Classification of Trusts

Every trust in this chapter is a choice along three independent axes, and the marketing names— dynasty, SLAT, ILIT, IDGT—are just familiar combinations of those three answers. Learn the axes and you can read any structure an advisor puts in front of you, including ones this book does not name. The three questions, in the order they actually matter:

1.

Can you undo it? Revocable or irrevocable—this decides whether you keep control or buy tax and creditor benefits.

2.

When does it come alive? During your life or at your death—this decides whether it avoids probate and covers incapacity.

3.

Who pays the income tax? You or the trust—this decides the annual tax bill and, often, how fast the trust compounds.

The first answer drives the other two, so start there. Everything else in this section is the detail behind those three questions.

1. Revocable vs. Irrevocable

• Revocable Trusts: The grantor retains the power to amend or terminate the trust. Assets remain within the grantor’s taxable estate ( IRC §2038) and are fully exposed to the grantor’s creditors. Upon the grantor’s death, the trust becomes irrevocable.
• Irrevocable Trusts: The grantor permanently relinquishes control. Once established, the trust cannot be modified except under narrow legal conditions or via decanting (transferring assets to a new trust). Assets leave the grantor’s taxable estate—but only if the grantor keeps no strings attached; retain the income, the enjoyment, or the power to control who gets what, and IRC §2036 and IRC §2038 pull the whole thing back in. Creditor protection follows the same logic and is narrower than the sales pitch: an irrevocable trust shields assets from the beneficiaries’ creditors, and from the grantor’s creditors only when the grantor is not also a beneficiary. Name yourself a beneficiary and, in most states, your creditors reach whatever the trustee could distribute to you—the exception being the handful of DAPT jurisdictions (section “Domestic Asset Protection Trusts (DAPTs)”). Non-grantor irrevocable trusts also require separate tax filings.

2. Lifetime (Inter Vivos) vs. Testamentary This axis has a default answer: choose lifetime. A trust you create and fund while alive works immediately—it avoids probate, and it carries you through incapacity, which is the risk you are far more likely to actually face.

• Lifetime Trusts: Created and funded during your lifetime. They operate immediately, providing probate avoidance and uninterrupted asset management if you become incapacitated.
• Testamentary Trusts: Written into your will and funded only after death, through probate. Because probate creates them, they avoid none of its cost, delay, or publicity, and they do nothing for you while you are alive. Their legitimate role is as a backstop for a minor or spendthrift beneficiary (section “Testamentary Trust”).

3. Grantor vs. Non-Grantor (Tax Classification) This is the axis people misread as a technicality. It is not—it decides who writes the check to the IRS every April, and over a long horizon that single answer can matter more than the estate tax you were originally worried about.

• Grantor Trusts: Disregarded for income tax purposes under IRC §§671–679. The trust’s income, deductions, and credits land on your Form 1040. Every revocable trust is a grantor trust. Sophisticated irrevocable trusts are deliberately drafted to be grantor trusts as well—the IDGTs (section “Intentionally Defective Grantor Trusts (IDGTs)”)—because you paying the trust’s tax is not a gift, so the corpus compounds untouched for your heirs while your own estate shrinks by the tax you pay. Read that twice: the tax bill is a feature.

• Non-Grantor Trusts: Separate tax entities that must file Form 1041. They are sub-classified under IRC §651 and IRC §661:

  Simple Trusts

  Mandated to distribute all accounting income annually, cannot distribute principal, and cannot make charitable distributions. Income is taxed to the beneficiaries, and the trust receives a corresponding distribution deduction ( IRC §651).

  Complex Trusts

  Allowed to accumulate income, distribute principal, and make charitable donations ( IRC §661).

Income retained in a non-grantor complex trust runs into a brutally compressed rate schedule—the trust reaches the top federal bracket at a level of income an individual would consider modest. That compression drives the recurring administrative decision of whether to distribute income or accumulate it, worked through with the numbers and the exceptions at section “Distribute or Accumulate: Making the Decision”. An IDGT sidesteps the question entirely, because the grantor pays the tax at individual rates.

Three things advisors get wrong about this axis. You will meet all three, often in writing, from people who are otherwise competent.

“Grantor trust means the assets are still in your estate.”

No. Income tax ownership under IRC §§671–679 and estate inclusion under IRC §2036 and IRC §2038 are decided by different powers in different parts of the Code, and the entire IDGT industry exists in the gap between them (section “Intentionally Defective Grantor Trusts (IDGTs)”). Every revocable trust is a grantor trust and every revocable trust is in your estate, which is where the confusion starts—but the implication runs one way only. A substitution power under IRC §675(4)(C) makes the trust a grantor trust and does not pull the assets back.

“Asset protection comes from being a non-grantor trust.”

It does not. Creditor protection follows irrevocability and beneficiary status, not who signs the income tax return. An irrevocable grantor trust you are not a beneficiary of protects assets exactly as well as the non-grantor version, and pays tax at your rates instead of the compressed fiduciary schedule.

“A grantor trust cannot have its own EIN.”

It can, and an ILIT that needs a bank account for Crummey deposits generally should. Treas. Reg. §1.671-4 gives a wholly-owned grantor trust three reporting choices: file a Form 1041 with a grantor statement attached, furnish payors with your own Social Security number and file nothing, or obtain an EIN for the trust and use it for reporting. Pick one with your accountant; the point is that the presence of an EIN tells you nothing about the trust’s tax classification.

The off switch, and why you rarely want to flip it. Grantor status can be turned off— release the substitution power, or draft it to require the consent of a party who can then withhold it—and the reason to consider it is real: the tax burn compounds with the trust, and a structure that transferred $600,000 a year gift-tax-free when you were earning can become an obligation you resent when you are not. A trust protector’s power to release grantor triggers is cheap insurance to write in at drafting.

Flipping it is another matter. Turning off grantor status while an installment note from a sale to the trust is outstanding is a taxable disposition. While the trust is disregarded, you and it are one taxpayer and the note is nothing; the moment it becomes a separate taxpayer you are treated as having transferred the assets to a new owner in exchange for that note, and gain is recognized to the extent the debt exceeds your basis—Madorin v. Commissioner, 84 T.C. 667 (1985), and Rev. Rul. 77-402. The same conversion also relocates the income tax to the trust, which is either the point (escaping a high-tax home state, section “The NING and Why It No Longer Works in California”) or a disaster (the compressed brackets), depending on where the trust is sited. Pay off the note first, or do not flip the switch.

Note the price of the whole arrangement, which is easy to miss because it is an absence, not a charge: assets you gifted into an irrevocable trust are out of your estate, so they get no basis step-up at your death. Rev. Rul. 2023-2 settled the argument in 2023 for anyone still hoping otherwise. Grantor status does not change that—the trust’s assets are yours for income tax and gone for estate tax, and IRC §1014 keys off the estate answer. Planning around it is section “Optimizing for Basis in the High-Exemption Era”.

The practical combination is a revocable trust for lifetime management, privacy, and probate avoidance (section “Revocable Living Trust”), with one or more irrevocable structures layered on top once there is an estate-tax or creditor problem worth solving.