Morrison & Foerster LLP on Grantor Trusts, Distribution of Liabilities and Recognized Gain

Morrison & Foerster LLP on Grantor Trusts, Distribution of Liabilities and Recognized Gain

Distribution of Liabilities from a Grantor Trust Likely Causes the Grantor to Recognize Gain

By Danielle T. Zaragoza, Esq. and Sonja K. Johnson, Esq.

A so-called "grantor trust" is a trust that is disregarded for income tax purposes.  Because the income and gratuitous transfer tax laws are not completely consistent with each other, it is possible for an irrevocable trust to be a grantor trust for income tax purposes but not for gratuitous transfer tax purposes.  In a grantor trust, the grantor is taxable with respect to the trust's taxable income, which results in a tax-free gift by the grantor to the trust each year in the amount equal to the income tax liability attributable to the trust's taxable income.  This grantor trust feature also enables the grantor to deal with the trust on an arm's length basis without adverse income tax consequences, which can further enhance the value of the trust.