DEMYSTIFYING GRANTOR TRUSTS. Audrey Patrone Peartree, Esq. Megan F. Barkley, Esq.

Transcription

1 DEMYSTIFYING GRANTOR TRUSTS by Audrey Patrone Peartree, Esq. and Megan F. Barkley, Esq. Harris Beach PLLC Pittsford 171

2 172

3 I. OVERVIEW OF GRANTOR TRUSTS A. Historical Background Setting the Stage In the aftermath of the Great Depression and World War II, married couples were not permitted to file joint returns and income tax rates were upwards of 80%. Soaring income tax rates encouraged taxpayers to shift income to other taxpayers in lower income tax brackets, such as a spouse. In addition, taxpayers shifted income to trusts and trust beneficiaries. Landmark Decision: Helvering v. Clifford, 309 U.S. 331 (1940) In Helvering, a taxpayer funded a trust for the benefit of his wife but retained the discretion to make distributions to her. The taxpayer also retained other powers over the trust assets, including the power to vote the shares of stock transferred to the trust. The trust was to terminate at the end of five years, when the accrued income was to be paid to the wife and the principal returned to the taxpayer. The Court held that the taxpayer was the owner of the trust and that income earned in the trust would be taxed to the taxpayer. In reaching its decision, the Court noted the short duration of the trust, the fact that the wife was the beneficiary, and the retention of control over the corpus by respondent all lead irresistibly to the conclusion that respondent continued to be the owner. Clifford Regulations Adopted in 1946 in response to Helvering v. Clifford, the Clifford regulations provided guidelines for when trust income would be taxed to the grantor, and for when the trust would be deemed a separate taxpayer from the grantor. Congress Acts In 1954, Congress adopted the grantor trust provisions in Subpart E of Subchapter J of the Internal Revenue Code (i.e., IRC ) 1, which effectively formalized the Clifford regulations. However, Subpart E does differ in some respects from the Clifford Regulations. Tax Reform Act of 1986 The Tax Reform Act flattened individual tax brackets and eliminated the incentive to split income among taxpayers. In addition, lower tax brackets for trusts were all but eliminated. Diverting income from taxpayers with substantial income to trusts and trust beneficiaries no longer achieved the significant income tax savings obtained in the past. Taxpayers began invoking the grantor trust rules so that the grantor would be treated as owning the trust for income tax purposes. 1 Unless otherwise noted, Code and IRC refer to the Internal Revenue Code of 1986 and Regulations and Reg. refer to the Treasury Regulations promulgated thereunder. 173

4 B. What is a Grantor Trust? A Symbiotic Relationship Most trusts are treated as separate entities for federal income tax purposes, and are subject to the same progressive tax rates applicable to individuals. Trusts, however, have much skinnier tax brackets. For instance, in 2017, a trust with taxable income in excess of $12,500 is in the 39.6% tax bracket. In contrast, a married couple does not reach the 39.6% tax bracket until they have taxable income in excess of $470,700. See Rev. Proc Grantor trusts are not treated as separate taxpayers. Rather, the income generated from a grantor trust is taxed to the grantor (or, in some cases, another individual) because he or she has retained some interest in or control over the trust s assets. Because federal income tax laws view the grantor and the grantor trust as the same taxpayer, the tax elections and opportunities available to the grantor should be available to the trust. The grantor can take into consideration all of the trust s tax items (e.g., income, deductions, and credits) to which he [or she] would have been entitled had the trust not been in existence during the period he [or she] is treated as owner. Reg (a)(1). Likewise, transactions between the grantor and the trust are disregarded because the transactions are deemed to be occurring between the same taxpayer. Subpart E: IRC IRC 671 provides, in part, that: there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that potion of the trust to the extent that such items would be taken into account under this chapter in computing taxable income or credits against the tax of an individual. C. Why Use a Grantor Trust? Grantor trusts can be used to enhance many estate planning strategies resulting in assets passing to intended beneficiaries with little or no gift or estate tax. A trust is a grantor for income tax purposes when a grantor transfers assets to a trust but retains one or more powers listed in IRC Such transfers are treated for income tax purposes as a nonevent, since the grantor is required to pay all income taxes on the trust income as if the trust assets belonged to him. Since the payment of the income tax liability by the grantor is not a gift to the beneficiary, the grantor is permitted to reduce his taxable estate by the amount of the income taxes paid without incurring gift tax liability. Rev. Rule A grantor trust also can facilitate the purchase or exchange of low basis assets in exchange for higher basis assets, such as cash, by the grantor shortly before death without the imposition of an income tax. Since the low basis assets will be included in the grantor s estate, they will acquire a new basis equal to estate tax values. IRC 1014(a). If a grantor is treated as the owner of a trust s income but not its corpus (see Portion 174

5 Rule in II Part D), it may be possible to avoid state income tax on trust receipts allocable to corpus (e.g., capital gains). 2 II. BASIC RULES GOVERNING GRANTOR TRUSTS IRC 673 through 677 set forth certain powers that make the grantor (or another person) the deemed owner of all or a portion of a trust. However, in order to understand how these powers should be used to create a grantor trust (or to avoid creating a grantor trust), it is necessary to be familiar with the types of individuals who may hold the powers or block the exercise of the powers. These definitions and rules are found in IRC 671 and 672 and the Regulations thereunder. A. Who is a Grantor? Definition [A] grantor includes any person to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer... of property to the trust. If a person establishes or funds a trust on behalf of someone else, both individuals are treated as grantors. If a person establishes a trust but does not make gratuitous transfers, that person is not treated as the grantor. Reg (e)(1). Examples of Grantors: Moore v. Commissioner, 23 T.C. 534 (1954) A state court order created a trust to hold the residue of the decedent s estate, and the residual beneficiaries consented to the establishment of the trust. The Tax Court found that each beneficiary was a grantor with respect to his or her interest in the trust. Reg (e) A creates and funds trust T for the benefit of A s children. B makes a gratuitous transfer to T. Both A and B are grantors of T. A creates trust T for his brother B s benefit. A transfers $50,000 to T. The trustee invests the $50,000 in Company X s stock. B s uncle, C, sells property with a fair market value of $1,000,000 to T in exchange for the stock when it has appreciated to a fair market value of $100,000. Under Reg (e)(2)(ii), the $900,000 excess is a gratuitous transfer by C. So, A is a grantor with respect to the portion valued at $100,000, and C is a grantor with respect to the portion valued at $900,000. In addition, A or C or both will be treated as the owners of the respective portions of the trust of 2 See, e.g., New York Tax Law 605(b)(3)(D), which provides that a New York resident trust with no New York tangible personal or real property, no New York source income, and no New York trustees will not be subject to New York State income tax. 175

6 which each person is a grantor if A or C or both retain power over or interest in such portions under IRC 673 through 677. However, a person who creates a trust but makes no gratuitous transfers to the trust, is a grantor of the trust but is not treated as an owner of any portion of the trust. A, an attorney, creates a foreign trust, FT, on behalf of A s client, B, and transfers $100 to FT out of A s funds. A is reimbursed by B for the $100 transferred to FT. Both A and B are treated as grantors of FT. In addition, B is treated as the owner of the entire trust. Both A and B are responsible parties for purposes of reporting requirements under B. Who are Adverse Parties and Non-Adverse Parties? An adverse party is [a]ny person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he [or she] possesses respecting the trust. In order for a party to be an adverse party, he or she must have a beneficial interest in a trust. A person who holds a general power of appointment over trust property is deemed to have a beneficial interest in the trust. IRC 672(a). A trustee is not an adverse party merely because of his or her role as trustee. An interest is substantial if its value in relation to the total value of the property subject to the power is not insignificant. Reg (a)-1(a) (emphasis added). Although the regulations provide that income beneficiaries can be deemed adverse parties, there is no definite threshold for having a not insignificant interest. Having a substantial beneficial interest does not automatically render a person an adverse party. Rather, to be an adverse party, the substantial beneficial interest must be adversely affected by the exercise or non-exercise of a power over the trust. A party may be an adverse party with respect to the exercise or nonexercise of a power over a portion of a trust. A, B, C and D are equal income beneficiaries of a trust and the grantor can revoke the trust with A s consent. The grantor is treated as owner of a portion which equals three fourths of the trust. The grantor is not treated as owner of the portion which represents one-fourth of the trust. A is an income beneficiary as to one fourth of the trust, and his beneficial interest in the trust would be adversely affected by consenting to the grantor s revocation of the trust. Reg (a)-1(b). A non-adverse party is anyone who is not an adverse party. C. Who are Related or Subordinate Parties? The term related or subordinate party means any non-adverse party who holds one of the following relationships with the grantor: 176

7 (1) the grantor s spouse; (2) the grantor s parent; (3) the grantor s issue; (4) the grantor s sibling; (5) the grantor s employee; (6) a corporation in which either or both the grantor and the trust have significant voting power (i.e., a controlled corporation ); (7) an employee of a controlled corporation; or (8) an employee of a corporation in which the grantor is an executive. The term related or subordinate party does not include the persons who have the following relationship with the grantor: niece, nephew, grandparent, spouse of children, spouse of grandchildren, partner, attorney, accountant, and financial advisor. In some cases, powers and actions of a related or subordinate party will be imputed to the grantor only if the related or subordinate party is subservient to the grantor with respect to the exercise or non-exercise of a power. A related or subordinate party is presumed subservient only for purposes of the powers under IRC 672(f), 674 and 675. IRC 672(e) provides that for purposes of Subpart E, a grantor is treated as holding any power or interest held by his or her spouse. D. The Portion Rule When a grantor is deemed the owner of any portion of the trust, the grantor must include the income, deductions, and credits against tax from that portion when computing his or her taxable income. IRC 671. The term portion is not defined in the Code or Regulations. However, Reg (a) identifies the ways in which a grantor (or other person) may be treated as owning a portion of a trust. Grantor is treated as owner of the entire trust. For instance, where the grantor retains a power to revoke a trust, he will be treated as owner of the entire trust. See IRC 676. Grantor is treated as owner of all items attributable to specific trust property. A grantor (or other person) who holds a power described in IRC over a specific trust asset and its income will be treated as owner of the specific trust asset and taxable on all items of income, deduction and credit attributable to the assets. Grantor is treated as owner of ordinary income portion of trust. For instance if a grantor creates an irrevocable trust directing that ordinary income is payable to him for life and that upon his death the corpus is payable to B, an unrelated person, the grantor will be treated as owner of the ordinary income portion of the trust for income tax purposes. Similarly, if a grantor retains a right to allocate income between or among non-charitable beneficiaries, with principal to pass to a certain beneficiary upon grantor s death, the grantor s power to allocate income results in him being treated as owner of the income of the trust under IRC 674(a). 177

8 Grantor is treated as owner of corpus. If a grantor is treated as owner with respect to only the corpus of a trust, the grantor must take into account the items of the trust s taxable income that are allocated to corpus in computing his income tax liability (i.e., capital gains and losses). Grantor is treated as owner of a fractional share of items of trust income and/or principal. If the portion of a trust treated as owned by a grantor consists of an undivided fractional interest in the trust, or of an interest represented by a dollar amount, the grantor is required to take into account that fractional share of the trust s items of income, deduction and credit. III. POWERS TRIGGERING GRANTOR TRUST STATUS Subpart E sets forth the powers that will render the grantor (or another person) the owner of all or a portion of the trust for income tax purposes. Each power described includes a discussion of the whether the power creates a grantor trust and whether that power triggers inclusion in the grantor s gross estate. A. Reversionary Interests: IRC 673 What is a Reversion? A reversion is a power to reclaim the possession or enjoyment of the trust property. If the grantor retains a reversionary interest in any portion of the trust income or principal, he or she will be deemed the owner of that portion of the trust so long as the value of the reversion is greater than 5% of the value of the portion of the trust to which the reversion relates. IRC 673(a). Drafters seeking to avoid invoking grantor trust status should ensure that the grantor holds no reversionary interest or that the value of the reversion is no more than 5% of the value of the trust portion of the trust to which the reversion relates. Exception IRC 673(b) The grantor is not treated as the owner if: The beneficiary of the trust is a lineal descendant of the grantor; The beneficiary holds all of the present interests in any portion of the trust; and The grantor s reversion takes effect upon the beneficiary s death if the beneficiary dies before reaching age 21. Estate Tax Consequences In general, if a reversionary interest triggers grantor trust status, the trust will be included in the grantor s gross estate. IRC

9 Survivorship and Reversion Tests: IRC 2037(a)(1) and 2037(a)(2) Estate tax inclusion of the trust assets in the grantor s estate will occur if both the survivorship test and the reversion test are met. To meet the survivorship test, a beneficiary must survive the grantor in order to obtain the possession or enjoyment of the trust property at issue. The survivorship test will not be met if the beneficiary can take ownership by any other means. To meet the reversion test, a grantor must retain a reversionary interest in the property at issue, and the value of the reversion immediately before the grantor s death must exceed 5% of the value of the transferred property. The mortality tables and actuarial principles set forth in Reg (c)(3) are used to determine the value of the reversion. Example: A decedent transferred property in trust with the income payable to his wife for her life and, upon her death, the remainder to the decedent s then surviving children or, if none, to the decedent or his estate. No part of this property is includible in the decedent s gross estate, regardless of the value of his reversionary interest, because each beneficiary can possess or enjoy the property without surviving the decedent. Reg B. The Grantor s Power to Control Beneficial Enjoyment: IRC 674 Grantor trust status will be triggered if the beneficial enjoyment of the trust property is subject to a power of disposition exercisable by the grantor, a non-adverse party, or both, without the approval or consent of an adverse party. A grantor will be deemed the owner of any portion of a trust where the beneficial enjoyment of the principal or income is subject to any power of disposition that either the grantor or a nonadverse party (or both) can exercise without an adverse party s consent or approval. Exceptions: 674 contains a number of exceptions to this rule. The exceptions can be categorized into three groups: (1) powers held by anyone; (2) powers held by independent trustees; and (3) powers held by trustees other than the grantor or the grantor s spouse. 1. Powers Held by Anyone The following powers that affect beneficial enjoyment will not invoke grantor trust status, even if the powers are held by the grantor, an adverse party, a non-adverse party, a related or subordinate party, someone else, or a combination of the foregoing. IRC 674(b)(1)-(8) and Reg (b)-1(b)(1)-(8). 179

10 Power to Apply Income to Support a Dependent A trust will not be deemed a grantor trust merely because someone (other than the grantor who is not acting as a trustee) holds a discretionary power to pay income for the support of a beneficiary whom the grantor is legally obligated to support (e.g., minor child). However, if the power is exercised, the grantor may be taxed on the income used for the beneficiary s support. IRC 674(b)(1) and Reg (b)-1(b)(1). Powers Affecting Beneficial Enjoyment Only After a Period The grantor is not deemed to own any portion of a trust that is subject to a power to affect the beneficial enjoyment of the income received after the occurrence of some event so long as the power would not invoke ownership under IRC 673 if the power were a reversionary interest. IRC 674(b)(2) and Reg (b)-1(b)(2). Powers Exercisable by Will In general, where the power to affect the beneficial enjoyment of trust property is exercisable only by will, the grantor will not be considered the owner of the trust. However, this exception does not apply if the grantor reserves in himself or herself the power to appoint trust income accumulated for disposition under the grantor s will. IRC 674(b)(3) and Reg (b)-1(b)(3). Power to Choose Charitable Beneficiaries A trust is not a grantor trust if the grantor retains only the power to allocate trust corpus or income to charitable organizations or an employee stock ownership plan. IRC 674(b)(4) and Reg (b)-1(b)(4). Power to Distribute Principal The grantor will not be treated as the owner if he or she has the power to distribute trust principal to an identified beneficiary or among a class of beneficiaries, so long as the power is limited by a reasonably definite standard. IRC 674(b)(5) and Reg (b)-1(b)(5). A reasonably definite standard is [a] clearly measurable standard under which the holder of a power is legally accountable. Reg (b)(1)-(1(b)(5)(i). For example, principal distributions for reasonable support and comfort will qualify as being reasonably definite, while principal distributions for happiness, desire, or pleasure will not. Note that grantor trust status will not be triggered where a power to distribute principal that is not limited by a reasonably definite standard if the distributions may be made only to current income beneficiaries and if the distributions are chargeable against the 180

11 proportionate part of corpus held in trust for payment of income to that beneficiary as if it constituted a separate trust. Reg (b)-1(b)(5)(ii). Example: A trust instrument provides for payment of the trust income to the grantor s two brothers for life, and for payment of the principal to the grantor s nephews in equal shares. The grantor retains the power to distribute principal to pay for medical expenses that his brothers or nephews might incur. Retaining this power does not trigger grantor trust status because IRC 674(b)(5)(A) excepts a power to invade principal for any beneficiary if the power is limited by a reasonably definite standard. If, however, this power was exercisable in favor of someone else who was not a beneficiary of the trust (for example a sister), IRC 674(b)(5)(A) would not apply. Reg (b)-1(b)(5). Power to Withhold Income Temporarily A trust is not a grantor trust if it includes the power to pay income to or withhold income from any current income beneficiary, so long as any accumulated income is ultimately paid to the income beneficiary (or to the beneficiary s estate or appointees). IRC 674(b)(6) and Reg (b)-1(b)(6). Example: A trust instrument provides that income shall be paid in equal shares to the grantor s two adult children. The grantor reserves the power to withhold from either child any part of that child s share of income and to add it to the principal until the younger child reaches the age of 30. When the younger child reaches the age of 30, the trust will terminate and the principal will be divided equally between the two children (or their estates). The exercise of this power is excepted under IRC 674(b)(6)(B), even though it may permit the shifting of accumulated income from one beneficiary to the other. Reg (b)- 1(b)(6). Power to Withhold Income During Beneficiary s Disability A grantor is not taxed on trust income merely because he or she has the right to withhold the distribution of income where an income beneficiary is disabled or where he is under age 21. Note that it is not necessary that the income ultimately be payable to the income beneficiary from whom it was withheld, his estate or his appointees. IRC 674(b)(7) and Reg (b)-1(b)(7). Power to Allocate Receipts Between Principal and Income The power of the grantor to allocate receipts between principal and income is not, in itself, enough to trigger grantor trust status. IRC 674(b)(8) and Reg (b)-1(b)(8). 181

12 2. Powers Held by Independent Trustees An independent trustee s power to pay or accumulate income or principal to a beneficiary or class of beneficiaries will not invoke ownership of the trust assets to the trustee or grantor, provided that the independent trust does not add to the class of permissible beneficiaries. IRC 674(c) and Reg (c) Power Held by Trustees Other Than the Grantor or the Grantor s Spouse The power to pay, allocate, or accumulate income in accordance with a reasonably definite external standard... set forth in the trust instrument will not impute grantor trust status provided that the power is held and exercisable by a trustee or trustees other than the grantor or his or her cohabitating spouse, and that the power does not include a power to add beneficiaries. IRC 674(d) and Reg (d)-2(b). Estate Tax Consequences The power to control the beneficial ownership of trust property typically results in inclusion in the grantor s gross estate under either IRC 2036 or IRC 2038 (or both). IRC 2036(a) Estate Inclusion IRC 2036(a) includes in the grantor s gross estate the value of any property the grantor gratuitously transferred and in which the grantor reserved the right to decide who shall receive the income from (or the possession or enjoyment of) the property for either the grantor s life, a period that is not ascertainable without reference to the grantor s death, or a period that does not terminate before the grantor s death. If the grantor retained or reserved an interest or right with respect to all of the property he or she transferred, the amount includible in the grantor s gross estate is equal to the value of the entire transferred property less the value of the outstanding income interest not subject to the decedent s interest or right and which is being enjoyed by another person at the time of the grantor s death. Reg (c). The grantor s retained power to designate the beneficiaries will typically trigger inclusion in the grantor s gross estate, so long as the grantor s power to choose affects the enjoyment of the income earned from the trust property. Reg (b)(3). Where the grantor serves as trustee and the trustee s discretion to distribute income or principal to beneficiaries is limited to an ascertainable standard that is related to the maintenance, education, support, or health of a beneficiary, the trust is not deemed to be part of the grantor s gross estate, since the trustee s discretion is so limited, the trustee is deemed to have merely a ministerial power and not a discretionary power to control the beneficial enjoyment of trust property. 182

13 IRC 2038 Estate Inclusion Estate inclusion under IRC 2038 is invoked when the grantor can revoke the transfer or when he retains the power to alter or amend a transfer of property (even if the transfer is otherwise irrevocable). The capacity in which a power to alter or amend a trust is irrelevant. Consequently, even if the grantor holds the power to alter or amend in a fiduciary capacity, 2038 still applies. Again, to avoid inclusion, if the grantor wants to serve as trustee, the trustee s discretion to distribute income or principal should be limited to an ascertainable standard related to the beneficiary s maintenance, education, support, or health. The trustee will then have a ministerial power and not a discretionary power to alter or amend the initial transfer. C. Administrative Powers: IRC 675 Non-Arms-Length Transactions Since administrative powers generally do not affect beneficial enforcement of trust property and do not represent a retained interest in trust assets, such powers would not trigger grantor trust status. However, if an administrative power allows the grantor to engage in non-arms-length transactions with the trust, the grantor will be treated as the owner of the portion of the trust as to which the power relates. IRC 675 lists six administrative powers that trigger grantor trust status. 1. Power to Deal for Less than Adequate and Full Consideration The grantor will be treated as the owner of the trust where the grantor, a non-adverse party, or both the grantor and a non-adverse party may purchase, exchange, or otherwise deal with or dispose of trust property for less than an adequate consideration in money or money s worth without the approval or consent of any adverse party. IRC 675(1) and Reg (c). 2. Power to Borrow Trust Property Without Adequate Interest or Security The grantor will be deemed to be the owner of at least a portion of the trust where the grantor, a non-adverse party, or both may borrow principal or income without having to pay adequate interest or adequate security for the loan. This power is inapplicable where a trustee (other than the grantor) has a general power to make loans to anyone without the payment of adequate interest or the giving of adequate security. IRC 675(2) and Reg (b)(2). 3. Grantor Borrows Trust Property Without Adequate Interest or Security The grantor will be treated as the owner of at least a portion of the trust if the grantor or the grantor s spouse has borrowed principal or income from the trust and has not completely repaid the loan (including interest) before the start of the taxable year. IRC 675(3) and Reg (b)(3). 183

14 4. Power to Vote Stock, Control Investments, or Substitute Property The existence of certain powers of administration exercisable in a non-fiduciary capacity and without the approval or consent of anyone in a fiduciary capacity, will trigger grantor trust status. The term powers of administration includes the following: (1) the power to vote or direct the voting of stock or other securities held by the trust; (2) the power to control the investment of trust funds; and (3) the power to reacquire the trust property by substituting other property of an equivalent value. IRC 675(4) and Reg (b)(4). Estate Tax Consequences 1. Power to Deal for Less than Adequate and Full Consideration If a grantor dies holding a power to deal with trust property for less than full consideration, that property may be included in his gross estate under IRC 2036(a), since the grantor may be deemed to have retained the right to choose who can enjoy the trust property. Under IRC 2035(a), if the grantor surrendered this right within three years of his or her death, the trust property would be included in the grantor s estate. 2. Power to Borrow Trust Property Without Adequate Interest or Security The grantor s power to borrow from the trust without having to pay adequate interest or without having to give adequate security should not trigger gross estate inclusion. Neither power affects the beneficial enjoyment of the trust property nor does such a power create an ability to alter or amend the trust. 3. Grantor Borrows Trust Property Without Adequate Interest or Security Again, the grantor s power to borrow from the trust does not necessarily indicate that the grantor has retained ownership of the trust property warranting inclusion in the grantor s gross estate. 4. Power to Vote Stock, Control Investments, or Substitute Property Where the grantor retains the right to vote shares of stock of a controlled corporation, he or she will be deemed to have retained the enjoyment of the transferred stock. IRC 2036(b)(1). Accordingly, the grantor s gross estate must include the value of the stock transferred to the trust. The power to control trust investments in corporate stock and securities is not a power to vote the shares, so there is less risk for inclusion in the grantor s gross estate. The power to reacquire trust assets by substituting property of equivalent value does not warrant inclusion in the grantor s gross estate because the grantor s right to swap assets does not permit the grantor to make additional wealth transfers or to reduce the value of the trust s holdings. 184

15 D. Power to Revoke: IRC 676 The grantor will be treated as the owner of the entire trust where the grantor, a non-adverse party, or both may, at any time, revoke the trust and revest title in the trust property to the grantor. Estate Tax Consequences Under IRC 2038, trust assets will be included in the grantor s gross estate if the grantor holds the power to revoke the trust upon his or her death. Even if the grantor relinquishes the right to revoke the trust, the assets will be included in his or her estate if he or she dies within three years of relinquishing the power to revoke. IRC 2035(a). E. Income for Benefit of Grantor: IRC 677 Under IRC 677(a), the grantor is taxable as the owner of any portion of a trust where, without the consent or approval of any adverse party, trust income may be distributed to the grantor or his or her spouse, held or accumulated for the benefit of the grantor or his or her spouse, or applied to the payment of premiums on life insurance policies held by the grantor or his or her spouse. Reg (a)-1(b)(2). Estate Tax Consequences Under IRC 2036(a), the trust property will be included in the grantor s gross estate if the grantor retains the right to the trust s income upon his or her death or for a period that is not ascertainable without reference to his or her death. Under IRC 2042, the payment of premiums on life insurance policies insuring the life of the grantor or the grantor s spouse will not invoke gross estate inclusion if the grantor possesses no incidents of ownership in the policy. IV. Liability for Income Taxes Prior to the issuance of Rev. Rule , the IRS had ruled privately in PLR that the grantor s payment of the income taxes on the income of a grantor trust would be a gift to the trust remainder beneficiaries. In Rev. Rule the IRS retreated from this position and issued guidance on the estate and gift tax consequences of the grantor s payment of the income tax attributable to a grantor trust and on income tax reimbursement provisions. Revenue Ruling The IRS determined that with respect to gift taxes, the grantor s payment of the income taxes attributable to inclusion of trust income in the grantor s taxable income is not a gift to the remainder beneficiaries because the grantor, not the trust, is liable for the income tax. This result is the same whether or not the trust contains a provision relating to reimbursement of income 185

16 taxes, and if there is such a provision, whether or not the trust is required to pay the income taxes or it is in the discretion of the trustee to do so. However, with respect to estate taxes, the IRS distinguished between mandatory and discretionary reimbursement provisions. If the trust document or local law requires the trust to reimburse the grantor for the income tax attributable to inclusion of the trust s income in the grantor s taxable income, IRC 2306(a)(1) requires that the full value of the trust be included in the grantor s estate because the grantor has retained the right to have trust income expended to discharge his legal obligation. If, on the other hand, the trust document or local law affords the trustee discretion to reimburse the grantor for income taxes, that provision does not cause the trust to be included in the grantor s estate whether or not the discretion is exercised. The IRS cautioned, however, that allowing the trustee discretion to reimburse for income taxes combined with other factors could cause estate inclusion. For instance, if the grantor and the trustee had an understanding or pre-existing arrangement as to the reimbursement of income taxes, or if the grantor retained the power to remove the trustee and name himself as successor trustee, then there could be estate inclusion. V. Toggling Grantor Trust Status On and Off Most grantor trust powers may be structured so that the grantor holding the power may relinquish it at any time, thereby terminating grantor trust status. The trust document also could give an independent third party the power to re-grant the released power to the grantor to trigger grantor trust status again. Turning Grantor Trust Status Off There are many reasons why a grantor may want to terminate grantor trust status. Notwithstanding the transfer tax advantages of reducing the grantor s taxable estate, the grantor may decide that he no longer has the financial wherewithal to pay the income taxes. Or there may be a tax on a sizable capital gain which the grantor is not prepared to pay. Although not specifically addressed in the Code or Regulations, it is presumed that the elimination of the specific power that created grantor trust status should instantly terminate its status as a grantor trust. See Madorin v. Commissioner, 84 T.C. 667 (1985) (finding that the power to add charitable beneficiaries was relinquished on January 1, and was effective from that date). It may not be advisable to imbue the trustee with the authority to discontinue grantor trust status since the trustee owes a fiduciary duty to the beneficiaries, rather than to the grantor. Perhaps conferring the right to terminate grantor trust status to an unrelated person (and not an adverse party) who has no fiduciary duty may provide a solution. Generally speaking many of the grantor trust powers can be turned off without significantly changing the dispositive provisions of the trust. For instance, a power to reacquire trust assets by substituting assets of equivalent value could be released without altering how the assets are to be distributed. Alternatively, if the power to alter beneficial enjoyment of the trust by adding 186

17 beneficiaries were retained, thereby achieving grantor trust status under 674(b), the person holding the power to add beneficiaries may also be given the ability to release that power, thereby terminating grantor trust status. Turning Grantor Trust Status On It may be more difficult to restart grantor trust status than to discontinue it. The person who has the power to release a grantor trust power should not be given the power to re-trigger grantor trust status. One means of reinstating grantor trust status may be available in a state that allows modification of an irrevocable trust. (See PLR where the grantor and beneficiaries agreed, under state law, to modify a trust to give the grantor a power, solely in a nonfiduciary capacity, to reacquire any property owned by the trust by substituting other property of equivalent value.) When a trust is not originally a grantor trust, it may be possible to convert it to a grantor trust at a certain date or upon the occurrence of a stated event. For example, the trust may be structured so that the trustee has the right to this power every two years. At that time, the trustee could determine whether to turn on grantor trust status. In addition, grantor trust status may be achieved by distributing the assets of the non-grantor trust to a grantor trust (i.e., decanting). IRS Scrutiny: Notice In Notice , the IRS characterized certain toggled grantor trusts as transactions of interest triggering disclosure rules, list maintenance obligations, and potential penalties under IRC 6011, 6111, and Specifically, the Notice focused on two tax shelters in which taxpayers toggled on and off grantor trust status in an effort to avoid recognizing gain or to claim a tax loss greater than actual economic loss. While the trusts at issue were both identified as transactions of interest, the Notice does not suggest that the mere act of terminating or reinstituting grantor trust status will subject the trust to IRS scrutiny. VI. Reporting Considerations Extent of the Grantor s Ownership If the grantor owns the entire trust (principal as well as ordinary income), all of the trust s income, deduction, and credit items (including capital gains and losses) will be reported on the grantor s individual tax return. Reg (a)(1). If the grantor owns specific trust property, he or she must report the items of income directly related to that property on his or her return, as well as a portion of the income for items related to the specific property and other trust property. Reg (a)(2). If the grantor is the deemed owner of an undivided fractional interest in trust property, all income, deduction, and credit items must be allocated on a pro rata basis. Reg (a)(3). 187

18 Methods of Reporting Where the Grantor Owns the Entire Trust Form 1041 The trust may file a Form Trust income is disclosed on a separate statement attached to the Form 1041 and given to the grantor. Reg (a), (b). Form W-9 The grantor may submit a Form W-9 to the trustee, and the trustee can provide each payor with the grantor s name and taxpayer identification number. Reg (b)(2)(i)(A). In addition, if the grantor is not a trustee or co-trustee, the trustee must provide the grantor with: (1) an annual statement listing items of income, deduction, and credit; (2) the identity of the payor of each item of income; (3) the information necessary to allow the grantor to properly report all items; and (4) a statement informing the grantor that items must be included on his or her individual return. Reg (b)(2)(ii). Form 1099 The trustee may provide each payor with the trust s taxpayer identification number and address and then file Form 1099 for all income items. The trust is listed as the payor and the grantor is listed as the payee. Reg (b)(2)(i)(B); (b)(2)(iii)(A). Method of Reporting Where There is More Than One Deemed Owner of the Trust s Assets The trustee can either file Form 1041 or Form Method of Reporting Where Only a Portion of the Trust is Treated as a Grantor Trust The trustee must file Form EIN Requirements Under Reg (a)(2), a grantor trust that is owned by a single person need not obtain a taxpayer identification number if the trustee provides the grantor s name and taxpayer identification number and the trust address to all income payors to the trust. Under Reg (b)(3), a taxpayer identification number must to be obtained if the trust is owned by more than one person. It is important to note that, under Reg (b)(8), a trust owned by a husband and wife who file jointly is considered to be owned by one grantor. VII. TYPES OF GRANTOR TRUSTS AND PLANNING OPPORTUNITIES A. Revocable Living Trust Arguably, a revocable living trust is the most common and well-known type of grantor trust. A trust is revocable if, under the trust agreement, the grantor has retained the right to revoke the 188

19 trust and reclaim the trust property. Because the grantor of a revocable trust retains all of the rights over the trust property, the trust property is taxed to the grantor under IRC 676 as if the grantor still owned the assets in his or her personal name. Generally, use of a revocable trust is warranted in one of three situations: 1) the grantor requires, or anticipates that he or she will require, asset management; 2) the grantor wishes to avoid dual probate since he or she owns real property in two or more jurisdictions; or 3) the grantor wishes to avoid probate all together. With respect to probate avoidance, a revocable trust is particularly effective where the grantor s distributees are not known or their whereabouts are unknown or where the grantor anticipates that objections will be filed to his or her Last Will and Testament. B. Income Only Trust A trust which is created and funded by the grantor and which directs that all income be distributed to or made available to the grantor is a grantor trust under IRC 677. Such a trust is included in the grantor s estate under IRC However, if drafted properly the trust will not be considered a resource for purposes of Medicaid eligibility, provided the trust is funded more than five years prior to the time that the grantor applies for government benefits. The grantor must relinquish the right to trust principal. C. Grantor-Retained Annuity Trust (GRAT) A GRAT must pay an annuity to the grantor for a specified term. Upon the conclusion of the term, the trust terminates and the remainder is paid to the beneficiaries. The Regulations set forth a number of requirements that the trust must meet. See Reg It is important to note that the beneficiaries of a GRAT do not receive a step-up in basis as to the trust property. Requirements for a GRAT Annual Payment of Annuity Amount The trust is required to pay an annuity amount at least once a year to (or for the benefit of) the holder of the annuity interest. In addition, the annuity amount payable on the anniversary date of the creation of the trust must be paid no later than 105 days after the anniversary date. Reg Fixed Amount The annuity amount must be based on a fixed fraction or percentage of the initial fair market value of the property transferred to the trust. Although the fixed amount payable need not be the same every year, the amount that is paid in a given year cannot exceed 120 percent of the fixed fraction or percentage payable in the preceding year. Reg

20 Formula Adjustment If the annuity amount is defined in terms of a fixed fraction or percentage of the initial value of the trust property, the trust should include an adjustment clause that allows the trustee to make adjustments for any incorrect determination of the fair market value of the trust property. Reg Additions Prohibited Additional contributions to the trust must be prohibited. Reg The trustee is not permitted to prepay the annuitant s interest. Payments to Other Individuals Prohibited Payments from the trust cannot be made to any individual other than the annuitant until the annuity interest expires. Reg Annuity Term The term of the annuity must be expressed as the life of the annuitant, a specified term of years, or the shorter of those two periods. Reg Consequences of GRAT Status Income Tax Consequences Because the annuity interest is typically worth more than 5% of the value of the trust at inception, a GRAT will usually qualify as a grantor trust. Therefore, the income tax consequences of grantor trust status will apply to the GRAT. IRC 677(a). Estate Tax Consequences If the grantor outlives the term of the trust, the trust property is not includible in the grantor s gross estate. However, if the grantor dies before the end of the trust term, estate inclusion is triggered under either or both of IRC 2036(a) and IRC Gift Tax Consequences The value of the grantor s gift is calculated by valuing the property transferred to the GRAT and deducting the actuarial value of the grantor s retained annuity interest. The present value of this interest is measured actuarially using IRC Zeroed Out GRATs GRATs can be drafted so that the grantor s taxable gift is extremely small if not zero. See Walton v. Commissioner, 115 T.C. 589 (2000). The IRS has now acquiesced in that 190

21 decision (Notice , I.R.B. 964) and the Department of Treasury has promulgated regulations adopting the Walton decision. See Reg (e), Ex. 5 and 6 (as amended by T.D. 9181). D. Intentionally Defective Grantor Trust (IDGT) The term IDGT is misleading. The trust is not actually defective at all, but operates exactly as it was intended to operate. As previously noted, initially grantor trust status was something that taxpayers sought to avoid. A trust that flunked the grantor trust rules came to be known as a defective grantor trust. Consequently, when a grantor intentionally retains a power over transferred assets that will trigger grantor trust status, the trust is known as an IDGT. The key to the IDGT tax planning strategy is the disconnect between the grantor trust rules and the estate tax treatment of transfers to trusts. As noted herein, not all of the retained powers listed in the grantor trust rules will cause trust assets to be included in the grantor s gross estate. Consequently, an IDGT is an irrevocable trust that is structured to be a grantor trust for income tax purposes and a transfer to which is deemed to be a completed transfer for gift and estate tax purposes. While the grantor is taxed on the income earned by the trust, the trust assets are not included in his gross estate. Two of the most widely used powers by estate planners to create IDGTs are 1) the power to reacquire trust corpus by substituting other property of equivalent value under IRC 675(4)(c) and 2) the power to borrow the corpus or income without adequate interest or security under IRC 675(2). If using the latter power, it is best to imbue the power in a non-adverse party. Installment Sale to an IDGT This is a tax-efficient transfer technique which involves the grantor selling appreciated property to an irrevocable trust established for the benefit of those other than himself and his spouse (typically his children and more remote issue), in exchange for a promissory note. The result is that the asset sold to the trust and any subsequent appreciation is removed from the grantor s grow estate and replaced with the note, essentially freezing the value of the asset included in the grantor s estate. Typically the grantor receives a 10% cash down payment ( seed money or seed capital ) and the balance in a promissory note structured as an interest-only note with a final balloon payment 3-9 years out. The note must charge a minimal interest rate equal to the Applicable Federal Rate ( AFR ) which is also known as the hurdle rate. The IDGT will make interest payments to the grantor and there is no penalty for prepayment of principal. Consequences of Installment Sale to an IDGT Income Tax Consequences The sale of the asset to the IDGT is a non-taxable event so that the transaction is disregarded for income tax purposes, meaning that the grantor will not recognize any gain from the sale. Annual interest payments payable to the grantor by the IDGT are not taxable as additional income. Rev. Rul

22 Asset Swaps Estate Tax Consequences If the grantor dies before the note has been repaid, the value of the note, not the value of the appreciated asset, is included in his gross estate. Essentially, the value of the asset has been frozen. If the grantor dies after the expiration of the term, no portion of the trust property is includible in the grantor s gross estate because the property was sold, rather than gifted, to the trust. IRC 2036(a). Gift Tax Consequences Because the trust pays adequate and full consideration in the form of a promissory note, the sale of property to a trust is not considered a gift. One of the most common ways for a grantor to achieve grantor trust status is by reacquiring trust assets by substituting property of equivalent value. Because the assets held in an IDGT are not includible in the grantor s gross estate upon his or her death, the assets are not eligible for the step-up in basis under IRC 1014(a). However, if the grantor exercises the swap power by exchanging high-basis assets for the trust s low basis assets, the assets will receive a step-up in basis upon the grantor s death. The exchange of assets is not deemed to be a taxable event. The high-basis assets swapped into the trust are not includible in the grantor s gross estate (so long as the trustee has a fiduciary obligation to ensure that the assets acquired and substituted are of equivalent value). Meanwhile, the low-basis assets are part of the grantor s estate and receive a step-up in basis. Many last-minute attempts to obtain a step-up in basis through gifting are not effective because of IRC 1014(e). It provides that if a donor makes a gift to a donee who dies within a year of the gift, the gifted asset will not receive a step-up in basis if the asset is devised to the donor. Since the grantor and the trust are the same person for federal income tax purposes, there cannot be the gift required to invoke IRC 1014(e). E. Qualified Personal Residence Trust (QPRT) A QPRT is an irrevocable trust that holds no assets other than an interest in the grantor s personal residence and certain other related assets (i.e., cash for certain expenditures, insurance proceeds if the residence is destroyed). The requirements of a QPRT are set forth in Reg The grantor gives his residence to a trust, but reserves the right to continue to occupy the residence for a certain period of time (the QPRT term). When the terms expires, ownership of the residence passes to the remainder beneficiaries of the trust. If the grantor dies before the term of the QPRT expires, the trust terminates and the residence reverts to the grantor s estate. Because the grantor retains the right to occupy the residence, the value of his gift to the trust is not the fair market value of the residence. Rather, the value of his gift is discounted; the longer the QPRT term, the greater the discount. However, the greater will be the risk of the QPRT failing because the grantor does not survive the term. Also, the higher the IRC 7520 rate (used to value the gift) the lower the value of the gift (i.e., the remainder interest). 192