IV. GRANTOR TRUSTS W. Verne McGough, Jr. January 28, 2014

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1 IV. GRANTOR TRUSTS W. Verne McGough, Jr. January 28, 2014 A. What Grantor Trusts are Used For 1. History of the Grantor Trust Rules The grantor trust rules developed as a reaction to tax planning in the wake of early U.S. income tax rules which provided very progressive tax rates and no provision for joint income tax returns. 1 Tax planning in that era centered around shifting income to taxpayers in lower tax brackets. One way to accomplish this result was to place income-producing assets in trusts. These strategies eventually ended up producing Helvering v. Clifford 2, in which the Supreme Court disregarded an attempted assignment of income from one spouse to another via the creation of a short-term trust. The Treasury Department issued regulations known as the Clifford regulations under the Internal Revenue Code of 1939 in reaction to the case. The Clifford regulations provided rules to determine when trusts would be recognized as taxpayers separate from their grantors. The adoption of a rule permitting joint income tax returns in 1948 eliminated the income tax incentive to shift income to spouses, but the progressivity of tax rates continued to motivate income-shifting strategies. Congress adopted of the Internal Revenue Code in 1954 which formalized the grantor trust rules. The enactment of the Internal Revenue Code of 1986 lowered income tax rates and dramatically reduced the incentive to shift income. 3 Trusts are currently a poor place to hold income as they reach the top income tax bracket of 39.6% at $12,150 (as opposed to $457,601 for married taxpayers filing jointly). 1 For example, the Revenue Act of 1942 levied a tax on income above $200,000 at a tax rate of 88%. Pub. L. No , , 56 Stat. 798, 802 (1942) (superseded 1944), available at (last checked December 27, 2013) U.S. 331 (1940). 3 The top income tax rate was lowered from 50% in 1986 (before passage) to an eventual top rate of 28% in 1988.

2 2. Current Importance of the Grantor Trust Rules Following the reduced incentive to shift income to others, tax advisors began intentionally invoking the grantor trust rules in situations where it would be beneficial for a grantor to be considered the owner of a trust s assets for income tax purposes but not the owner of the assets for estate tax purposes. Invoking the grantor trust rules in this way allows the grantor to pay the income taxes on the trust s income, thus leaving the assets to appreciate income tax-free. Grantor trusts also benefit clients in the following ways: a. No gain is recognized on sales between a grantor and a grantor trust - appreciated assets may be sold to a grantor trust without the imposition of income tax; b. Grantor trusts are permissible S corporation stockholders; c. Grantors may substitute high basis assets held outside the trust for low basis assets held by the trust shortly before death without the imposition of income tax on the low basis assets (pulling the low basis assets into the grantor s estate to qualify such assets for a step-up in basis); and d. The $500,000 (joint filers) exclusion from income under 121 for the sale of a principal residence is available for a residence held in trust if the trust is a grantor trust. Trusts may be treated as grantor trusts by being subjected to the grantor trust provisions of The trust becomes subject to these rules if the grantor, the grantor s spouse or a nonadverse party retains certain powers with respect to the trust. Selection of the power used to trigger grantor trust status is important as the grantor may later decide he wants to terminate grantor trust status. Application of the grantor trust rules to a person causes the items of income, deductions and credits of the trust to be included in the person s income and credits for the portion of the trust subject to the power. The powers which cause a trust to be treated as a grantor trust are discussed in Section C below.

3 Definitions and Rules 672 contains a number of definitions and ground rules that apply to the various provisions which cause application of grantor trust status. (a) Adverse vs Nonadverse Party - 672(a)-(b) An adverse party is a person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power causing grantor trust status. 4 The holder of a general power of appointment is considered to have a beneficial interest in the trust for grantor trust purposes. 5 An interest in trust is deemed to be substantial by the regulations if the value of the interest is not insignificant in relation to the total value of the property subject to the power. 6 The interest of an ordinary income beneficiary will be adverse to the exercise of a power affecting income but may or may not be adverse with respect to a power over the corpus. 7 For example, assume trust income is payable to A for life with a limited power in A to appoint the corpus to the grantor during life or by will. A s interest is adverse with respect to the power during A s life because exercise of the power would adversely affect the income received by A. However, A s interest is not adverse with respect to an exercise of the power by will because A has no interest in the trust following A s death. 8 Grantor trust status in this example would be applied to any income allocable to corpus (e.g. capital gains/appreciation of trust assets) due to 677 because such income may in the discretion of a nonadverse party be accumulated for future distribution to the grantor (via A s appointment of the corpus to the grantor). 4 I.R.C. 672(a). All references to sections ( ) herein refer to sections of the Internal Revenue Code of 1986, as amended, unless otherwise indicated. 5 I.R.C. 672(a). 6 Treas. Reg (a)-1(a). 7 Treas. Reg (a)-1(c). 8 See id.

4 The interest of a remainderman is only adverse as to the exercise of a power over trust corpus, but not with respect to a power over an income interest preceding his remainder interest. 9 Therefore, X will be nonadverse where a trust provides income to A for 10 years followed by corpus to X and a power exercisable by X to distribute ordinary income to the grantor. In this example the income would be taxable to the grantor as a grantor trust pursuant to 677(a)(1). 672(b) provides succinctly that a nonadverse is any person who is not an adverse party. (b) Related or Subordinate Party - 672(c) 672(c) provides that a related or subordinate party means a nonadverse party who is: (i) the grantor s spouse if living with the grantor, (ii) the grantor s father or mother, (iii) one of the grantor s issue, (iv) a sibling of the grantor, (v) a corporation or any employee of a corporation in which the stock held by the grantor and the trust are significant from the viewpoint of voting control, or (vi) a subordinate employee of a corporation in which the grantor is an executive. 672(c) creates a rebuttable presumption that related or subordinate parties are subservient to the grantor for purposes of 674 and 675. (c) Spousal Unity Rule - 672(e) The spousal unity rule of 672(e) provides that the grantor will be treated as holding any power or interest held by: (i) the grantor s spouse at the time of creation of the power or interest, or (ii) a person who becomes the grantor s spouse after the creation of the power or interest (but only with respect to the periods after such person became the grantor s spouse). For purposes of (i) above, if the grantor and the grantor s spouse are legally 9 Treas. Reg (a)-1(d).

5 separated under a decree of divorce or separate maintenance at the creation of the power or interest they will not be considered to be married at such time. 10 This rule makes it possible to avoid estate inclusion issues in the grantor s estate by providing a spouse with a power triggering grantor trust treatment for the grantor. (d) Portion Rule The general rule regarding treatment as a grantor trust provides that a grantor may be treated as owning the income or principal in whole or only in part. 11 This is commonly known as the portion rule. 671 further provides that portions not subject to grantor trust status will be treated under the normal tax rules for trusts. The portion rule allows the following parts of a trust to be treated separately under the grantor trust rules: (1) Income or corpus only - the grantor may be treated as owning only the corpus or the income of the trust. (2) Fractional or pecuniary shares only a fractional or pecuniary share of the trust may be subject to grantor trust status. This can occur when a power or interest does not extend to the entire trust (e.g. where the person treated as a grantor may borrow only the assets in their share of a trust with multiple beneficiaries). (3) Specific assets the grantor may be treated as owning only specific assets (e.g. a trust containing a power to substitute only certain assets or excluding some assets such as life insurance policies). The issue regarding whether the grantor s payment of the income taxes on the portion of the trust treated as a grantor trust was an additional gift to the trust was settled by Revenue Ruling , which provided that the grantor s payment of income taxes is not a gift if tax reimbursement is not required by the terms of the trust or state law or if the reimbursement was in the discretion of an independent 10 I.R.C. 672(e)(2). 11 I.R.C. 671.

6 trustee. 12 If the trust agreement mandates reimbursement to the grantor of the income tax paid there are no gift tax consequences but 2036(a)(1) would include the assets of the trust in the grantor s estate due to the grantor s retention of the right to have trust property expended in discharge of the grantor s legal obligation. 13 B. Types of Grantor Trusts The following types of trusts utilize the grantor trust rules to divest a grantor of assets for estate tax purposes while the grantor continues to be treated as the owner of the assets for income tax purposes: 1. Grantor Retained Annuity Trusts (GRATs) Grantor retained annuity trusts are irrevocable trusts to which a grantor transfers property and retains an income interest for a term of years. The effect of a GRAT is to transfer a remainder interest in the property to a beneficiary. The present value of the remainder interest is a gift for gift tax purposes. The gift does not qualify for the gift tax annual exclusion because it is not a gift of a present interest in property. The value of the gift depends on the length of the GRAT term and the annuity payments to be made to the grantor. The annuity payment is a fixed annual amount based on the value of the property transferred to the GRAT at its inception. GRATs are a type of estate freeze technique. These techniques transfer the current value of the grantor s property in a way that removes future appreciation from the grantor s gross estate for estate tax purposes thus freezing the value of the asset for transfer tax purposes. The transfer of the remainder in the GRAT is a gift for gift tax purposes, but the receipt of the assets of the GRAT at their (hopefully) appreciated value at the end of the GRAT term is not a transfer for transfer tax purposes. As with any transaction, there are risks and disadvantages to establishing a GRAT. Due to the retention of an interest in the GRAT, a portion of the GRAT assets will be includible in the grantor s gross estate if the grantor dies during the 12 Rev. Rul , C.B Id.

7 GRAT term. The assets transferred to the GRAT will also keep their income tax basis pursuant to Therefore, the beneficiaries of the GRAT will not receive a step up in basis upon the death of the grantor. 2. Grantor Retained Unitrusts (GRUTs) Grantor retained unitrusts are similar to GRATs but require a set percentage payout of trust assets on an annual basis rather than an annuity payment. The trust assets are revalued each year to determine the amount of the payout (compared to a single valuation at funding in the case of a GRAT). For this reason the GRAT is a preferred technique for transferring future appreciation to beneficiaries. 3. Qualified Personal Residence Trusts (QPRTs) Qualified personal residence trusts are irrevocable trusts to which a grantor transfers a parcel of real estate, usually the grantor s primary residence or possibly a second home. The QPRT gives the grantor any income it produces for a specified term as well as the use of the residence. If the grantor survives the QPRT term, the property is deeded to the remainder beneficiaries. If the grantor dies during the QPRT term, the residence reverts to the grantor s estate. The primary benefit of a QPRT is to establish a gift tax value at the funding of the trust. Similar to GRATs and GRUTs, the value of the gift is equal to the present value of the remainder interest at inception of the QPRT. This value is impacted by several factors including the fair market value of the property, interest rates at the time of funding, the age of the grantor and the term of the QPRT. If the grantor lives to the end of the QPRT term, the QPRT is also a freeze technique any appreciation of the property is transferred to the beneficiaries without inclusion in the grantor s gross estate. Even if the grantor dies during the QPRT term he or she is no worse off than in the absence of the QPRT (fees for establishing and funding the trust excluded) as the property would have been in the grantor s gross estate at the appreciated value anyway.

8 4. Intentionally Defective Grantor Trusts (a.k.a. Intentional Grantor Trusts) (IDGTs) Intentionally defective grantor trusts involve a completed transfer to an irrevocable trust for gift tax purposes but, due to the grantor trust rules, an incomplete transfer for income tax purposes. The assets of a properly structured IDGT are not includible in the gross estate of the grantor. Future appreciation of the assets is also removed from the grantor s estate (another freeze technique). IDGTs are commonly used in combination with a sale of property. In this transaction, the grantor funds the trust with a minimum value of property known as a seed gift. The seed gift should be at least 10% of the fair market value of the assets to be purchased by the IDGT to avoid an argument by the Internal Revenue Service ( IRS ) that the transaction lacks economic substance. The seed gift is a gift for gift tax purposes and usually requires the filing of a gift tax return due to the size of the gift and the desire to start the running of the gift tax statute of limitations on assessment. If the grantor desires to avoid the making of a gift other alternatives are available which are beyond the scope of these materials (e.g. requiring the beneficiaries to guarantee a portion of the promissory note issued as a part of the sale or obtaining a standby letter of credit from a commercial lender). Following the seed gift, the grantor sells property to the IDGT for fair market value. This sale may be of assets held by the grantor or may be combined with the grantor s establishment of an entity, such as a family limited partnership, in order to obtain lack of control and marketability discounts on the fair market value of the property sold to the trust. In exchange for the property sold to the IDGT, the grantor will receive a promissory note from the IDGT. The promissory note should bear interest at least equal to the applicable federal rate to avoid recharacterization of the sale as a gift back to the grantor. The note generally will provide that the principal and any accrued interest will be due and payable after a certain term of years. Appreciation in the value of the assets in excess of the interest due to the grantor will escape taxation in the grantor s estate.

9 Due to the grantor trust treatment of the IDGT, the sale is not recognized for income tax purposes (the grantor is treated as having sold the property to himself or herself). Therefore, the grantor will pay no income tax on the sale. However, the beneficiaries will lose the ability to receive a step up in basis at the death of the grantor. 5. Spousal Lifetime Access Trusts (SLATs) The use of spousal lifetime access trusts reached a peak in 2012 as uncertainty regarding the level of the estate tax exemption reached a peak during the fiscal cliff crisis. SLATs function as bypass trusts which are funded during lifetime rather than at death. The grantor s spouse has limited access to the assets of the SLAT, usually subject to a health, support and maintenance standard (depending on the identity of the trustee). Children and other descendants may also be included as beneficiaries of the SLAT. At the end of 2012 it was unknown whether Congress would continue to allow the transfer of over $5 million in property estate and gift tax free. Many proposals were made for lowering the exemption and conservative planners in this environment recommended SLATs as an option to utilize the $5.12 million exemption in 2012 before it possibly disappeared. SLATs continue to have uses but are not as popular now given Congress permanent fixing of the estate tax exemption at an inflation adjusted $5 million Revocable Trusts Garden variety revocable trusts which are used in many estate plans which do not necessitate estate tax planning are also treated as grantor trusts. C. Provisions Triggering Grantor Trust Status Reversionary Interests 673(a) provides that grantor will be treated as owner of any portion of a trust in which he has a reversionary interest in the corpus or income if, as of the inception of such portion, the value of the reversionary interest exceeds 5% of the 14 The inflation adjusted basic exclusion amount in 2014 is $5,340,000. See Rev Proc , I.R.B. 537.

10 value of such portion. For example, assume A creates a trust which provides for discretionary distributions of income and principal to or for the benefit of B. Upon the death of B, all principal and income remaining in the trust reverts to A, if living, or if not then to A s estate. If the value of A s reversion (following B s death) exceeds 5% of the value of the trust at the time the trust is created, A will be treated as owner of the trust pursuant to 673(a). The wording of the statute suggests that a subsequent decline in the value of the trust or the reversionary interest will not affect treatment as a grantor trust. The 7520 tables are used to determine the value of the reversionary interest. 15 The 5% rule of 673(a) will therefore require grantor trust status during periods of low interest rates unless the pre-reversion term of the trust is long. For example, if the trust discussed above were created by A in December 2013 there is no age of B for which the trust would escape application of A term of years would have to be so long under the current interest rate that the grantor would not survive it. 17 Under 673(b), the grantor will not be treated as owner of a portion of the trust if the reversion only takes effect upon the death before the age of 21 of a beneficiary who is a lineal descendant of the grantor and who holds all the present interests in such portion of the trust. Therefore, in the above example if B were A s child (or grandchild), 673 would not apply if upon B s death prior to B s 21st birthday A would have a reversion, but upon B s death after B s 21st birthday the trust would pass to B s estate or to B s appointees. Any postponement of the date specified for the reacquisition of possession or enjoyment of the reversion will be treated as a new transfer in trust commencing with the date the postponement is effective. 18 Therefore, a delay in the reversion in 15 Rev. Rul , C.B If B were 0 years old at inception of the trust, the value of the remainder interest using the December rate of 2.0% would be 23.3% of the value of the trust. 17 The author tested a 99 year term using the December rate of 2.0%. The remainder interest was 14.1% of the initial value of the trust. 18 I.R.C. 673(d).

11 addition to the initial term of years or life estate is treated as a new transfer and a new calculation of the value of the remainder interest will be necessary. The grantor will not be attributed income during the postponement period under 673(d) if he otherwise would not be taxed under the grantor trust rules. 19 The grantor s retention of a reversionary interest under 673(a) will in many cases result in inclusion of the trust assets subject to the reversion in the grantor s gross estate pursuant to provides that property subject to a reversion will be included in the decedent grantor s gross estate if the value of the reversion exceeds 5% of the value of the property. 20 The 5% test provided in 2037 is applied immediately before the death of the decedent rather than at the time of creation of the reversionary interest as in 673. Therefore, unlike the reversion calculation in 673, subsequent changes in the value of the property will impact the 5% calculation under Additionally, 2702 (dealing with transfers in trust where an interest is retained by the grantor or a member of his family) will treat the entire transfer to a trust for the benefit of the grantor s family members as a gift unless the trust is structured properly (e.g. as a GRAT, a GRUT or a QPRT) Power to Control Beneficial Enjoyment Section 674(a) treats the grantor as the owner of any portion of a trust over which the grantor or a nonadverse party retained the power to control beneficial enjoyment of the corpus or income, provided no adverse party s consent is required. Any power which can affect the beneficial enjoyment of trust property, including fiduciary powers and powers of appointment, will cause grantor trust treatment. 21 However, numerous exceptions apply to remove many trusts from grantor trust treatment under 674. These powers are generally divided into three categories: (a) powers which are excepted regardless of who holds them, (b) powers held by a trustee which are excepted if at least half the trustees are independent and the 19 Id. 20 I.R.C. 2037(a)(2). 21 Treas. Reg (a)-1(a)

12 grantor is not a trustee, and (c) a power which is excepted if it is held by a trustee other than the grantor or the grantor s spouse (if the spouse lives with the grantor). (a) Powers Excepted Regardless of By Whom Held - 674(b) (1) Power to Apply Income to Support Dependent 674(b)(1) provides an exception to grantor trust status for powers held by any person to pay or apply trust income to discharge the grantor s legal obligation of support with respect to a dependent. 677(b) preempts 674(b)(1) and would cause grantor trust treatment if income is actually distributed in a manner which discharges a legal obligation of the grantor. Pursuant to Treas. Reg (b)-1(b)(1), the grantor or the grantor s spouse (due to the spousal unity rule) would have to be exercising this power in their role as trustee. This provision may cause estate inclusion if held by the grantor. 22 (2) Power Affecting Beneficial Enjoyment Only After Occurrence of an Event 674(b)(2) provides that a power which can only affect beneficial enjoyment of the income for a period beginning after the occurrence of an event such that the trust would not be a grantor trust under 673 will not cause grantor trust treatment under 674. If the exercise of the power is far enough into the future, this exception provides that the value of the power must be at least 5% of the value of the portion of the trust subject to the power in order for the trust to be treated as a grantor trust. 23 If the grantor does not relinquish the power following the occurrence of the event, the trust will become a grantor trust. Finally, this exception will cause estate inclusion under 2036 because 2036 does not recognize the waiting period before occurrence of the event. 22 Treas. Reg (b)(2). 23 I.R.C. 674(b)(2).

13 (3) Power Exercisable Only By Will Powers exercisable only by will do not cause grantor trust treatment unless the power is a power in the grantor to appoint the income of the trust which may be exercised by the grantor or a nonadverse party without the approval of an adverse party. 24 Powers of appointment which qualify for this exemption may also cause trust property to be included in the grantor s gross estate. 25 Finally, if the grantor is able to appoint trust principal to the grantor s creditors or the grantor s estate, the power could be deemed to be a power to control income invoking grantor trust status as to trust corpus. 26 (4) Power to Allocate Among Charitable Beneficiaries 674(b)(4) provides that a power to determine beneficial enjoyment of a portion of a trust if such portion is irrevocably payable for a purpose described in 170(c) (charitable contributions) will not trigger grantor trust status. (5) Power to Distribute Corpus Subject to Standard 674(b)(5) provides an exception from grantor trust treatment for powers to distribute corpus to or for: (a) any beneficiary, provided that the power is limited by a reasonably definite standard set forth in the trust instrument; or (b) a current income beneficiary, provided the distribution must be chargeable against such beneficiary s portion of the corpus held for the payment of the income (as if such portion were held as a separate share). Discretionary spray or sprinkle powers (powers to distribute corpus to various beneficiaries with no reasonably definite standard) can be included to avoid 674(b)(5) and invoke grantor trust status. However, 674(c), which deals with independent trustee powers, may continue to 24 I.R.C. 674(b)(3). 25 See I.R.C See Treas. Reg (b)-1(b)(3) (last sentence).

14 prevent grantor trust status unless the grantor or the grantor s spouse is named trustee. This exception does not apply if any person has the power to add beneficiaries who are not after-born or after-adopted children. 27 The question arises as to what is considered a reasonably definite standard. The regulations provide that [a] clearly measurable standard under which the holder of a power is legally accountable is deemed a reasonably definite standard 28 The regulations continue to provide that the following are reasonably definite standards: (a) education, support, maintenance, or health of the beneficiary; (b) for the beneficiary s reasonable support and comfort; (c) to enable the beneficiary to maintain his accustomed standard of living; and (d) to meet an emergency. 29 The power to distribute for the pleasure, desire, or happiness of a beneficiary is not limited by a reasonably definite standard. 30 Finally, if the trustee s determination is conclusive with respect to the exercise or non-exercise of the power (e.g. a purely discretionary standard), the regulations provide that the power is not limited by a reasonably definite standard. 31 The beneficiary must be able to enforce the standard in order to avoid grantor trust status under this exception. (6) Power to Withhold Income Temporarily Grantor trust status will not flow from a power to distribute, apply or accumulate trust income for a beneficiary so long as the income must ultimately be distributed in one of following ways: (a) to the beneficiary; 27 I.R.C. 674(b)(5) (last sentence). 28 Treas. Reg (b)-1(b)(5)(i). 29 Id. 30 Id. 31 Id.

15 (b) to the beneficiary s estate; (c) to the beneficiary s appointees provided such appointees do not exclude anyone other than the beneficiary, the beneficiary s estate, the beneficiary s creditors, or the creditors of the beneficiary s estate; or (d) to the current income beneficiaries upon termination of the trust or together with a current corpus distribution if the shares of the beneficiaries are irrevocably specified in the trust agreement. As with the exception from grantor trust status for distributions of corpus subject to a standard, this exception will not apply if any person has the power to add beneficiaries who are not after-born or afteradopted children. 32 The trust income will not be considered to be taxable to the grantor under 677 because of a power of appointment referred to in subsection (c) which includes the grantor as a permissible appointee. 33 (7) Power to Withhold Income During Disability 674(b)(7) provides that a power to distribute, apply or accumulate trust income for a beneficiary which is exercisable only during the existence of a legal disability of a current income beneficiary or during the period when a beneficiary is under the age of 21 will not cause grantor trust treatment. Unlike the exception described in subsection (6) above, accumulated income may be distributed to other beneficiaries of the trust without invalidating this exception to grantor trust treatment. This exception will not apply if any person has the power to add beneficiaries who are not after-born or after-adopted children I.R.C. 674(b)(6). 33 Treas. Reg (b)-1(b)(6)(i). 34 I.R.C. 674(b)(7).

16 (8) Power to Allocate Between Corpus and Income 674(b)(8) provides that a power to allocate receipts and disbursements between income and corpus will not cause grantor trust status, even if the power is expressed in broad language. (b) Exception for Powers of Independent Trustees - 674(c) 674(c) provides an exception from grantor trust treatment for the following powers solely exercisable by a trustee or trustees, none of whom is the grantor or the grantor s spouse, and no more than half of whom are related or subordinate parties who are subservient to the wishes of the grantor or the grantor s spouse: (1) Power to distribute, apportion or accumulate income to or for a beneficiary, beneficiaries or a class of beneficiaries; or (2) Power to pay out corpus to or for a beneficiary or beneficiaries (whether or not income beneficiaries). This exception will not apply if any person has the power to add beneficiaries who are not after-born or after-adopted children. 35 If the grantor or the grantor s spouse is the trustee and has the discretionary power to distribute income and principal, the exception provided by 674(c) will not apply. The grantor s retention of this power will cause estate inclusion issues under 2036, but this power in the grantor s spouse will avoid estate inclusion in the spouse s estate. (c) Exception for Power to Allocate Income Limited by Standard 674(d) 674(d) provides an exception from grantor trust status for a power solely exercisable by a trustee or trustees who are not the grantor or a spouse living with the grantor, to distribute, apportion or accumulate income to or for a beneficiary, if such power is limited by a reasonably definite external standard which is set forth in the trust instrument. This exception applies 35 I.R.C. 674(b)(7).

17 whether or not the exceptions in 674(b)(6) or 674(b)(7), regarding powers to deal with income temporarily or during a beneficiary s disability, are satisfied. 36 Reasonably definite external standard has a similar meaning as applied under the exception to grantor trust status contained in 674(b)(5). 37 The exception in 674(d) will not apply if any person has the power to add beneficiaries who are not after-born or after-adopted children. 38 The exception also does not apply to corpus according to its terms. 39 However, the exception contained in 674(b)(5) would prevent grantor trust treatment for a similar power with respect to corpus Administrative Powers The grantor will treated as the owner of a trust (or a portion thereof) if any of the following administrative powers are present: (a) Power to Deal for Less Than Adequate and Full Consideration - 675(1) 675(1) provides that grantor trust status will apply if a power enabling the grantor to purchase, exchange or otherwise deal with trust property (corpus or income) for less than adequate consideration is exercisable by the grantor or a nonadverse party without the approval or consent of an adverse party. A 675(1) power held by the grantor would cause estate inclusion issues under 2036 or Similarly, a 675(1) power held by anyone else could prove problematic for such person under 2041(a)(2). (b) Power to Borrow Without Adequate Interest or Security - 675(2) Grantor trust treatment will be applied to an entire trust if the grantor or a nonadverse party may exercise a power to borrow corpus or income, directly or indirectly, without adequate interest or adequate security. 40 An exception is granted where the trustee is authorized under a general lending power to make 36 I.R.C. 674(d). 37 Treas. Reg (d) Id. 39 Id. 40 I.R.C. 675(2).

18 loans to any person without regard to interest or security, provided that the grantor is not the trustee (2) provides that the existence of the power is enough to cause grantor trust treatment, but that the grantor s authority to borrow must be more specific than a general lending power in the trustee as long as the grantor is not acting as the trustee. 42 Similarly, a general lending power in the grantor as trustee will not be sufficient under 675(2) in the absence of other factors if the power merely provides that the trustee has the power to determine interest rates and the adequacy of security. 43 While a provision in the grantor, as trustee, to make loans without adequate security or interest pursuant to 675(2) could cause grantor trust treatment, such a power also provides the grantor with a gross estate inclusion problem. Therefore, utilization of the grantor s spouse or another nonadverse party as the trustee is preferred when using a lending power under 672(2) to obtain grantor trust treatment. (c) Borrowing of the Trust Funds - 675(3) If the grantor directly or indirectly borrows corpus or income from the trust and fails to completely repay the loan, including any interest, before the beginning of a taxable year, the trust will be treated as a grantor trust. 44 The spousal unity rule may also apply to provide grantor trust treatment due to loans to the grantor s spouse. 675(3) provides an exception from grantor trust treatment if the loan (i) provides for adequate interest and adequate security, and (ii) is made by a trustee other than the grantor or a related or subordinate trustee subservient to the grantor under rules provided in 672(c) and discussed above in Section A Id. 42 Treas. Reg (b)(2). 43 Id. 44 I.R.C. 675(3).

19 The rules of 675(3) can apply to lending arrangements which are structured to avoid the provisions of 675(2). For example, if the trust agreement is not specific enough about the lending power (or even fails to provide a lending power to the trustee), 675(3) will apply where adequate security or interest are not charged regardless of the identity of the trustee. (d) General Powers of Administration - 675(4) Several general administrative powers which are exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity will cause grantor trust treatment. 45 When a person serving as trustee holds the administrative power, there is a presumption that the power is exercisable in a fiduciary capacity. 46 This presumption is rebuttable by clear and convincing proof that it is not exercisable in a fiduciary capacity. 47 If the power is exercisable by a person not serving in a fiduciary role, the regulations provide that whether the power is exercisable in a fiduciary capacity depends on the terms of the trust and the circumstances of creation and administration of the trust (4) provides that the administrative powers discussed below may be held by any person (subject to the rule requiring the power s exercise in a non-fiduciary capacity). However, the regulations discuss the non-fiduciary exercise of these powers by a nonadverse party rather than by any person. 49 Therefore, the most conservative course of action when using 675(4) to trigger grantor trust treatment is to ensure that the holder of the power is not an adverse party. Three such administrative powers are listed by 675(4) as causing grantor trust status: 45 I.R.C. 675(4). 46 Treas. Reg (b)(4)(iii). 47 Id. 48 Id. 49 Treas. Reg (b)(4).

20 (1) Power to Vote Stock 675(4)(A) provides that a power to vote or direct the voting of stock or securities of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control will cause grantor trust status. No definition of significant from the viewpoint of voting control is provided by the statute or the regulations. Therefore, trust agreements which intend to avoid grantor trust treatment must be careful when the trust and the grantor own stock in a corporation which may be deemed significant. The grantor should not hold this power due to gross estate inclusion with respect to the stock pursuant to The power to control the vote of a closely-held corporation could be provided to the grantor s spouse, but grantor trust would end on the death of the spouse unless a successor was named with the ability to exercise the power. Finally, the portion rule limits grantor trust status to the value of the stock. For these reasons, this power may not be the best to use to trigger grantor trust treatment. (2) Power to Control Investments 675(4)(B) provides grantor trust treatment to the extent of trust assets constituting stock or securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control where a power exists to control the investments of the trust by directing investments or reinvestments or by vetoing proposed investments. This power has the same issues discussed in section (1) above with respect to the power to vote stock provided by 675(4)(A). (3) Power to Substitute Trust Assets 675(4)(C) provides that the power to reacquire the corpus of the trust by substituting other property of an equivalent value will cause grantor trust status. This grantor trust trigger is commonly used and its

21 use is discussed further in Section E below. The potential of this power to be included in the grantor s estate pursuant to 2036 or 2038 has a history worth brief review. The IRS argued in Estate of Jordahl v. Commissioner 50 that a grantor/trustee s power of substitution was a power to alter, amend or revoke the trust under In ruling against the IRS, the Tax Court stated that [t]he trust agreement specifically provided that any property substituted should be of equal value to property replaced. Decedent was thereby prohibited from depleting the trust corpus. 51 The Service subsequently acquiesced in the result of Estate of Jordahl. 52 The IRS subsequently issued several Private Letter Rulings which provided that estate inclusion would not follow where a grantor held a power of substitution in a fiduciary capacity. 53 Revenue Ruling provided that estate inclusion would not be the result under 2036 or 2038 if the grantor held a substitution power in a non-fiduciary capacity. 54 Revenue Ruling further provided that the trustee has a duty to ensure that equivalent value is substituted. 55 This obligation to ensure the equivalent value of the substitution may be provided by the trust agreement or by state law. 56 The trustee also has the obligation to ensure the substitution power cannot shift benefits among the trust beneficiaries. 57 Substitution powers cannot be exercised in a manner that can shift benefits if: (a) the trustee has both the power to reinvest the trust corpus and a duty of impartiality with respect to the trust T.C. 92 (1975), acq., C.B Id. at C.B See Priv. Ltr. Rul (Jan. 20, 2006) and Priv. Ltr. Rul (Feb. 10, 2006). 54 Rev. Rul , C.B Id. at Id. 57 Id.

22 beneficiaries; or (b) the nature of the trust s investments or the level of income produced by the trust s investments does not impact the respective interests of the beneficiaries. 58 This later situation can occur, among others, when the trust is administered as a unitrust (requiring specific annual distributions) or when all distributions from the trust are discretionary. 59 Former disagreement regarding whether a power of substitution over a life insurance policy on the life of the grantor is an incident of ownership which would cause estate tax inclusion under 2042 was substantially resolved by Revenue Ruling , which provided that such a power would not cause estate inclusion provided equivalent value was substituted. 60 However, exercise of the power should be carefully thought out as the life insurance policy would become a part of the gross estate upon the reacquisition of the policy Power to Revoke A trust will be treated as a grantor trust to the extent the grantor, the grantor s spouse or a non-adverse party possesses the power to revest the assets of the trust in the grantor. 61 The mechanics by which the power allows title to trust assets to be revested in the grantor are immaterial a power to revoke, terminate, alter or amend the trust, or a power to appoint the assets of the trust in favor of the grantor will be sufficient to qualify the trust under Reservation of a power to purchase the trust corpus for nominal consideration will result in grantor trust status to the extent the fair market value of the assets purchased exceeds the consideration will apply grantor trust status whether the power to revoke 58 Id. 59 Id. 60 Rev. Rul , I.R.B I.R.C. 676(a). 62 Treas. Reg (a) Fisher v. Comm r, 28 B.T.A (1933).

23 the trust is exercised or not and even if the power does not operate on the trust immediately (b) provides one exception to the general rule. Trusts will not be treated as grantor trusts if the exercise of the power to revoke can only affect beneficial enjoyment of income after the occurrence of an event such that the trust would not be treated as a grantor trust under 673 if the power were a reversionary interest. 65 Therefore, if the revocation power were a reversion and the value of the revocation power was less than 5% of the value of the portion of the trust subject to the revocation power, the trust would not be treated as a grantor trust. Powers to change beneficial interests will not be treated as revocation powers if they cannot be exercised to revest the trust corpus in the grantor, but this may trip other grantor trust sections. 66 State law determines whether a trust is revocable or not (a) of the Code of Laws of South Carolina, 1976, as amended ( S.C. Code ), provides a presumption that a trust is revocable. 67 Therefore, grantors desiring to create irrevocable trusts in South Carolina should explicitly state that the trust is irrevocable. A power of revocation under 676 is likely to cause gross estate inclusion for the grantor under 2036 or Therefore, a 676 power is not a good choice for creating a grantor trust if the intention is to keep the trust property out of the grantor s estate Income for Benefit of Grantor 677 provides for grantor trust status if certain powers which affect the income of the trust (or a portion thereof) are or may be exercised without the consent of an adverse party. 676 dealt with the grantor s ability to affect the trust corpus. 677 deals with the grantor s ability to affect the income. The powers 64 I.R.C. 672(d). 65 I.R.C. 676(b). 66 See I.R.C S.C. Code (a), ( Unless the terms of a trust expressly provide that the trust is irrevocable, the settlor may revoke or amend the trust ).

24 triggering grantor trust status under Section 677(a) when exercisable by the grantor or a non-adverse party include the: (a) Power to distribute the income of the trust (or a portion) to the grantor or the grantor s spouse; 68 (b) Power to hold or accumulate the income of the trust (or a portion) for future distribution to the grantor or the grantor s spouse; 69 or (c) Power to apply the income of the trust (or a portion) to the payment of premiums on life insurance policies covering the life of the grantor or grantor s spouse. If the trust provisions require the consent of an adverse party with respect to the distribution, accumulation or payment of premiums, the trust (or such portion) will not be treated as a grantor trust. 70 The inclusion of the words may be in 677(a) results in grantor trust treatment where the power exists, regardless of whether it is exercised or not. For example, a discretionary power to distribute income to the grantor s spouse will cause the income portion of the trust to be treated as a grantor trust under 677(a)(1). Likewise, a discretionary power to distribute corpus of the trust to the spouse combined with a provision allowing accumulation of income runs afoul of 677(a)(2). When the grantor is only deemed to own the income portion of the trust, the grantor will only be taxable on ordinary income items. 71 The trust remains taxable with respect to capital gains. 72 However, if the capital gain items are treated as corpus but may be accumulated for future distribution to the grantor or the grantor s spouse, then the grantor would also be taxable with respect to the capital gains I.R.C. 677(a)(1). 69 I.R.C. 677(a)(2). 70 I.R.C. 677(a). 71 Treas. Reg (a)-1(e). 72 Treas. Reg (a)-1(g). 73 Treas. Reg (a)-1(g), Ex. (2).

25 The exception provided in 676(b) also applies to 677 a trust will not be treated as a grantor trust if the exercise of the power can only affect beneficial enjoyment of income after the occurrence of an event such that the trust would not be treated as a grantor trust under 673 if the power were a reversionary interest. 74 Therefore, if the power with respect to income were a reversion and the value of the power was less than 5% of the value of the portion of the trust subject to the power, the trust would not be treated as a grantor trust. If the grantor does not relinquish the power with respect to trust income following the occurrence of the event, the trust will become a grantor trust. This exception will not apply if the income of the trust for the current year is accumulated and held for distribution to the grantor or the grantor s spouse after the occurrence of the event referred to by reference to (b) also provides that the trust will not be a grantor trust merely because the income may be applied or distributed for the support or maintenance of a beneficiary other than the grantor s spouse whom the grantor is legally obligated to support. This means that the income must actually be used to discharge a support obligation of the grantor (other than an obligation to support a spouse) in order for grantor trust status to be applied to a trust pursuant to 677 where the trust permits such a distribution. However, most grantor trusts should not rely on 677(b) because payments for a beneficiary which the grantor has an obligation to support will trigger estate inclusion under Grantor trusts may be properly created under 677 without fear of gross estate inclusion if the grantor s spouse is a discretionary beneficiary of income and principal. The grantor, however, may not be such a beneficiary without estate tax consequences. In the situation where the grantor s spouse is a discretionary beneficiary the trustee should be a non-adverse party who is not the grantor or the grantor s spouse. One problem with this approach is that at the death of the spouse 74 I.R.C. 677(a). 75 Treas. Reg (b)(2).

26 the grantor trust status would terminate in the absence of another power. Another issue is that toggling (discuss in Section G below) may be difficult using 677. The properly drafted 677 grantor trust will avoid gross estate inclusion for the spouse as well because the spouse contributed nothing to the trust. SLATs, discussed in Section B above, are examples of a type of grantor trust utilizing 677. If a trust is not intended to be a grantor trust the payment of premiums for life insurance on the life of the grantor or the grantor s spouse should be prohibited. The existence of the ability to pay these insurance premiums, not actual payment, is enough to cause grantor trust treatment. However, if the trust is to be treated as a grantor trust, a premium payment provision may be one of several triggers to ensure grantor trust treatment with respect to the entire trust Person Other than Grantor Treated as Substantial Owner Under 678, a person other than the grantor may be treated as the owner of a portion of a trust if such individual has the power exercisable solely by himself to vest the corpus or income in himself. 76 The person will also be treated as the owner if he previously released or modified a power to vest the corpus or income in himself in such a way as to subject him to the provisions of 671 through 677 if he were the grantor. 77 This rule will be applies whether or not the power is actually exercised. 78 If the grantor of the trust is already being treated as the owner of the income of the trust for federal income tax purposes, 678 will not operate to treat another person as the owner of the same income. 79 The statute only applies this provision when the trust is a grantor trust as to income. Therefore, if the trust is a grantor trust to the grantor as to principal only, a beneficiary may still be treated as owner of the income under I.R.C. 678(a)(1). 77 I.R.C. 678(a)(2). 78 See Rev. Rul , C.B. 225; Rev. Rul. 81-6, C.B I.R.C. 678(b).

27 A common situation implicating this principal is a trust containing Crummey withdrawal powers exercisable by the beneficiaries. 80 Under 678(a)(1), a Crummey beneficiary will be treated as the owner of the portion of the trust subject to the Crummey power while the power exists and similarly under 678(a)(2) after the power has lapsed. As long as the entire trust is treated as a grantor trust with respect to the grantor, the Internal Revenue Service has indicated in a Private Letter Ruling that none of the beneficiaries will be treated as owning a portion of the trust. 81 However, it is unclear what the treatment of the Crummey beneficiaries will be upon the death of the grantor. If the trust is only a grantor trust as to principal it appears the Crummey beneficiaries may be treated as owners of the portion of the trust subject to the Crummey withdrawal rights (or former withdrawal rights) following the grantor s death. Another exception to grantor trust status under 678 is a trust with a power that enables a person, in their capacity as trustee, to apply the income of the trust to the support or maintenance of a person whom the holder of the power is obligated to support, except to the extent that such income is so applied. 82 This can occur where a child is named trustee for a trust for the benefit of the grantor s grandchildren. This exception only applies if the power is held in a fiduciary capacity and the payment for support or maintenance is from trust income. Finally, 678(d) provides that a power may be disclaimed within a reasonable time after the holder of the power first becomes aware of its existence Foreign Trusts The transfer of property from a U.S. person to a foreign trust will generally trigger grantor trust status for the U.S. person if the trust has one or more United States beneficiaries. 83 There are two exceptions to grantor trust treatment under 679. If the property is transferred to the foreign trust by reason of the death of the 80 See Crummey v. Comm r, 397 F.2d 82 (9th Cir. 1968). 81 Priv. Ltr. Rul (Jul. 27, 2007). 82 I.R.C. 678(c). 83 I.R.C. 679(a)(1).