Basic Trust & Estate Income Tax Planning, Including a Discussion of Intentionally Defective Grantor Trusts. Philip M. Lindquist, Dallas, TX

Transcription

1 Basic Trust & Estate Income Tax Planning, Including a Discussion of Intentionally Defective Grantor Trusts Philip M. Lindquist, Dallas, TX Copyright 2014 by K&L Gates LLP. All rights reserved.

2 Introduction

3 0. Introduction A. How is Internal Revenue Code divided? Sections. Title, Subtitle, Chapter, Subchapter, Part, Subpart. Subtitle A Income Taxes. Chapter 1 Normal Taxes and Surtaxes. Subchapter J. Subparts A, B & C Regular Trusts & Estates. Subpart E Grantor Trusts. Subtitle B Estate & Gift Taxes. Includes GSTT. Transfer Taxes.

4 0. Introduction B. The Great Divide in Subchapter J. Non-grantor or regular trust (and estate). Grantor aka: Defective Intentionally defective grantor trust ( IDGT ) C. Need to be aware of this divide because it is fundamental to income taxation of trusts you will be drafting. Goal this afternoon is to create awareness. Will never get to the place you will not need to look these rules up from time to time.

5 General Overview

6 I. General Overview A. Income Taxation Has Risen in Importance The estate and gift tax exemption of $5 million (in 2011 dollars) means only the most wealthy individuals have to worry about transfer taxes. The 40% estate and gift tax rate, down from a high of 77%, means that even when paid, estate and gift taxes may be less than potential income tax savings. Income tax rates for trusts and estates will often exceed 40% because of: Very compressed rate structure; The Obamacare 3.8% surtax; and State income taxes.

7 I. General Overview B. For income tax purposes, there are four basic classes of taxpayers: Individuals; Corporations (and associations taxable as corps.); Estates and Trusts; and Partnerships. There are subsets of these categories, such as grantor trusts, which are taxed under different rules. Guardianships, conservatorships, custodial accounts, bankruptcy estates, and receiverships are not trusts, and not separate taxpayers.

8 I. General Overview C. Income tax rates. IRC 1 has the income tax rates for all taxpayers except for corporations. What are these numbers? a. $457,600. b. $432,200. c. $406,750. d. $228,800. e. $12,150.

9 I. General Overview C. Income tax rates. $457,600 married individuals filing joint returns and surviving spouses. $432,200 heads of households. $406,750 unmarried individuals. $228,800 married individuals filing separate returns. $12,150 estates and trusts. Beginning of the 39.6% income tax bracket. Regulations says you cannot simply create multiple trusts to avoid or mitigate the progressive rate structure or the alternative minimum tax.

10 I. General Overview D. Net Investment Income Tax (Obamacare Surtax). $250,000 married individuals filing joint returns and surviving spouse with dependent child. $200,000 heads of household or single. $125,000 married individuals filing separate returns. $12,150 estates and trusts. Threshold for the 3.8% Obamacare surtax. So estates and trusts face a top marginal federal income tax of 43.4% on taxable income over $12,150.

11 I. General Overview E. Basis of Property Acquired from a Decedent. IRC (a)(2). When a person dies, the following property takes a new basis: Most property included in the taxable estate; Surviving spouse s 1/2 of community property; and Property on which a generation-skipping transfer tax is imposed because of a taxable termination. A new basis can be a huge tax benefit if assets have substantial unrealized capital gains. Property given takes a carry-over basis, with an adjustment for gift tax paid. IRC 1015.

12 I. General Overview E. Basis of Property Acquired from a Decedent. IRC Traditional by-pass estate planning foregoes a new basis at the second death in exchange for keeping assets out of the surviving spouse s taxable estate. Assume $3 million securities portfolio in by-pass trust doubles in value between the first and the second death. Capital gains tax exposure is $714,000 ($3 million * 23.8%). Will by-pass trust save taxes overall? How much estate tax will by-pass planning save? How much income tax will be paid, and when?

13 I. General Overview E. Basis of Property Acquired from a Decedent. IRC The high estate tax exemption and portability (if you can count on it) make planning to get a new basis at the second death attractive for many couples that do not have substantial estate tax exposure. Planning for couples with $5+ to $10+ million has gotten more complicated than it used to be. Consider: Expected appreciation rate and length of time; Expected income tax recognition date; Expected income tax rates at recognition; and Anticipated estate tax at second death.

14 General Rules

15 II. General Rules. A. General Taxable Income Rules. IRC 641. Taxable on all taxable income of the estate or trust. General rule is that taxable income is computed in the same manner as in the case of an individual. Tax shall be computed and paid by the fiduciary, (although beneficiaries are taxable on trust income, instead of the trust, to the extent the income is deemed to have been distributed to the beneficiaries).

16 II. General Rules. B. Special Rules for Credits & Deductions. IRC 642. Foreign tax credit may be allocated to beneficiaries. Deduction for personal exemptions. Estates - $600. Trusts required by their governing instrument to currently distribute all of their income for the taxable year (even if not simple trusts) and certain disability trusts - $300. All other trusts - $100.

17 II. General Rules. B. Special Rules for Credits & Deductions. IRC 642. Charitable deduction under 642(c) (not 170, 651 or 661). Can elect to treat amounts paid in year following taxable year as if paid in taxable year. No percentage of adjusted gross income limitations. No carry-overs for unused deductions. Estates (not trusts) for amounts permanently set-aside. Proportionate characterization of income contributed. Other special adjustments and rules. Limited for unrelated business taxable income.

18 II. General Rules. B. Special Rules for Credits & Deductions. IRC 642. Special rule for net operating loss deduction. Deduction for depreciation, depletion, and amortization may be allocated to beneficiaries. Cannot take an income tax deduction for amounts deductible for estate tax purposes for administration expenses and uninsured casualty and theft losses. Exception if the estate tax deduction is waived. Similar rule applies for administration expenses incurred with respect to taxable distributions and terminations for generation-skipping transfer tax purposes.

19 II. General Rules. B. Special Rules for Credits & Deductions. IRC 642. If a trust or estate does not have enough taxable income to use all of its loss carryovers or deductions, they are not deductible by the beneficiaries. The theory is that if there is not enough income, then trust or estate corpus was used for the carryover or deduction, and the beneficiaries have not suffered a loss.

20 II. General Rules. B. Special Rules for Credits & Deductions. IRC 642. The exception is the year in which the estate or trust terminates, when: a net operating loss carryover; a capital loss carryover; and deductions (other than the personal exemption and the charitable deduction) can be taken by the beneficiaries. Estates and trusts cannot be unreasonably prolonged, but they can continue past legal termination for a reasonable period for winding-up the administration.

21 II. General Rules. C. Types of Trusts and Estates for Income Tax Purposes (at least for our purposes). Decedent s estate. Simple trust. Complex trust. Electing small business trust. Charitable remainder trust. Grantor trust. Provisions regarding foreign trusts and other particular kinds of trusts are beyond our scope today.

22 II. General Rules. D. IRC 643(a) defines distributable net income as the taxable income of the estate or trust for the taxable year with the following modifications: No deduction for distributions; No deduction for the personal exemption; Some capital gains and losses are excluded; Some extraordinary dividends and taxable stock dividends are excluded for simple trusts; Net tax-exempt interest is included. Special rules for foreign trusts and abusive transactions.

23 II. General Rules. D. To the extent a distribution is made from a trust that has different kinds of income (taxable, taxexempt, foreign, etc.): The general rule is that each distribution shall be deemed to consist of the same proportion of each class of items of income of the estate or trust as the total of each class bears to the total of all classes; and The exception is if there are specific provisions in the governing instrument to the contrary. I.R.C. 652(b), 661(b) and 662(b).

24 II. General Rules. E. Other Defined Terms. For purposes of the non-grantor trust income tax rules, the term income, when not preceded by the words taxable, distributable net, undistributed net, or gross, means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. IRC 643(b). State law may treat unitrust amount as income or provide for adjustments between principal and income. Beneficiary includes heirs, legatees, and devisees. IRC 643(c).

25 II. General Rules. F. Treatment of property distributed in kind. IRC 643(e). The basis of any property received by a beneficiary in a distribution from an estate or trust shall be the adjusted basis of such property in the hands of the estate or trust immediately before the distribution, adjusted for any gain or loss recognized to the estate or trust on the distribution.

26 II. General Rules. F. Treatment of property distributed in kind. The amount of a distribution of property for purposes of computing the amount of taxable income deducted by the estate or trust as a distribution, and includible by the beneficiary in income, shall be the lesser of: The basis of such property in the hands of the beneficiary (see prior slide); or The fair market value of the property. An election can be made for the year to recognize gain or loss as if the property were sold to the distributee at its fair market value with the taxable distribution to the beneficiary being at fair market value.

27 II. General Rules. G. Estimated tax for a trust and back-up withholding for a trust or estate can be treated as if they were a part of the taxable distribution for a beneficiary who then gets credit for the tax payment. IRC 643(d) and (g). H. Taxable year. IRC 644. For an estate, a trust exempt from tax or a charitable trust, the first taxable year can end on the last day of any month as long as the first taxable year is not more than one year. For all other trusts the taxable year is the calendar year.

28 II. General Rules. I. An estate and the decedent s revocable trust can, for the estate s first year, irrevocably elect to treat the trust as a part of the estate for income tax purposes. IRC 645. The election is made by both the estate s executor and trustee of the revocable trust. The period for which the election is made ends: Two years after decedent s death, if no estate tax return is required to be filed; and Six months after the date when the estate tax is finally determined if an estate tax return is required.

29 Simple Trusts

30 III. Simple Trusts. To be a simple trust for the taxable year, the terms of the trust (but not an estate) for the taxable year must: Provide that all of its income is required to be distributed currently (IRC 651(a)(1); Do not provide that any amounts are to be paid, permanently set aside or used for charitable purposes (IRC 651(a)(2); and And does not make any distribution other than current income (Treas. Reg (a)-1). Note that last requirement is not in IRC. Year to year determination (and never in last year).

31 III. Simple Trusts. A simple trust is allowed a deduction in computing its taxable income for the amount of the income required to be distributed currently (limited to the trust s taxable distributable net income). IRC 651. The amount allowed as a deduction to the trust is included in the income of the beneficiary (or beneficiaries), whether distributed or not. IRC 652(a). The character of the amounts included in income are the same as the character in the hands of the trust. IRC 652(b).

32 Complex Trusts and Estates

33 IV. Complex Trusts and Estates. For trusts that are complex trusts (i.e., not simple trusts) and estates, a deduction is allowed from income for the taxable year for amounts required to be or otherwise properly distributed to the beneficiaries. IRC 661(a). The deduction may not exceed taxable distributable net income of the estate or trust. IRC 661(a). The character of the amounts included in the distributed income are the same as the character in the hands of the trust. IRC 661(b) and 662(b). The amount allowed as a deduction to the trust is included in the beneficiaries income. IRC 662(a).

34 IV. Complex Trusts and Estates. Special rules. Whether or not capital gains are properly included in taxable distributable net income of the trust depends upon the terms of the governing document and the trustee s prior allocation of capital gains to income or corpus, but a trustee s initial reasonable exercise of discretion will be respected if it is consistent with the treatment by that trust in prior years. If the estate or trust have different taxable years, the beneficiary includes the income of the estate or trust in the beneficiary s taxable year in which the taxable year of the estate or trust ends. IRC 662(c).

35 IV. Complex Trusts and Estates. Special rules. A gift or bequest that per the terms of the governing instrument is a pecuniary or specific bequest or gift and paid or credited in not more than 3 installments (including all at once) are not treated as distributions for this purpose. IRC 663(a)(1). Charitable gifts are deducted under the charitable deduction provision and not under these provisions. IRC 663(a)(2). A distribution can only carry out distributable net income for one year, so no double deductions. IRC 663(a)(3).

36 IV. Complex Trusts and Estates. Special rules. An election can be made to treat amounts paid within the first 65 days of a taxable year of an estate or complex trust as having been paid on the last day of the preceding taxable year of the estate or trust. IRC 663(b). Substantially separate and independent shares of a trust for different beneficiaries are to be treated as separate trusts, and this rule is mandatory for estates. IRC 663(c).

37 Electing Small Business Trusts

38 V. Electing Small Business Trusts ( ESBIT ). S Corporations generally cannot have non-individual shareholders, with limited exceptions. IRC 1361(b)(1)(B). An ESBIT is one of the exceptions. IRC 1361(c)(2)(v). The S Corporation related income of the trust is computed separately from the trust s other income. IRC 641(c)(1). Trust s other income may include: Grantor portion (foreshadowing); and Non-grantor, non-s portion.

39 V. Electing Small Business Trusts ( ESBIT ). The S Corporation related income so computed is taxed at the top marginal income tax rate that applies to a trust without any distribution deduction. IRC 641(c)(2). An ESBIT can have a charity as a beneficiary. IRC 1361(e)(1(A). An election is required to be an ESBIT. IRC 1361(e)(3).

40 Charitable Remainder Trusts

41 VI. Charitable Remainder Trusts ( CRT ). A CRT is a trust that provides for annuity or unitrust distributions for a terms of years or specified life or lives with the remainder passing to charity and meets other technical requirements. IRC 664(d). A CRT does not pay income taxes. IRC 664(c)(1). Distributions from a CRT are generally taxable to the current beneficiary to the extent of current or accumulated income of the CRT. IRC 664(b).

42 Grantor Trusts

43 VII. Grantor Trusts. A. Grantor trusts are not normal and are under a completely different set of income tax rules Normally trustee and/or beneficiaries pay taxes on the income generated by the trust property Normally trust is a separate taxpayer Trust has its own taxpayer identification number Trust becomes subject to the trust & estate income tax rate schedule Trust property is used to pay income taxes on all income generated by the trust property Grantor trusts are ignored for tax purposes and income tax on trust income is generally imposed on the grantor

44 VII. Grantor Trusts B. Why were the grantor trust rules enacted? Income was being shifted to trust s lower income tax brackets Each trust has its own set of low income tax brackets Led to a protracted series of cases and legislative responses Should the trust be respected as a separate taxpayer? Should the trust s income taxed to the settlor? The grantor trust rules came to be relatively stable The rules became predictable Trusts could reliably be drafted to the trust income would not be added to the other income of the settlor

45 VII. Grantor Trusts C. The original reason for the complex grantor trust income tax rules largely became moot In the Tax Reform Act of 1986, the income tax brackets were narrowed to the point that there was little income tax benefit to be gained by shifting income from a topbracket taxpayer to a trust To the contrary, the tax brackets that applied to trusts and estates often became disadvantageous Regardless of the rate structure, some trusts, such as revocable trusts, are economically indistinct from their grantors

46 VII. Grantor Trusts D. Epiphany! Grantor trusts could be used to provide other tax benefits! Grantor can intentionally retain certain powers with respect to the property transferred to the trust Grantor will be treated as the owner of the trust property for federal income tax purposes. Trust will not be a taxpayer for income tax purposes Grantor will report items of income, deduction and credit associated with the trust property on her own individual income tax return and pay the resulting income tax The separate identity of the trust Will be ignored only for income tax purposes Will not be ignored for transfer tax & state law purposes

47 VII. Grantor Trusts E. The Tax Exclusive Gift Tax v. the Tax Inclusive Estate Tax, i.e., Why Gifts are More Tax Efficient After the $5.34 million exemption equivalent has been used, to transfer an additional $1 million after tax to a donee (other than a charity or spouse) Would cost $400,000 of gift tax if transferred inter vivos Would cost $666,667 of estate tax if transferred at death If donor dies within 3 years of the date of the gift, the difference is recaptured, but other differences remain See Exhibit A

48 VII. Grantor Trusts F. Grantor trust rules are in IRC Section If the grantor is treated as the owner of trust property under , trust s items of income, deduction and credit are used to compute grantor s taxable income and credits Grantor trust is treated as being but one and the same as the grantor Not clear from the statute Longstanding position of the IRS (Rev. Rul ) Position is not seriously questioned Unity of trust & grantor is only for income tax purposes

49 VII. Grantor Trusts F. Grantor trust rules are in IRC (cont.) Section 672 provides some definitions and ground rules Sections 673 through 679 describe various powers and controls that if retained by: The grantor, An affiliated party, or Sometimes even an unrelated party will cause the trust to be a grantor trust for federal income tax purposes

50 VII. Grantor Trusts F. Grantor trust rules are in IRC (cont.) Powers and controls include: The right to a reversionary interest in trust property ( 673) The power to control beneficial enjoyment of trust property ( 674) Various administrative powers with respect to trust property ( 675) The power to revoke the trust ( 676) and The right to income generated by trust property ( 677)

51 VII. Grantor Trusts G. A powerful vehicle for tax planning & wealth transfer Grantor s payment of income taxes on trust property is a gift not taxed by the federal transfer tax system Transactions between the grantor and the grantor trust are ignored for federal income tax purposes Grantor may use the trust losses against his personal income Grantor trust may be an eligible shareholder of a subchapter S corporation and Grantor trust can take advantage of the less compressed income tax rates that apply to individuals without making distributions to the trust beneficiaries

52 VII. Grantor Trusts H. Drawbacks to grantor trust status Grantor paying tax on trust income may be hardship Trust usually structured to prohibit reimbursement Mandatory reimbursement results in inclusion of all or part of trust corpus in grantor s taxable estate ( 2036(a)(1); Rev. Rul ) Permissive reimbursement would be okay except creditor s rights under most states laws will cause trust property to be included in grantor s taxable estate (Rev. Rul ) Income taxes may increase at a compound growth rate

53 VII. Grantor Trusts H. Drawbacks to grantor trust status (cont.) Possible solution might be a carefully structured loan from trust to grantor Possibility that grantor s payment of income taxes will be treated as a gift for federal gift tax purposes If state law or the trust agreement requires the trustee to reimburse grantor for her payment of the trust s income taxes but trustee doesn t reimburse grantor Gift to trust of the amount of the taxes that should have been reimbursed (Rev. Rul )

54 Grantor Trust Definitions and Rules

55 VIII. Grantor Trust Definitions and Rules A. Adverse Party Any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or non-exercise of the power which he possesses respecting the trust When grantor creates a trust and retains certain powers with respect to the trust property (such as a right to revoke), trust will be treated as a grantor trust If power may only be exercised with the approval of an adverse party, then trust may not be treated as a grantor trust Person having a general power of appointment over trust property has a beneficial interest in the trust

56 VIII. Grantor Trust Definitions and Rules A. Adverse Party (cont.) To determine if a potentially adverse party has an interest that is a substantial beneficial interest compare the value of the party s interest to the total value of the property subject to the party s power Interest is a substantial beneficial interest if the value of the interest is not insignificant when compared to total value of property subject to the party s power If party has a substantial beneficial interest in trust, next consider whether that interest would be adversely affected by the exercise or non-exercise of his power over the trust

57 VIII. Grantor Trust Definitions and Rules B. Nonadverse Party Once you have determined who the adverse parties are, it is easy to figure out who the nonadverse parties are They are everyone else

58 VIII. Grantor Trust Definitions and Rules C. Related or Subordinate Party Any nonadverse party who is Grantor s spouse, if living with the grantor Any one of the following Grantor s father, mother, issue, brother or sister An employee of grantor A corporation or any employee of a corporation in which the stock holdings of grantor and the trust are significant from the viewpoint of voting control A subordinate employee of a corporation in which the grantor is an executive

59 VIII. Grantor Trust Definitions and Rules C. Related or Subordinate Party (cont.) For purposes of Sections 672(c), 674(c) and 675(3), a related or subordinate party Is presumed to be subservient to the grantor s wishes with respect to the exercise or nonexercise of the powers conferred upon him Unless the contrary is shown by a preponderance of evidence

60 VIII. Grantor Trust Definitions and Rules D. Spouse (grantor is treated as holding any power or interest that is held by grantor s spouse) Grantor s spouse is Any individual who was the spouse of grantor at the time of the creation of such power or interest Any individual who became the spouse of grantor after the creation of such power or interest, but only with respect to periods after such individual became the spouse of grantor An individual who was legally separated from grantor under a divorce decree or separate maintenance decree at the time the power or interest was created will not be considered a spouse of grantor

61 GRANTOR TRUST STATUS

62 IX. Grantor Trust Status Grantor trust status for income tax purposes is determined by IRC Sections 673 through 679 Review each section to determine grantor trust status under the terms of the trust instrument, whether grantor trust status is intended or to be avoided. In general, each Code section first sets out the power that results in grantor trust status, then lists the exceptions to the general rule.

63 IX. Grantor Trust Status A. IRC 673 Reversionary Interests General Rule. A trust is a grantor trust if the value of the interest retained by the grantor exceeds 5% of the value of the trust property Rule is the same whether reversionary interest is an interest in corpus or income A grantor can be treated as the owner of only a portion of a trust A retained interest may not be sufficient to make the entire trust a grantor trust under 673, but under 677, the grantor will be subject to taxation on the portion she retains unconditionally, such as a remainder interest

64 IX. Grantor Trust Status A. IRC 673 Reversionary Interests (cont.) The value of the retained interest is determined at the time of the transfer to the trust using the 7520 rate Example. Sam creates a trust for the benefit of Debbie that has a term of 45 years, remainder to Sam or his estate If the 7520 rate on the date the trust is created is 4.4%, Sam s retained interest is % and the trust is a grantor trust If the 7520 rate had been 7% instead of 4.4%, the value of Sam s retained interest would have been % and the trust would not have been considered a grantor trust.

65 IX. Grantor Trust Status A. IRC 673 Reversionary Interests (cont.) A retained reversionary interest taking effect at death is valued using actuarial tables Example. Sam creates a trust for the benefit of 22 year old Debbie for her life, with the remainder passing to Sam or his estate at Debbie s death If the 7520 rate on the date the trust is created is 4.4%, Sam s retained interest is 12.13% (and a grantor trust) If the 7520 rate had been 7% instead of 4.841%, the value of Sam s retained interest would have been % (not a grantor trust)

66 IX. Grantor Trust Status A. IRC 673 Reversionary Interests (cont.) If the trust agreement includes discretionary terms, the maximum exercise of discretion in favor of the grantor will be assumed in determining the value of the retained interest If the time of vesting of the reversionary interest to the grantor is postponed for any reason, the postponement will be treated as a new transfer in trust

67 IX. Grantor Trust Status A. IRC 673 Reversionary Interests (cont.) If the grantor retains a reversionary interest in a trust established solely for the benefit of the grantor s lineal descendant, and the retained interest is limited to a reversionary interest that only takes effect if the beneficiary dies before reaching age 21, the trust will not be considered a grantor trust Can avoid creating a revision by making remainder payable to descendant s estate An interest retained by the grantor may result in estate inclusion under 2037

68 IX. Grantor Trust Status B. IRC 674 Power to Control Beneficial Enjoyment General Rule. A trust is a grantor trust if the grantor or a nonadverse party (or both) has the power to dispose of the income or corpus of the trust without the consent of an adverse party Although this rule is very broad, there are many exceptions that substantially limit the application of the rule

69 IX. Grantor Trust Status B. IRC 674 Control of Beneficial Enjoyment (cont.) Various places in the grantor trust rules distinguish between income and corpus One may be tempted to understand these words in their state law, or trust accounting, context When it is stated in the regulations that income is attributed to the grantor or another person, the reference, unless specifically limited, is to income determined for tax purposes and not to income for trust accounting purposes When it is intended to emphasize that income for trust accounting purposes is meant, the phrase ordinary income is used

70 IX. Grantor Trust Status B. IRC 674 Control of Beneficial Enjoyment (cont.) Exceptions - Powers that can be held by anyone, including the grantor or a nonadverse party (cont.) An unexercised discretionary power to apply trust income for the support or maintenance of a beneficiary whom the grantor or his or her spouse is legally obligated to support A power to affect beneficial enjoyment of the trust that can only be exercised after the occurrence of an event that is very unlikely to occur

71 IX. Grantor Trust Status B. IRC 674 Control of Beneficial Enjoyment (cont.) Exceptions - Powers that can be held by anyone, including the grantor or a nonadverse party (cont.) A testamentary power of appointment over the trust, except for A power held by the grantor to appoint accumulated income of the trust, where income is required to be accumulated or where it may be accumulated at the discretion of the grantor or a nonadverse party, without the approval or consent of an adverse party or A power held by the grantor to appoint the trust principal where capital gains are added to corpus, if the power can be exercised without the approval or consent of an adverse party

72 IX. Grantor Trust Status B. IRC 674 Control of Beneficial Enjoyment (cont.) Exceptions - Powers that can be held by anyone, including the grantor or a nonadverse party (cont.) The power to allocate corpus or income among charitable beneficiaries of the trust The power to make distributions of corpus among the beneficiaries of the trust if the distributions are subject to a reasonably definite standard or if the distributions must be charged against the beneficiaries respective shares (as if a separate share exists for each beneficiary)

73 IX. Grantor Trust Status B. IRC 674 Control of Beneficial Enjoyment (cont.) Exceptions - Powers that can be held by anyone, including the grantor or a nonadverse party (cont.) To distribute income to a beneficiary or accumulate income if any income accumulated for a beneficiary must ultimately be payable To that beneficiary, his estate, or his appointees under the broadest special power of appointment or To the current income beneficiaries in shares that have been irrevocably specified in the trust instrument or

74 IX. Grantor Trust Status B. IRC 674 Control of Beneficial Enjoyment (cont.) Exceptions - Powers that can be held by anyone, including the grantor or a nonadverse party (cont.) To the beneficiary s appointees or to one or more designated alternate takers whose shares have been irrevocably specified in the trust instrument (other than the grantor or grantor s estate) if the beneficiary dies before a distribution date that could reasonably be expected to occur within the beneficiary s lifetime The power to withhold income during the disability of a beneficiary (due to legal disability or being under age 21) The power to allocate receipts and disbursements of the trust between corpus and income

75 IX. Grantor Trust Status B. IRC 674 Control of Beneficial Enjoyment (cont.) Exception for Non-Grantor Trustee If the trustees (other than the grantor or grantor s spouse) have the power to make or withhold distributions of income or corpus to or for a beneficiary, beneficiaries, or a class of beneficiaries, if the power is limited by a reasonably definite external standard set forth in the trust agreement Exception does not apply if any person has the power to add a beneficiary (other than after-born or afteradopted children) to the trust

76 IX. Grantor Trust Status B. IRC 674 Control of Beneficial Enjoyment (cont.) Exception for Independent Trustee If the grantor or the grantor s spouse is not serving as trustee, and no more than half of the trustees are related or subordinate parties who are subservient to the wishes of the grantor, trustees can have the power to distribute or accumulate income or corpus to or for a beneficiary, beneficiaries, or a class of beneficiaries Exception does not apply if any person has the power to add a beneficiary (other than after-born or afteradopted children) to the trust

77 IX. Grantor Trust Status B. IRC 674 Control of Beneficial Enjoyment (cont.) Problems that Arise for Estate Tax Planning If the grantor retains the right to remove and replace a trustee, and the grantor can appoint any person, including himself as trustee, the trustee s powers are deemed to be held by the grantor for purposes of determining grantor trust status and estate tax inclusion, so prohibit grantor from being trustee In these situations, 674 powers held by a grantor may frustrate the grantor s estate tax planning See Exhibit D for distribution language for a person who is independent to avoid these problems

78 IX. Grantor Trust Status C. IRC 675 Administrative Powers Power to Deal for less than Adequate and Full Consideration - if the grantor or a nonadverse party can allow any person to deal with the trust property for less than adequate consideration without the consent of an adverse party Power to Borrow without Adequate Interest or Security - if the grantor or a nonadverse party can make a loan to the grantor without adequate interest or security unless the trustee (who is not the grantor or the grantor s spouse) can make loans to any other person under the same conditions

79 IX. Grantor Trust Status C. IRC 675 Administrative Powers (cont.) Actual Borrowing of Trust Funds by Grantor or Grantor s Spouse Without Adequate Interest Or Security - If the grantor or the grantor s spouse has actually borrowed from the trust, whether directly or indirectly, and has not completely repaid the loan with interest before the beginning of the taxable year Unless the grantor borrows the entire corpus, there can be no assurance that the grantor will be treated as the owner of the entire income and corpus of the trust for income tax purposes

80 IX. Grantor Trust Status C. IRC 675 Administrative Powers (cont.) Actual Borrowing of Trust Funds by Grantor or Grantor s Spouse Without Adequate Interest Or Security (cont.) If the loan is made by a trustee other than the grantor or a related or subordinate party who is subservient to the grantor, and adequate interest and security are provided, the trust will not be considered a grantor trust Actual borrowing is required; the mere power to borrow is not sufficient

81 IX. Grantor Trust Status C. IRC 675 Administrative Powers (cont.) Administrative Powers Exercised in Nonfiduciary Capacity Without Consent of Fiduciary Voting Trust s Stock - Power to vote the trust s stock if the trust s & grantor s holdings are significant from the viewpoint of voting control Controlling Investment - Power to control the trust s investment in stock if the trust s & grantor s holdings in the stock are significant from the viewpoint of voting control Substitution of Assets - Power to reacquire trust assets by substituting assets of equivalent value

82 IX. Grantor Trust Status C. IRC 675 Administrative Powers (cont.) Problems that Arise for Estate Tax Planning If the grantor has the power to Allow any person to deal with the trust property for less than full and adequate consideration Make loans without adequate interest or security the trust may be included in the grantor s estate for estate tax purposes

83 IX. Grantor Trust Status D. IRC 676 Power to Revoke General Rule - If the grantor or a nonadverse party has the power to revoke or otherwise revest the assets of the trust in the grantor without the consent of an adverse party Exception - If the revocation power is postponed for a period of time that would result in the revested interest being equal to or less than five percent of the value of the trust funds, so that the grantor is not considered the owner under 673 Problems that Arise for Estate Tax Planning - A revocable trust will be included in the grantor s estate for estate tax purposes

84 IX. Grantor Trust Status E. IRC 677 If the grantor or nonadverse party has the power to distribute trust income for benefit of the grantor or spouse without the consent or approval of an adverse party, including Actual or constructive distributions Amounts held or accumulated for future distribution Actual or constructive distributions used to pay premiums on policies of insurance on the life of the grantor or spouse Income actually applied to or distributed in satisfaction of the grantor s or spouse s legal obligation to support another

85 IX. Grantor Trust Status E. IRC 677 Income for Benefit of Grantor (cont.) Uncertainty as to Extent of Grantor Trust Status - It is unclear whether including this distribution power within a trust results in the grantor being treated as the owner of only the income portion of the trust or of both the income and the corpus of the trust Problems that Arise for Estate Tax Planning - Estate inclusion issues arise from this distribution power

86 IX. Grantor Trust Status F. IRC 678 Person Other Than Grantor Treated as Substantial Owner If the grantor is not treated as the owner of the trust otherwise, a third party may be treated as the owner of the trust if the third party Has the sole power to vest the corpus or income of the trust in himself or herself Has partially released or modified this power and retains control that would result in a grantor be treated as the owner of the trust

87 IX. Grantor Trust Status F. IRC 678 Person Other Than Grantor Treated as Substantial Owner (cont.) This situation often arises in the context of trusts that Give beneficiaries a power of withdrawal over the trust Are structured to be beneficiary grantor trusts It can also arise if a beneficiary is the sole trustee of the trust to the extent that the beneficiary/trustee has a power to distribute to himself or herself; however, the consequences might be limited if the distribution power is limited to an ascertainable standard PLR is wrong as to who the grantor is

88 IX. Grantor Trust Status G. IRC 679 Foreign Trusts Having One or More United States Beneficiaries General Rule - Any foreign trust with a United States person as a grantor and a United States person as a beneficiary will be treated as grantor trust Exceptions The general rule does not apply to any transfer to a foreign trust at death There is also an exclusion for certain transfers in exchange for consideration of at least the fair market value of the transferred property

89 Common Methods for Creating a Grantor Trust that Do Not Result in Estate Tax Inclusion

90 X. Common Methods for Creating a Grantor Trust that Do Not Result in Estate Tax Inclusion A. Substitution of Assets Grantor s power to reacquire trust assets by substituting assets of equivalent value if exercisable in a nonfiduciary capacity Whether power of substitution is exercisable in a fiduciary capacity depends on all the terms of the trust and the circumstances surrounding its creation and administration See Exhibit E for sample swap power & release Rev. Rul No adverse estate tax consequences in most situations

91 X. Common Methods for Creating a Grantor Trust that Do Not Result in Estate Tax Inclusion A. Substitution of Assets (cont.) While it should be possible for the grantor to release this power, and thereby terminate grantor trust status, the IRS has expressed concern about abusive transactions that use this technique (no round trips?) This power of substitution should not be held by the trustee, because it must be held in a nonfiduciary capacity, which arguably could be inconsistent with a trustee s fiduciary duties

92 X. Common Methods for Creating a Grantor Trust that Do Not Result in Estate Tax Inclusion A. Substitution of Assets (cont.) The power of substitution can be given to not only the grantor, but can also be given to the grantor s spouse or another party Giving the power to someone other than the grantor should result in no risk of estate inclusion (concern?) As with other powers given to a spouse or a third party to trigger grantor trust status, upon the death of the spouse or third party, grantor trust status will terminate unless a successor holder of a swap power has been provided for in the document

93 X. Common Methods for Creating a Grantor Trust that Do Not Result in Estate Tax Inclusion B. Loans C. Power of Disposition by a Related or Subordinate Party without a Reasonably Definite Outside Standard D. Addition of Beneficiaries (exception to an exception) E. Spouse as a Beneficiary or Powerholder Spouse is the same as grantor for grantor trust purposes Spouse is not the same for transfer tax purposes This works only during the marriage

94 Uses of Grantor Trusts in Estate Planning

95 V. Uses of Grantor Trusts in Estate Planning General Grantor benefits trust by bearing the trust s income tax (with no gift tax & reducing the taxable estate) This allows the trust assets to grow free of income tax Assume a 10% annual return from a family business for 25 years, with a 45% income tax If trust pays its income tax, it will have grown 281% If trust does not pay its income tax, it will have grown 983% See Exhibit B for more examples and different rates Be sure you have an exit strategy for grantor client

96 V. Uses of Grantor Trusts in Estate Planning A. Sales & Loans Transactions between grantor and grantor trust are not recognized for income tax purposes Sale won t trigger capital gain or recapture Loan won t give rise to interest income or expense Minimum 10% equity is the lore Sales, loans, etc. are recognized for state law, and transfer tax, purposes If a standard grantor trust can transfer more wealth than intended, beware of using leverage without monitoring carefully and regularly (see Exhibit C)

97 V. Uses of Grantor Trusts in Estate Planning B. Grantor Retained Annuity Trusts (GRATs) Economically similar to a sale to a grantor trust Different legal analysis & tax consequences C. Irrevocable Life Insurance Trusts (ILITs) D. Qualified Personal Residence Trusts (QPRTs)

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