PLANNING WITH GRANTOR TRUSTS

Transcription

1 PLANNING WITH GRANTOR TRUSTS By Lawrence P. Katzenstein Thompson Coburn LLP One Mercantile Center St. Louis, Missouri (314) PLANNING WITH GRANTOR TRUSTS Lawrence P. Katzenstein Thompson Coburn LLP One Mercantile Center St. Louis, Mo (314) I. Introduction. The grantor trust rules of the Internal Revenue Code ( ) determine when a grantor ( ) or another person ( 678) will be treated as owner of all or a portion of a trust; ( 679 governs foreign trusts). To the extent the grantor trust rules apply, the trust entity is for the most part ignored for tax purposes, and the regular rules governing taxation of trusts are inapplicable. Reg (a) 0. The grantor trust rules represent a legislative response to a long history of attempts to shift income to trusts or trust beneficiaries while retaining the benefit of trust property, or the right to control beneficial enjoyment of trust property. It should be kept in mind, however, that the rules governing ownership of income of a trust are not coterminous with (and are generally broader than) the rules governing ownership of assets for federal estate tax purposes: an asset may be treated as owned by the grantor for income tax purposes, but not estate tax purposes, or for estate tax purposes, but not income tax purposes. It should also be kept in mind that the grantor trust rules are a complete codification of the rules of trust income ownership. If the rules are followed, the Service cannot assert taxability under general principles of assignment of income or otherwise: Items of income, deduction and credit not attributed to or included in any portion of a trust of which the grantor or another person is treated as the owner under subpart E are subject to the provisions of subparts A through D (section 641 and following), of such part I. Reg (d). II. Effect of Applicability of Grantor Trust Rules.

2 A. In General. If the grantor trust rules apply, the trust items of income, deduction and credit are treated as if received or paid by the grantor himself. Reg (c) gives as an example a charitable contribution made by a grantor trust, which is treated as if made directly by the grantor, and aggregated with the grantor s other contributions for purposes of determining whether the grantor has run afoul of the percentage limitations of 170(b)(1). In other words, trust items of income or deduction are treated as owned by the grantor on an item by item basis, as if there were no trust and he had received or paid all of the items directly. Such treatment may or may not be detrimental to the grantor, because items of deduction are owned by the grantor as well. Reg (c) apportions to the grantor a pro rata portion of all DNI items. In fact, the grantor trust rules are mostly of interest to planners these days because of the numerous occasions on which grantor trust treatment is intentionally invoked. The income will be taxed to the grantor in the calendar year in which the income is earned, rather than the calendar year in which the trust fiscal year ends. Charles Amabile, TC Memo , Scheft v. Commissioner, 59 T.C. 428 (1972). (Trusts other than grantor trusts are required to be on a calendar year.) B. What portion is included? The grantor may be the owner of less than the entire trust under the grantor Trust rules. 1. Income or principal. The grantor may own the income portion of a trust or the principal portion, or both. Example: A created a Pre Tax Reform Act of 1986 ten year and one month reversionary ( Clifford ) trust, with income to child, reversion to A. A is the owner of the income allocable to corpus because it will revert to him at the termination of the trust. Reg (b)(2). Capital gains therefore would be taxable to A if under state law or the governing instrument capital gains are allocable to corpus. Depreciation would also be considered as owned by A. See 677(a). Example: A creates an irrevocable trust, reserving income for A s lifetime, remainder to B. A is taxed on items allocable to income only. Items allocable to corpus are taxed under the regular trust rules. See Rev. Rul , C.B Fractional or percentile amount? Rather than be treated as the owner of certain items of income, the grantor may be treated as the owner of a certain percentage or fraction of the trust. Example: A creates an irrevocable trust, reserving a right to one half of the trust income. A is treated as owning one half of the income, as well as one half of the deductions attributable thereto. Example: A creates an irrevocable trust retaining the right to withdraw $100,000. A is treated as owning the following fractional share of trust assets annually: $100,000 Value of Trust assets on 1st day of grantor s

3 taxable year See Scheft v. Comm, 59 T.C. 428 (1972). Note that retaining a prohibited power over a dollar amount will affect the percentage of items taxable each year, because the fraction will change as the trust grows or shrinks. only. 3. Specific asset. The grantor may be treated as owning specific assets Example: A creates an irrevocable trust consisting of 100 shares of I.B.M. and 100 shares of General Motors, retaining a greater than 5% reversion in the I.B.M. stock. A is treated as owning the I.B.M. stock but not the General Motors stock. See Reg (a)(2). C. Specific effects of ownership of trust property. 1. Sale of personal residence by grantor trust. If the grantor is treated as the owner of trust property, a personal residence sold by the trust and occupied by grantor will qualify for the tax free exclusion of gain on sale of a principal residence. See Rev. Rul , C.B. 162 for a comparable rollover situation. See also C.B. 183 and IRS. Let. Rul and Transactions between trust and grantor. The United States Court of Appeals in Rothstein v. U.S., 735 F.2d 704 (2d.Cir.1984) held that where a grantor purchased stock from a trust created by him in exchange for his promissory note, the trust entity could not be ignored and the grantor s basis in the stock purchased is the face value of the note. The grantor was treated as owner of the trust under 675(3) because in exchanging his unsecured note for the trust corpus he had, in effect, borrowed the trust corpus. In Rev.Rul , C.B.184, the Service announced that it would not follow Rothstein. See also IRS Let. Rul , which involved a grantor trust s exchange of partnership interests. The Service, relying on Rev. Rul , ruled that because the grantor was treated as the owner of the underlying trust assets, no gain or loss resulted, and the basis in the partnership was not affected. III. Grantor Trust Rules. The grantor of a trust is treated as the owner of trust property in the following circumstances. Note that the rules are both analogous to and different from the parallel estate tax rules. 1. G has a reversionary interest in either income or corpus of any portion of a trust the value of which exceeds 5% of such portion at the inception of the trust Under pre Tax Reform Act of 1986 law, the reversionary trust was taxed to the grantor only if the reversionary interest would or could reasonably be expected to take effect in possession or enjoyment within ten years commencing with the date of the transfer of that portion of the trust.

4 2. G retains certain prohibited powers to affect beneficial enjoyment without the approval or consent of an adverse party G retains certain prohibited administrative powers G retains the right to revoke Income can be used to benefit the grantor For transfers in trust after March 1, 1986, the grantor s spouse holds any such interest or power. New 672(e). A. 673 Reversionary Trusts. 1. History. In Helvering v. Clifford 309 U.S. 311 (1940) the Supreme Court taxed to the grantor income of a trust which provided for income to be distributed to grantor s wife for 5 years with reversion to grantor. The short term was only one of the factors leading the Supreme Court to tax the income to the grantor. The 1954 revision of the Internal Revenue Code codified the so called Clifford Regulations in which the Treasury had attempted to bring order into a very vague and confused area of the law. These rules were codified by section 673 which before revision by the Tax Reform Act of 1986, provided generally that a trust with a reversion which would not occur sooner than ten years would not be taxed as a grantor trust. 2. Present Section 673. Under present section 673, the grantor is treated as the owner of any portion of a trust in which he has a reversionary interest in either corpus or income therefrom, if as of the inception of that portion of the trust, the value of such interest exceeds five percent of the value of such portion. TAMRA added an assumption of maximum exercise of discretion in favor of the grantor. a. Note: This is a five percent valuation test, not a five percent probability test. The factor can be computed with commutation tables published by the Internal Revenue Service in publication 1457, Volume Aleph, or with software such as the author s Tiger Tables. b. Section 673 includes an exception for a reversionary interest taking effect at the death of a minor lineal descendant beneficiary solely by reason of a reversionary interest which takes effect upon the death of such beneficiary before the beneficiary attains age 21. This exception was included for the benefit of lawyers who aren t good at math, since the value of a reversion to occur only on the death of a beneficiary before reaching age 21 will always be less than five percent. Therefore, a reversionary interest only on the death of a beneficiary before the beneficiary attains age 21 can be created for any person, whether or not such person is a lineal

5 descendant of the grantor. In fact, at younger ages the tables permit an age quite in excess of 21 years. Actuarially, if the person is young enough, any reversion if the person dies before termination of a trust is likely to be less than 5%. This is logical: if the person is young, it is unlikely that the death will occur within a short period of time. If the trust term is longer, although there is a greater possibility that the death will occur during the term, the age of the death is pushed out so far as to make the reversion worth very little. For example, assuming a 10% interest rate, at age 30 a reversion during a term of any years can never be more than 5%. Example: Section 7520 rate: 10% Age 30 Term of years Value of reversion Therefore, if the measuring life is young enough, any reversion is safe at any time during a trust term even for non lineal descendants. This will obviously not be true at older ages. For example, at age 60 the reversion is worth more than 5% for any trust longer than 3 years. The message is that you must do the math (using the commutation tables and the M and D factors) to measure whether the reversion is more than 5%. e. The repeal of the old Clifford trust rules had effects on other planning areas. For example, under pre Tax Reform law, grantor type charitable lead trusts these were typically made grantor trusts by retention of a reversion within ten years so the donor was permitted a charitable deduction in the year of transfer. The current five percent rule makes possible a grantor type charitable lead trust lasting longer than ten years. If the donor dies before the reversion, however, there will be a partial recapture of the tax benefits. IRC 170(f)(2)(B). 3. The 5% reversionary rule may sometimes be intentionally invoked to obtain grantor trust treatment. A typical example is in a common law grantor retained income trust for a non family member (such as a niece or nephew) where the grantor retains a reversion in corpus if he dies during the GRIT term. A reversion of more than 5% makes the trust a grantor trust under 673 and, therefore, enables the GRIT to hold S corporation stock. B. 674 Power to Control Beneficial enjoyment. 674(a) treats the grantor as the owner of any portion of a trust with respect of which the grantor retains the right to control beneficial enjoyment of corpus or income, exercisable by the grantor or a non adverse party (or both) without the approval or consent of an adverse party. 674(b) enumerates 8 exceptions, which apply regardless of the identity of the holder of the power. 674(c) specifies two exceptions, which apply only if held by an independent Trustee. 674(d) includes a further exception which applies only if the trustee (or holder of the power) is