Grantor Trust California Tax Guide

What Is a Grantor Trust?

A grantor trust is any trust where the grantor (the person who created the trust) retains certain powers or interests that cause the trust's income to be taxed to the grantor rather than to the trust. Revocable living trusts are the most common type of grantor trust — since the grantor can revoke the trust at any time, all income is taxed to the grantor. Certain irrevocable trusts can also be structured as grantor trusts for income tax purposes while still being outside the grantor's estate for estate tax purposes.

Income Tax Treatment

A grantor trust's income is reported on the grantor's personal tax return — the trust does not file a separate income tax return (or files a simplified informational return). This means the grantor pays income tax on trust income at their personal tax rates, even if the income is retained in the trust. For a revocable living trust, this is transparent — the grantor owns the assets and pays tax on the income. For an irrevocable grantor trust, the grantor pays tax on income they do not receive — effectively making an additional tax-free gift to the trust beneficiaries.

Estate Tax Treatment

The grantor trust rules for income tax and estate tax are independent. A trust can be a grantor trust for income tax purposes (income taxed to grantor) but not included in the grantor's estate for estate tax purposes. This "defective" structure — taxable for income tax but not for estate tax — is the basis for some of the most powerful estate planning strategies available.

Intentionally Defective Grantor Trusts (IDGTs)

An Intentionally Defective Grantor Trust (IDGT) is an irrevocable trust that is intentionally structured to be a grantor trust for income tax purposes but outside the grantor's estate for estate tax purposes. The grantor sells assets to the IDGT in exchange for a promissory note — the sale is not taxable for income tax purposes (because the grantor and the trust are treated as the same person for income tax), but the assets are removed from the grantor's estate. The grantor then pays income tax on the trust's income, effectively making additional tax-free gifts to the trust beneficiaries. KDA works with estate planning attorneys to implement IDGT strategies for clients with large estates.

California Grantor Trust Rules

California follows federal grantor trust rules for income tax purposes. However, California has an additional rule: if a California resident is the grantor or beneficiary of a trust, California may tax the trust's income even if the trust is administered in another state. This "throwback" rule can create unexpected California tax liability for trusts established in no-income-tax states like Nevada or South Dakota. KDA analyzes the California tax implications of out-of-state trusts for California clients.

Grantor Trust Planning Strategies

KDA's grantor trust planning strategies: (1) IDGT installment sale — sell appreciated assets to an IDGT in exchange for a promissory note; the sale is income-tax-free, and the assets are removed from the estate. (2) Grantor trust swap power — give the grantor the power to swap assets of equivalent value with the trust; this maintains grantor trust status and allows the grantor to swap low-basis assets back into the estate to get a step-up in basis at death. (3) Spousal Lifetime Access Trust (SLAT) — an irrevocable trust that benefits the grantor's spouse; the grantor pays income tax on trust income, effectively making additional gifts to the trust.