the trust entity paying the tax itself (as a non-grantor trust does).
The Internal Revenue Code (IRC) lists several grantor trust definitions and if a trust meets one of the definitions, then the trust is a grantor trust. Probably the most commonly used grantor trust rule is the “power to revoke.” Hence, every revocable living trust a grantor trust.
Some irrevocable trusts where the grantor is not a beneficiary are treated as grantor trusts, which means the grantor is paying income tax on property that he has no beneficial interest in. Why would the grantor do this? For a couple of reasons. First, a non-grantor trust generally pays higher taxes than the grantor would, not because the rates are technically higher, but because the rates are compressed (a non-grantor trust moves up the tax chart and reaches the maximum rate very, very fast). So if the grantor pays the income tax instead of the trust, then that is presumably more money being passed onto the grantor’s heirs. The second reason is that by paying the taxes on the trust property is equivalent to making a tax-free gift while reducing the estate size of the grantor at the same time. For example, grantor is planning on having a taxable estate and is gifting $14,000 to each of his children each year to move money out of his future taxable estate. If he pays $100,000 in income tax on the irrevocable grantor trust property, that is equivalent to making an additional gift of $100,000 to his children, because if he didn’t pay that tax, the trust would have to pay it (and thus the children’s interest in the trust would be $100,000+ less).