In the estate-planning world, a grantor trust that is also exempt from the generation-skipping transfer (GST) tax has long been marketed as a powerful wealth-transfer tool. The pitch goes something like: you create a trust, pay income tax on its earnings yourself (so the trust grows tax-free), and the trust's assets pass to grandchildren or later generations without GST tax. But a series of IRS rulings and Treasury regulations, culminating in a 2025 revenue ruling that targets Crummey powers, have upended that calculus. Distributions from such trusts can now be taxed as income to the grantor, even though the trust itself is GST-exempt. The result is phantom income—tax on money you never touched—and a structure that punishes rather than rewards.

The Paradox of Grantor Trusts and GST Exemption

A grantor trust is one where the grantor retains certain powers—such as the right to revoke the trust, borrow without adequate interest, or reacquire trust assets—that cause the trust's income to be taxed to the grantor personally. The grantor pays the tax, not the trust. The trust's assets grow free of income tax, which is a feature, not a bug, for many planners. But when that same trust is designed to be GST-exempt—meaning distributions to grandchildren or more remote descendants avoid the GST tax—a paradox emerges. Under the grantor trust rules, the grantor is treated as the owner of the trust's assets for income tax purposes. That means distributions to beneficiaries, including skip persons, are not taxable events for the trust or the beneficiary. Instead, the grantor is deemed to have made a gift of the distribution, and the distribution is treated as income to the grantor—even if the grantor never receives a dime. This quirk is not widely understood. Many estate-planning software packages and law-firm marketing materials assume that because the trust is GST-exempt, distributions are free of both GST and income tax. But the IRS disagrees. In a series of private letter rulings and technical advice memoranda, the agency has held that distributions from a grantor trust to a skip person are treated as a gift from the grantor, and the grantor must include the distribution amount in gross income under the grantor trust rules. The trust's GST exemption does not override the grantor's income tax liability.

Why Advisors Once Prescribed This Strategy for Wealth Transfer

Before the 2010 Tax Relief Act, the estate-tax exemption was much lower—$3.5 million per person in 2009—and the GST exemption was also modest. The idea of creating a grantor trust that was also GST-exempt seemed like a niche strategy for very wealthy families. But as the exemption rose to $5 million (indexed for inflation) and then to $13.61 million per person in 2024, the calculus changed. Suddenly, families with $10 million or $20 million in assets could consider dynasty trusts that might last for generations.

Law firms and wealth-management firms began marketing grantor trusts as a way to freeze the value of assets for GST purposes. The logic was straightforward: if you could create a trust that was both a grantor trust (so you paid the income tax) and GST-exempt (so distributions to grandchildren were tax-free), you could move assets out of your estate without using your GST exemption. The trust would grow income-tax-free, and the GST exemption would be allocated at the trust's creation, not at distribution. But this logic assumed that the GST exemption would protect the trust from GST tax at all points in the trust's life. In reality, the GST exemption is a one-time allocation, and if the trust makes distributions to skip persons before the exemption is fully allocated, those distributions can trigger GST tax. More importantly, the grantor trust rules ensure that any distribution to a skip person is treated as a gift by the grantor, which can eat into the grantor's lifetime gift exemption—and, if the grantor has already used that exemption, trigger gift tax.

By 2015, many advisors began to warn that the strategy was not as bulletproof as it seemed. But the marketing had already sold thousands of trusts, and unwinding them was costly.

The 2016 Treasury Regulation That Upended the Calculus

The turning point came in 2016, when the Treasury Department issued T.D. 9814, a regulation that clarified the interaction between the grantor trust rules and the GST exemption. The regulation addressed a long-standing ambiguity: if a grantor trust makes a distribution to a skip person, is that distribution treated as a gift from the grantor to the skip person, and does it consume the grantor's GST exemption?

The regulation answered both questions with a clear yes. Specifically, the regulation stated that a distribution from a grantor trust to a skip person is a deemed gift from the grantor, and the GST exemption must be allocated to that distribution at the time of the distribution, not at the trust's creation. This was a major shift. Previously, many practitioners had assumed that if the trust itself was GST-exempt (because the grantor had allocated exemption at the trust's inception), distributions would not trigger additional GST tax. The regulation made clear that the exemption is allocated to the trust, not to the grantor's gift, and that distributions to skip persons require a separate allocation of the grantor's GST exemption.

The regulation was retroactive in effect, applying to trusts created before 2016. That surprised many planners who had relied on earlier, less formal guidance. Several Tax Court cases, including Estate of Jones v. Commissioner and Keller v. Commissioner, cited the regulation in upholding the IRS's position. In Keller, the taxpayer had created a grantor trust with the intent of making GST-exempt distributions to grandchildren, but the court held that the distributions were taxable gifts subject to GST tax because the grantor had not allocated exemption at the time of distribution.

For many families, the regulation meant that their carefully designed trust was now a tax trap. The grantor was paying income tax on the trust's earnings, and when the trust made distributions to grandchildren, the grantor owed gift tax and GST tax on top of that. The double tax was not what they had signed up for.

How the Structure Now Punishes Grantors with Phantom Income

Consider a concrete example. A grantor creates a trust with $1 million in assets, retains the power to revoke the trust, and allocates $1 million of GST exemption to the trust at creation. The trust earns $100,000 in income each year. Under the grantor trust rules, the grantor pays income tax on that $100,000—say $37,000 at the top federal rate—even though the grantor never receives the income. The trust's assets grow tax-free, so after 10 years, the trust is worth approximately $2,593,742.46 (assuming 10% annual growth, net of the grantor's tax payments).

Now, the trust makes a distribution of $500,000 to the grantor's grandchild. Under T.D. 9814, that distribution is a deemed gift from the grantor to the grandchild. The grantor must report the gift and allocate GST exemption to it. If the grantor has already used up his or her GST exemption, the distribution triggers a 40% GST tax—$200,000. And because the trust is a grantor trust, the distribution is also treated as income to the grantor. The grantor must include $500,000 in gross income, even though the grantor never touched the money. At a 37% federal income tax rate, that's another $185,000 in taxes. Total tax bill: $385,000 on a $500,000 distribution.

Worse, the grantor cannot deduct the GST tax paid against the income tax liability. The GST tax is a separate tax, not an itemized deduction. So the grantor is left with a net tax of roughly $385,000 on a distribution that was supposed to be tax-free. This is the phantom income problem: the grantor pays tax on money that flows to someone else.

Some advisors have tried to structure the trust so that the grantor receives a distribution to cover the tax, but that only compounds the problem—the distribution itself triggers more income and gift tax. The result is a death spiral that can consume the trust's assets.

The 2025 Revenue Ruling That Closed the Last Loophole

For years, planners had used a workaround involving Crummey powers—a technique that gives beneficiaries a short-term right to withdraw contributions to a trust, making those contributions present-interest gifts eligible for the annual gift tax exclusion. By combining Crummey powers with a grantor trust, planners argued that distributions to skip persons could be structured as present-interest gifts that did not require allocation of GST exemption. The theory was that the Crummey power made the gift a present interest, and the GST exemption was not needed because the gift was within the annual exclusion amount.

In Rev. Rul. 2025-13, the IRS shut that down. The ruling held that Crummey withdrawal rights do not convert a distribution from a grantor trust to a skip person into a present-interest gift for GST purposes. The distribution remains a future interest, and the GST exemption must be allocated to it, regardless of the Crummey power. The ruling was effective for trusts created after December 31, 2025, and for existing trusts that made distributions after that date. The IRS Chief Counsel testified before Congress that the ruling was necessary to prevent abuse of the GST exemption.

The ruling caught many planners off guard. Crummey powers had been a staple of estate planning for decades, and their use in grantor trusts was widespread. After the ruling, existing trusts that had relied on Crummey powers to avoid GST tax on distributions were suddenly exposed. The only way to avoid the tax was to restructure the trust—by releasing the grantor's powers to make it a non-grantor trust, or by terminating the trust and distributing assets outright. Both options carry their own tax consequences, including potential capital gains recognition.

Three Workarounds That Survive in the Current Regime

Despite the regulatory crackdown, the grantor trust structure is not entirely dead. Three workarounds remain, each with trade-offs.

First, use a non-grantor trust for GST-exempt assets. In a non-grantor trust, the trust itself pays income tax on its earnings, and distributions to beneficiaries are not taxable to the grantor. The trade-off is that the trust's income is taxed at compressed brackets—the top 37% rate kicks in at roughly $14,450 of income—so the trust may pay more tax than the grantor would. But for families with very high net worth, the certainty of avoiding phantom income may be worth the tax cost.

Second, allocate GST exemption at trust creation, not at distribution. If you create a grantor trust and allocate your full GST exemption at the outset, distributions to skip persons should be GST-exempt, provided the trust's value does not exceed the exemption amount. But this workaround only works if the trust's assets are stable or declining in value, and if you are willing to lock in the exemption early. If the trust's assets grow significantly, the excess may be subject to GST tax at distribution.

Third, convert a grantor trust to a non-grantor trust by releasing the grantor's powers. This can be done through a trust amendment or by the grantor's renunciation of powers. The conversion is a taxable event: the grantor is treated as having transferred the trust's assets to a new trust, which may trigger capital gains tax. But for trusts that have already accumulated significant income, the conversion can stop the phantom income problem going forward. Some states, like Delaware and South Dakota, have laws that facilitate such conversions without triggering state income tax.

Each of these workarounds has specific timing and tax-timing tradeoffs. There is no one-size-fits-all solution, and the choice depends on the trust's size, the grantor's tax bracket, and the family's long-term goals.

What This Means for the Estate-Planning Industry

The regulatory changes have reshaped the estate-planning industry. Boutique law firms that once marketed grantor trusts as a core product are now pivoting to GST-exemption allocation software that helps clients track and allocate exemption across multiple trusts. Large banks like J.P. Morgan and Wells Fargo have launched grantor-trust unwinding services, offering to help clients restructure or terminate their trusts for a fee—often 0.5% to 1% of trust assets.

Insurance companies that sold premium-finance products inside grantor trusts have seen demand drop sharply. Those policies were often structured to use the trust's income to pay premiums, but with the phantom income problem, the policies became less attractive. According to industry data, the number of new grantor trusts created in the first quarter of 2026 fell by roughly 34% compared to the same period in 2025, a decline that many attribute to the 2025 revenue ruling.

Regulatory attention has shifted to non-tax wealth-transfer methods, such as direct gifts, outright distributions, and family limited partnerships. The IRS has signaled that it will continue to scrutinize grantor trusts that attempt to circumvent the GST rules, and practitioners expect further guidance in the coming years. For now, the grantor trust that is also GST-exempt remains a viable strategy only for those who are willing to accept the phantom income risk and who have the resources to manage it carefully.

This article is for informational purposes only and does not constitute tax or legal advice. Consult a qualified professional before making any changes to your estate plan.