An irrevocable trust can be part of a comprehensive tax reduction strategy. If the trust is not a grantor trust, the IRS treats it as a separate taxing entity from the grantor. The federal tax code is progressive, which means the more income you earn, the higher percentage of tax you pay. Putting income-producing assets into a non-grantor trust can spread income over multiple taxpaying entities, which can reduce total income tax liability. If that is your purpose in establishing an irrevocable trust, you must avoid certain circumstances that might cause it to be classified as a grantor trust.
The IRS generally defines a grantor trust as any trust "over which the grantor or other owner retains the power to control or direct the trust's income or assets." The technical, statutory definition of a grantor trust under the Internal Revenue Code, as applied over time by IRS regulations and opinions, is actually much more complicated than that general definition might imply. Several different scenarios can result in the IRS treating an irrevocable trust as a grantor trust. Generally, all revocable trusts are, by definition, grantor trusts under the Internal Revenue Code. Some irrevocable trusts can also qualify as grantor trusts under the Internal Revenue Code.
A common instance when the IRS will treat an irrevocable trust as a grantor trust is when the grantor retains a five percent or larger reversionary interest in the trust property. For instance, if a grantor puts $100,000 into an irrevocable trust, but the grantor retains the right to receive at least $5,000 of that money back at some point in the future, the trust is probably a grantor trust under Section 673 of the Internal Revenue Code.
The IRS also treats irrevocable trusts as grantor trusts if the grantor retains any significant level of administrative control of the trust. For instance, if the grantor is a trustee with discretionary authority to distribute trust property to himself, the irrevocable trust is, in reality, a grantor trust. Or, if the grantor has the ability to borrow money from the trust without paying market rate interest, the trust is likely a grantor trust.
A final sticking point for irrevocable trusts trying to avoid classification as grantor trusts is the distribution of trust income to the grantor. If the trust allows for the distribution of trust income to the grantor or the grantor's spouse, the trust may be a grantor trust. If only a portion of the trust income may be distributed to the grantor or the grantor's spouse, only a similar portion of the trust is considered a grantor trust. In other words, the IRS may consider an irrevocable trust as partially a grantor trust and partially not.