Since at least 1986, when tax brackets for almost all Americans were compressed, and as a result of Rev. Rul. 85-13, which held that grantor trusts effectively did not exist for income tax purposes, grantor trusts have been one of the most commonly used estate tax planning tools. A “grantor trust” is a trust in which the income is attributed to the creator of the trust under Section 671 of the Internal Revenue Code of 1986 (or in certain cases to the trust beneficiary under Section 678), as though the trust did not exist.
Many, if not most, common lifetime estate tax planning strategies have been built on the chassis of a grantor trust, exploiting the differences between the income tax rules and the estate tax inclusion rules to create a trust that is excluded from the grantor's estate for estate tax purposes, yet invisible for income tax purposes. This has many benefits. Because the income of the trust is attributed to the grantor, tax on the income or gain experienced by the trust will be paid by the grantor, allowing the trust to grow on a tax-free compounded basis, which is one of the most powerful forces in financial planning. The IRS conceded in Rev. Rul 2004-64 that the grantor’s payment of tax on income generated by trust assets is not a gift to the trust or its beneficiaries, essentially allowing those tax payments to constitute additional tax-free gifts to the trust. Under the current law, grantor trust status alone does not cause inclusion in the grantor's estate for estate tax purposes, so all appreciation and income (the tax on which was paid by the grantor) pass free of transfer tax. A so-called grantor retained annuity trust (GRAT), described in Reg. 25.2702-3(b), almost always will be a grantor trust, which usually is beneficial because appreciated assets can be used to pay an annuity back to the grantor without gain recognition. The sale or purchase of an appreciated asset between a grantor and a grantor trust does not cause gain recognition, because of the determination in Rev. Rul 85-13, which can allow a reshuffling of assets in and out of the trust free of income tax (with the hope that appreciation of the assets will generally occur while the assets are held by the trust, outside the taxable estate of the grantor, and depreciation will happen while assets are held by the grantor).