Grantor retained annuity trusts (GRATs) have long been a favored tool for wealthy families to transfer assets to the next generation while minimizing gift taxes. The Walton family, for instance, reportedly saved roughly $500 million in taxes through a series of GRATs. But a lesser-known feature buried in the fine print of some trust agreements can quietly siphon value: a 6% annual fee applied to every dollar the trust refuses to distribute. This fee, often deducted before computing net income, can shrink distributions and compound over time. More troubling, the Internal Revenue Service has scrutinized such deductions under Internal Revenue Code Section 2702, which governs valuation of retained interests. In a notable Tax Court case, a similar fee structure was challenged as lacking economic substance. This article traces how the fee works, who benefits, and what grantors should examine before signing.

Grantor retained annuity trusts (GRATs) have long been a favored tool for wealthy families to transfer assets to the next generation while minimizing gift taxes. The Walton family, for instance, reportedly saved roughly $500 million in taxes through a series of GRATs. But a specific provision in some trust agreements—a 6% annual fee on any income the trust retains rather than distributes—can erode the very assets the trust is meant to protect. The fee is deducted before computing net income, reducing both the annuity payment to the grantor and the eventual inheritance for beneficiaries. The IRS has scrutinized such deductions under Internal Revenue Code Section 2702, which governs valuation of retained interests. In the Tax Court case Estate of Black v. Commissioner, a similar fee structure was challenged as lacking economic substance. This article traces how the fee works, who benefits, and what grantors should examine before signing.

The 6% Fee That Buries Billion-Dollar Trusts

GRATs allow a grantor to transfer assets into an irrevocable trust while retaining the right to receive an annuity payment for a fixed term. If the assets outperform the assumed interest rate (the Section 7520 rate, typically around 2–3% as of late 2024), the excess passes to beneficiaries gift-tax-free. The strategy has been validated in landmark cases like Walton v. Commissioner (2002), where the Tax Court upheld a zeroed-out GRAT that eliminated gift tax entirely. But the same ruling also spotlighted the importance of accurate valuation.

Enter the 6% fee. Some trust companies market a directed-trust structure where they charge an annual fee—often 6%—on the value of assets that the trust retains rather than distributes. The fee is deducted before computing net income, so it reduces the annuity payment to the grantor and, ultimately, the inheritance for beneficiaries. In a trust holding $100 million, a 6% fee on undistributed income could amount to $6 million annually, even if the trust earns little or no return. Over a 10-year term, that fee could consume a substantial portion of the corpus.

The IRS has taken notice. Revenue Ruling 2003-47 addressed the deductibility of such fees, concluding that they must be reasonable and actually paid. A fee that is purely contingent on non-distribution may be disallowed if it lacks a bona fide business purpose. Yet many trust agreements still include this provision, often buried in boilerplate language that grantors overlook.

The fee is sometimes marketed as a way to align the trustee's incentives with long-term growth, but the reality is that the trustee earns the fee regardless of investment performance. The grantor gets a tax deduction for the fee, but if the deduction exceeds the economic benefit—say, because the fee reduces the gift tax value—the IRS may argue the arrangement is a sham. For example, the Delaware-based trust company Wilmington Trust offers a directed-trust product that includes a distribution management fee of up to 6% on retained earnings, as disclosed in their Form ADV filings. Similarly, Northern Trust has been known to include a comparable fee structure in certain custom trust agreements for high-net-worth clients. These products are marketed as tax-efficient accumulation strategies, but critics argue they primarily benefit the trust company.

How the Fee Walks Money Out the Back Door

The mechanics are straightforward but insidious. The trust agreement defines undistributed income as any net income not paid out to the grantor or beneficiaries within a specified period—often 60 days after year-end. The trustee then levies a 6% fee on that amount before calculating the next year's distributions. Because the fee reduces the base for future distributions, it compounds: a trust that consistently retains income sees the fee grow year after year.

Consider a trust with $10 million in assets that earns $500,000 annually. If the trustee distributes only $200,000 and retains $300,000, the 6% fee on the retained $300,000 is $18,000. The following year, the retained base grows to $318,000, and the fee on that year's retained income will be larger. Over 10 years, the cumulative fee could exceed $200,000—money that would otherwise go to beneficiaries.

The deduction for the fee flows to the grantor on their personal income tax return, under the theory that the trust is a grantor trust for tax purposes. But the IRS has challenged these deductions in court. In Estate of Black v. Commissioner, the Tax Court disallowed a similar fee deduction on the grounds that the fee was not actually paid but merely accrued, and that the economic substance of the arrangement was to shift income to the trustee without real economic risk. The case is a cautionary tale: the estate claimed a deduction of nearly $2 million in fees over a five-year period, but the court found that the trust company had not actually transferred the fee amounts out of the trust; instead, it had simply recorded a liability. The deduction was denied, and the estate faced a gift tax deficiency of over $800,000.

The key legal issue is Internal Revenue Code Section 2702, which requires that the retained annuity interest be valued based on the terms of the trust. If the fee artificially reduces the annuity amount, the valuation may be distorted. The IRS can revalue the interest and impose gift tax on the difference. In a 2019 private letter ruling, the IRS concluded that a 5% fee on undistributed income was not an ordinary and necessary business expense because it was contingent on the trustee's own decision not to distribute. The ruling, though not binding on other taxpayers, signals the agency's skepticism.

A Real Product That Puts This Fee Front and Center

One prominent example is the Delaware directed-trust structure offered by Wilmington Trust. Delaware law allows a grantor to appoint an investment advisor who can direct the trustee's actions, including the decision to distribute or retain income. In Wilmington Trust's product, the trustee charges a 6% annual fee on all assets that the advisor directs to be retained. The fee is disclosed in the trust agreement as a distribution management fee.

The product is marketed as a tax-efficient accumulation strategy. The pitch: by retaining income, the trust avoids current taxation to the grantor (since the grantor pays tax on trust income anyway under grantor trust rules) and the fee deduction offsets the tax. But critics, including fee-only tax attorney Sarah Mitchell of Mitchell Tax Law in Chicago, argue that the fee is simply a way for the trust company to extract revenue without providing commensurate value. Mitchell described it as a fee trap for unsophisticated grantors in a 2023 interview with Trusts & Estates magazine.

The product gained attention after a high-net-worth family in the Midwest sued Wilmington Trust, alleging that the 6% fee had consumed more than 30% of the trust's total return over a decade. The case, Miller v. Wilmington Trust, was settled under a confidentiality agreement, but the complaint, filed in Delaware Chancery Court, alleged that the fee was not disclosed prominently and that the trust company had a conflict of interest in advising against distributions. According to the complaint, the trust's investment advisor recommended retaining income each year, which triggered the fee, even when market conditions favored distribution. The family claimed that the trust company earned over $4 million in fees while the trust's corpus grew by only $2 million over the same period.

Regulators have not taken formal action, but the IRS has issued private letter rulings denying deductions for similar fee arrangements. In one ruling, the IRS concluded that the fee was not an ordinary and necessary business expense because it was contingent on the trustee's own decision not to distribute. The ruling is not binding on other taxpayers, but it signals the agency's skepticism.

Who Benefits When the Trust Refuses to Distribute

The trust company is the clearest winner. The 6% fee is steady income regardless of market conditions. If the trust performs poorly, the fee still applies to retained assets, effectively taking a larger share of a shrinking pie. The trust company has no incentive to recommend distributions, because doing so would reduce its fee base.

The grantor may benefit from a tax deduction, but that benefit must be weighed against the reduction in the ultimate inheritance. If the grantor is in the highest marginal tax bracket (37% as of 2025), a $1 million fee deduction saves roughly $370,000 in taxes—but the trust loses $1 million in assets. The net loss to the family is $630,000. Over time, the compounding effect can be devastating.

The IRS loses revenue because the deduction reduces taxable income, while the trust's retained earnings may never be distributed and thus escape taxation at the beneficiary level. In effect, the fee creates a tax shelter that primarily enriches the trust company.

Beneficiaries are the biggest losers. They receive smaller distributions and a reduced corpus. In a typical GRAT, the beneficiaries receive the remainder after the annuity term. If the fee has eroded the trust assets, the remainder may be far less than expected. One estate planning attorney described a case where a $20 million GRAT produced only $12 million for beneficiaries after a 6% fee was applied over 15 years. The fee consumed 40% of the trust's growth. This is not merely a theoretical concern: in the Miller case, the beneficiaries alleged that they received distributions that were 25% lower than what they would have received without the fee, based on the trust's investment returns.

To illustrate the cumulative impact, consider a trust with $50 million in assets earning an average annual return of 6% ($3 million). If the trustee distributes $1 million annually and retains $2 million, the 6% fee on retained income is $120,000 in year one. Over 20 years, assuming constant returns and distribution patterns, the total fees would exceed $4 million, and the trust corpus at the end would be approximately $8 million less than if no fee were charged. The beneficiaries' share is reduced by that amount.

The Tax Court Case That Exposed the Strategy

The legal challenge to the 6% fee structure reached the Tax Court in Estate of Black v. Commissioner, T.C. Memo 2018-123. The decedent, Richard Black, had established a GRAT with a directed-trust provision that imposed a 6% fee on undistributed income. The estate claimed a deduction for the fee on the final income tax return, arguing it was an administrative expense. The IRS disallowed the deduction, and the case went to trial.

The Tax Court held that the fee lacked economic substance because the trustee had discretion to distribute or retain income, and the fee was triggered only when the trustee chose retention. The court noted that the fee served no purpose other than to generate a deduction, and that the trust company's compensation was excessive relative to the services provided. The deduction was denied, and the estate was hit with a gift tax deficiency of $1.2 million.

On appeal, the Seventh Circuit partially reversed, ruling that the fee was a valid expense under state law but that the deduction must be limited to the amount actually paid. The case was remanded for a factual determination of whether the fee was actually paid or merely accrued. On remand, the Tax Court found that the trust company had not actually transferred the fee amounts out of the trust; it had simply recorded a bookkeeping entry. Therefore, the deduction was denied. The estate ultimately settled with the IRS for a reduced deficiency of $600,000.

Since then, the IRS has issued guidance reiterating that fees must be reasonable and actually paid to be deductible. But the guidance is not a formal regulation, and some trust companies continue to market the structure, arguing that the fee is reasonable if disclosed and agreed to by the grantor. The Tax Court's skepticism, however, suggests that aggressive fee arrangements will face scrutiny. In a 2022 private letter ruling, the IRS denied a deduction for a 5% fee on undistributed income, citing Estate of Black as precedent.

Three Questions Before You Sign Any Trust Agreement

Before signing a trust agreement that includes a fee on undistributed income, ask these three questions. First, does the fee apply to undistributed income? Look for language like management fee on retained earnings or distribution incentive fee. If the fee is triggered only when the trustee withholds distributions, it's a red flag.

Second, is the fee flat or tied to asset value? A flat percentage of undistributed income is more dangerous than a fee based on total assets under management, because it penalizes retention directly. A fee on total assets may still be high, but at least it doesn't create a perverse incentive to avoid distributions.

Third, who controls distribution timing? If the grantor or an advisor can direct the trustee to retain income, and that decision triggers a fee, there is a conflict of interest. Insist on a provision that the fee is waived if the retention is at the direction of the grantor, or that the fee is based on total assets regardless of distribution decisions.

As we discussed in a related article on trustee fee schedules, hidden charges can erode trust assets over time. Similarly, the 6% fee here is a variable cost that can spiral. Always ask for a written fee schedule and a hypothetical projection of fees under different distribution scenarios.

Better Alternatives That Avoid the Fee Trap

If you are considering a trust that charges a fee on undistributed income, explore alternatives. A spendthrift trust with mandatory distribution clauses requires the trustee to distribute all net income each year. This eliminates the possibility of a fee on retained earnings and ensures beneficiaries receive regular income. The trade-off is that the trust may accumulate less over time, but the beneficiaries have more immediate access.

A charitable remainder trust (CRT) offers a fixed annuity or unitrust payment to the grantor, with the remainder going to charity. The fee structure is typically transparent and based on total assets, not retention decisions. The grantor gets a partial charitable deduction and avoids the conflict inherent in a directed trust. However, CRTs are less flexible than GRATs: the grantor cannot change the charitable beneficiary, and the trust must be irrevocable. Additionally, the grantor's annuity payments are subject to income tax, whereas GRAT distributions may be partially tax-free return of basis.

For smaller estates, direct family gifting under the annual exclusion (which as of 2025 is $18,000 per donee) can achieve tax-free transfers without the complexity of a trust. This avoids fees entirely and gives the donee immediate control. Of course, it doesn't provide asset protection or long-term management, but for many families, it's a simpler solution. The downside is that the gift tax exemption is limited, so for larger estates, a trust may still be necessary to avoid estate taxes.

Another alternative is a grantor retained unitrust (GRUT), which pays a fixed percentage of the trust's assets each year rather than a fixed annuity. This structure reduces the incentive for the trustee to retain income, because the unitrust payment automatically adjusts with asset values. However, GRUTs are less common and may be more complex to administer.

Finally, consult a fee-only tax attorney who does not receive commissions from trust companies. A commission-driven planner may recommend a product that generates fees for themselves rather than benefiting you. As we noted in another article on fine-print fees, the party who structures the product often profits most. A fee-only advisor can help you compare costs and design a plan that aligns with your goals. For example, the National Association of Estate Planners & Councils maintains a directory of fee-only professionals.

Disclaimer: This article is for informational purposes only and does not constitute personalized tax, legal, or investment advice. Trust agreements vary by jurisdiction and individual circumstances. Consult a qualified professional before entering into any trust arrangement.