What specific powers cause a trust to be a "grantor trust" for income tax purposes?

IRC sections 671-679 enumerate seven categories of retained powers that trigger grantor-trust status (income tax flows to grantor's personal return). Knowing each one is critical for trust design.

The seven trigger categories:

§673 — Reversionary interest. If the grantor retains a future interest in the trust corpus worth more than 5% of the trust at funding, the trust is a grantor trust. So funding a trust where you'll get the assets back after 20 years usually qualifies.

§674 — Power to control beneficial enjoyment. If the grantor retains discretion to redirect benefits among beneficiaries, the trust is a grantor trust. Subject to many exceptions for ministerial powers and ascertainable standards.

§675 — Administrative powers. Specific powers that trigger grantor-trust status:

• Power to deal with trust assets for less than full and adequate consideration
• Power to borrow without adequate interest or security
• Power to vote stock held by trust (if grantor holds the stock as an officer)
• Power to control voting of stock in a closely-held corporation
• Power to substitute trust property with property of equivalent value

The last one — power to substitute property — is the most useful in IDGT design. The grantor retains it WITHOUT making the trust includible in their estate.

§676 — Power to revoke. If the grantor can revoke the trust, it's automatically grantor-trust. This is why revocable trusts are always grantor-trust.

§677 — Income for grantor's benefit. If trust income is or could be distributed to (or for the benefit of) the grantor or grantor's spouse, it's a grantor trust. Note: even the possibility of distribution is enough.

§678 — Power in person other than grantor. Rare. Applies if a person other than the grantor has a withdrawal power that would make them treated as the owner for tax purposes.

§679 — Foreign trusts. If a US person funds a foreign trust with a US beneficiary, the foreign trust is treated as a grantor trust regardless of the other rules.

Why intentionally trigger grantor-trust status?

The Intentionally Defective Grantor Trust (IDGT) is "defective" only for INCOME tax purposes. The grantor pays the trust's income tax personally — which is effectively a tax-free gift to the trust beneficiaries (the trust corpus grows untaxed). For ESTATE tax purposes, the trust is NOT in the grantor's estate.

The cleanest way to trigger grantor-trust status without triggering estate inclusion:

Worked example:

A grantor funds a $10M IDGT. The grantor retains the §675 power to substitute property of equivalent value. The trust is grantor-trust for income tax — meaning the grantor pays tax on trust income.

Over 20 years, the trust earns 6% growth. Trust corpus would grow to $32M tax-free (if grantor pays the tax personally). If the trust were a non-grantor trust paying its own tax at 37%, post-tax growth would be only ~3.8%, growing to about $21M.

Difference: $11M more in the trust at grantor's death, all outside the grantor's estate. This is one of the highest-leverage techniques in estate planning.

Risks of grantor-trust status:

• Cash flow burden. The grantor must come up with cash to pay trust income tax annually, which could be substantial.
• Income tax bracket creep. Adding trust income to the grantor's personal return may push them into a higher bracket.
• "Turn-off" mechanism. Sometimes grantors want to turn off grantor-trust status (when they become unable or unwilling to keep paying tax). The trust agreement should anticipate this.

For the exam:

CFA L3 tests this conceptually. You should know:

• Grantor-trust rules (the seven IRC sections)
• Intentionally Defective Grantor Trust (IDGT) concept
• Substitution power as the cleanest IDGT trigger
• Trade-off: grantor pays trust income tax personally as a benefit