Understanding grantor trusts, compressed tax brackets, and the overlooked power of Section 678

I recently attended the North Texas Probate Bench Bar and had the pleasure of hearing John Hunter of the Blum Firm speak on the 678 Trust. John and I have crossed paths before, and he is someone worth listening to on this topic. His presentation prompted me to think carefully about something that gets less attention than it deserves in estate planning conversations: the income tax problem that trusts create, and the three distinct ways the law lets you solve it.

Most discussions about trusts focus on estate tax savings. That’s understandable. A 40% tax on assets at death is a powerful motivator. But the income tax consequences of how a trust is structured are just as important, and they play out every single year during the trust’s life, not just at the end. Getting this wrong can silently cost a family hundreds of thousands of dollars over time.

The Problem: Trusts Are Taxed Differently (and Worse)

Here is the core issue. The federal income tax brackets for trusts are severely compressed compared to those for individuals. In 2024, a trust hit the top income tax bracket of 37% at just $15,200 of taxable income. A single individual doesn’t reach that same 37% bracket until taxable income exceeds $609,350. A married couple filing jointly doesn’t get there until $731,200.

That means a trust earning $150,000 per year is paying the maximum federal rate on almost all of it. An individual earning the same amount is taxed at materially lower rates on most of it. The difference isn’t trivial. Over the life of a multi-generational trust holding $10 million in investment assets, this compressed rate structure can cost the family millions of dollars in entirely avoidable income tax.

This is not an accident of drafting. It’s structural. Congress did it deliberately in 1986 to kill the strategy of shifting income from high-bracket individuals to lower-bracket trusts. The problem is that the same compression now applies to trusts that are not trying to shift income at all. The income tax penalty has become collateral damage for legitimate planning.

So how do you fix it? The tax code actually gives us three distinct modes for how a trust can be taxed, and a sophisticated estate plan takes advantage of all three.

Mode 1: Taxed as the Grantor

The first mode is the most commonly used tool in modern estate planning: the Intentionally Defective Grantor Trust, or IDGT. Under the grantor trust rules in Sections 671 through 677 of the Internal Revenue Code, if the person who creates and funds a trust (the grantor) retains certain rights or powers over the trust, the grantor (not the trust) is treated as the income tax owner of the trust’s assets.

This is “defective” in the sense that it defeats the old strategy of income-shifting to a trust, but “intentional” because the failure is engineered on purpose. The grantor pays the income taxes on trust earnings at their individual rate, which in most cases is far more favorable than the trust’s compressed rates. This has two additional effects that make the IDGT one of the most powerful estate planning vehicles available.

First, the grantor’s payment of the trust’s income taxes is not treated as a taxable gift to the trust. The economic benefit flows to the trust beneficiaries (they receive the value of assets that grow without being eroded by income taxes), but the grantor pays the bill without gift tax consequence. It’s as though the grantor is making an additional tax-free gift every year equal to the trust’s income tax liability.

Second, because the grantor and the trust are the same person for income tax purposes, transactions between them (including sales of appreciated assets) are not recognized for income tax. This is what makes the installment sale to a grantor trust work as an estate freeze technique.

The most common mechanism for creating grantor trust status is the “swap power” — the grantor retains a nonfiduciary right to reacquire trust assets by substituting other property of equivalent value. This has no estate or gift tax consequence under existing IRS guidance, but it causes the entire trust to be taxed to the grantor for income tax purposes.

Mode 2: Death of the Grantor: The Trust Stands Alone

Grantor trust status doesn’t last forever. When the grantor dies, it ends. The trust then becomes what the Code calls a non-grantor trust, and it is taxed as a separate entity under the Subchapter J rules, precisely the compressed bracket structure we described above.

For trusts designed to outlast the grantor and benefit multiple generations of descendants, this is not an incidental detail. It’s a structural feature that must be planned around. A $10 million trust that was growing tax-efficiently during the grantor’s lifetime can suddenly become a significant taxpayer at the grantor’s death, every year, for as long as the trust exists.

There are planning responses to this. Some clients choose to distribute trust income to beneficiaries annually, who then report it on their individual returns at their own rates. Others use distributions for expenses that effectively consume taxable income. The grantor trust status can in some cases be “toggled” off before death if the grantor no longer wishes to bear the income tax liability, giving the family flexibility in managing the transition. But the point is this: the end of the grantor’s life is a meaningful inflection point for the trust’s income tax profile, and planning for it deserves as much attention as planning for the estate tax at that same moment.

Mode 3: Beneficiary as Grantor: The 678 Solution

This is where Section 678 enters the picture, and it’s genuinely interesting.

What if you could achieve grantor trust treatment – income taxed at favorable individual rates, tax-free transactions between the trust and its deemed owner – without the grantor bearing the income tax burden? What if, instead, the beneficiary of the trust was treated as the grantor?

That’s exactly what Section 678 accomplishes. Under this provision, a person other than the trust’s grantor is treated as the deemed owner of the trust (and therefore liable for its income taxes at their individual rate) if that person holds a power to withdraw the trust’s corpus or income. The trust is still a grantor trust for income tax purposes. The trustee doesn’t file a separate trust income tax return. The assets grow without being depleted by the compressed trust rate structure. But it’s the beneficiary paying the taxes, not the original grantor.

The practical mechanism is a withdrawal right. A third party (a parent, sibling, or close friend) creates the trust and seeds it with a modest gift (typically $5,000). The beneficiary receives a short-term right to withdraw that contribution. When the right lapses, the income tax law continues to treat the beneficiary as the trust’s owner, because the beneficiary now retains a beneficial interest in the trust that, under the principles of the grantor trust rules, would make any grantor the deemed owner of the trust.

The estate tax law, however, does not follow this same logic. Because the gift was small enough to fall within what’s known as the “5 and 5” exception (allowing a lapse of up to the greater of $5,000 or 5% of trust assets without estate tax consequence), the trust assets are not included in the beneficiary’s taxable estate. The income tax code and the estate tax code are looking at the same lapse and reaching opposite conclusions. That “disconnect” is the engine of the 678 Trust.

Why This Creates a Genuinely Valuable Planning Opportunity

Stepping back, what we have is a trust that can be toggled across three meaningfully different income tax profiles depending on how it is designed and when in its life cycle you are evaluating it.

During the grantor’s lifetime, the trust can be structured as a traditional grantor trust, with income taxed to the grantor at favorable individual rates. When the grantor’s circumstances change, or when the grantor dies, the trust can transition. And where the beneficiary is the appropriate person to bear the income tax burden (because their rates are favorable, and because keeping the tax bill inside the trust would be far more expensive), the 678 structure allows the beneficiary to step into the grantor’s shoes.

For clients with large estates who are thinking about how to structure multi-generational trusts, this framework is worth taking seriously. The estate tax savings often get the headlines. But a trust that is poorly structured for income tax purposes can quietly give back a meaningful portion of those savings over time.

In the second post in this series, we will take a closer look at the two most prominent vehicles that use Section 678 in practice, the Beneficiary Defective Inheritor’s Trust and the Beneficiary Deemed Owner Trust, along with the legal questions and economic risks that come with each.

Read Part 2 of this series →

This post is for informational purposes only and does not constitute or contain tax or legal advice.