9 Avoiding And Attracting Grantor-Trust Treatment This chapter addresses the implications of using certain powers and interests to include trust income in, and to exclude trust income from, the gross income of the grantor of a trust. Although the rules are discrete, they are neither clear nor sensible. The rules appear in Subpart E (consisting of sections 671 through 679) of Part I of Subchapter J of Chapter 1 of the Internal Revenue Code ("Code"). This chapter does not address Code Section 679, which deals with foreign trusts. Grantor-trust treatment easily can occur inadvertently. Many of the determinants are subtle or unclear. As an example, in common configurations a broadest form of nongeneral power to appoint by will might cause grantor-trust treatment according to Code Sections 673, 676 and 677. If these observations are correct, lawyers apparently are ignoring them, or, less likely in the view of the writer, lawyers either are (i) excluding as permissible appointees the grantor, the spouse of the grantor, their respective creditors and estates and the creditors of their respective estates or (ii) properly reporting a very large (indeed, in the view of the writer, an unexpectedly large) number of trusts as grantor trusts. The avoidance of grantor-trust treatment, always important, now is joined in importance with its obverse, the attraction of grantor-trust status. A person who creates a trust must know whether he or she or another will bear the tax on the income. Advisers to all grantors must know how to exclude trust income from, and to include trust income in, the gross income of the client. Traditionally, a person who during life gave property to a trust for the benefit of one or more others wanted to exclude the trust estate from his or her gross estate for estate tax purposes and wanted also to exclude the trust income from his or her gross income for income tax purposes. Some grantors want to avoid the risk of having to service an obligation the future magnitude of which is unknown or only dimly perceived. Others want to give gifts of fixed amounts, and no more. These grantors want to avoid inclusion of the trust income in their gross income. The grantor-trust rules are a barrier to the traditional objective of excluding income from the gross income of the grantor. The principal purpose of the grantor-trust rules is to prevent the grantor from fragmenting the family income and subjecting it to lower tax rates but retaining enjoyment or control. Today, during a regime in which trusts and beneficiaries often are taxed at rates at least as high as those at which grantors are taxed, a grantor has less incentive to exclude trust income from his or her gross income. Indeed, if the grantor can retain an obligation to pay the income tax without the trust being included in his or her gross estate for estate tax purposes, the family often suffers no detriment for income tax purposes and, because the grantor can pay the tax without the payment being an additional gift for gift tax purposes, enjoys a benefit for transfer tax purposes. This chapter is divided into two parts. Subchapter A focuses upon exclusion of trust income from the gross income of the grantor. Subchapter B focuses upon inclusion of trust income in the gross income, coupled nevertheless with exclusion of the trust estate from the gross estate, of the grantor.
250 Flexible Trusts and Estates, Fourth Edition SUBCHAPTER A: EXCLUDING INCOME FROM GROSS INCOME OF GRANTOR 9A.01 METHODOLOGY Subchapter A is an analysis of the grantor-trust implications of the trusts that are described in 9A.02 and of their respective powers and interests that are described in 9A.03. These trusts, and, therefore, their powers and interests, do not include any in which the grantor explicitly retains any power or interest. Accordingly, grantor retained annuity trusts, grantor retained unitrusts, grantor retained income trusts and other vehicles in which the grantor retains any interest or power are outside the scope of this subchapter A. The methodology that is used in this subchapter A is to test in 9A.04 for grantortrust treatment according to Code Sections 673, 676(a) and 677(a) because of powers and interests that permit the transfer of all or part of a trust estate to the grantor or the spouse of the grantor or to the estate of the grantor or the estate of the spouse of the grantor, to test in 9A.05 for grantor-trust treatment of powers of disposition according to Code Section 674 and to test in 9A.06 for grantor-trust treatment of powers of withdrawal according to Code Section 678. The conclusions in 9A.07 relate to the specimen powers and interests that are described in 9A.03. The conclusions in 9A.08 relate to the specimen trusts that are described in 9A.02. An analysis of the effects, both income tax and transfer tax, of administrative powers that are described in Code Section 675 appears in subchapter B. 9A.02(a) Code Section 2503(c) Trusts 9A.02 SPECIMEN TRUSTS As a first specimen, assume a trust that follows the statutory format of Code Section 2503(c), including that no substantial restriction prevents the trustee from distributing income and principal to the donee, that the trust is included in the gross estate of the donee if the donee dies before the trust terminates and that when the donee attains age twenty-one, the trust estate is distributed to the donee or is subject to the right of the donee to withdraw all of the trust estate. See Code 2503(c), Treas. Reg. 25.2503-4(b)(1) and Rev. Rul. 74-43, 1974-1 C.B. 285. Assume, also, that the trust is not usable to discharge any legal obligation owed to the donee and that the trust includes a proscription of the administrative powers that could cause grantor-trust treatment according to Code Section 675. 9A.02(b) Code Section 2642(c) Trusts Potential formats of Code Section 2503(c) trusts are few, but potential formats of other Code Section 2642(c) trusts are many. All trusts (including Code Section 2503(c) trusts) that are described in Code Section 2642(c) share the characteristics that none of the trust estate is distributable to other than the donee during the life of the donee and that the trust estate is included in the gross estate of the donee if the donee dies before the trust terminates. Additionally, each trust that is described in Code Section 2642(c) serves as a receptacle for annual-exclusion gifts. Therefore, each possesses at least one of the following characteristics:
Grantor-Trust Treatment 251 (i) The trustee must distribute the income currently to the donee (see Code 2503(b)), (ii) 9A.02(a)) or (iii) the trust. The trust is described in Code Section 2503(c) (see The donee has a Crummey power with respect to each gift to See Code 2642(c)(3). As it is used in this chapter, "Code Section 2642(c) trust" refers only to the type of trust that is described in (iii). Assume, in other words, as a second specimen, that, consistently with Code Section 2642(c), the donee has a Crummey power with respect to each gift to the trust and that the trust is included in the gross estate of the donee if the donee dies before the trust terminates. Also, assume that the trust is not usable to discharge any legal obligation owed to the donee and that the trust includes a proscription of the administrative powers that could cause grantor-trust treatment according to Code Section 675. 9A.02(c) Trust, With Crummey Powers, For One Non-Skip Person As a third specimen, assume that the trust is designed as a vehicle for annualexclusion gifts to one non-skip person (e.g., a child of the donor). The trust includes a Crummey power with respect to each gift to the trust. The trust is similar to the Code Section 2642(c) trust described in 9A.02(b), above, except that the trust is included in the gross estate of the donee for estate tax purposes only to any extent that (i) a Crummey power is "hanging" at the time that the donee dies, (ii) a lapse of a Crummey power produces a transfer for estate tax purposes or (iii) absent the inclusion of the trust estate in the gross estate of the donee, a generation-skipping transfer would occur at the death of the donee. 9A.02(d) Trust, Without Crummey Powers, For One Person As a fourth specimen, assume that the trust is designed as a vehicle for taxable gifts for the primary benefit of one person (e.g., a descendant of the donor). The trust does not include Crummey powers. The trust is excluded from the gross estate of the primary beneficiary except to any extent that (i) at death the primary beneficiary can exercise a right to withdraw (e.g., a right to withdraw at stated age(s) or a right to withdraw five percent of the trust estate each year noncumulatively) or (ii) if the trust were excluded from the gross estate, a generation-skipping transfer would occur at the death of the primary beneficiary.
252 Flexible Trusts and Estates, Fourth Edition 9A.03 SPECIMEN POWERS AND INTERESTS Each of the specimen trusts that is described in 9A.02 includes one or more of the specimen powers and interests that are described in this 9A.03. 9A.03(a) Powers and Interests that Can Transfer Trust Estate to Grantor or Spouse of Grantor (i) (ii) Remainder to the spouse of the grantor if the spouse survives the last-surviving descendant of the grantor. Remainder to the estate of the spouse of the grantor if the spouse fails to survive the last-surviving descendant of the grantor but the grantor does survive the last-surviving descendant of the grantor. (iii) Remainder to the estate of the last-surviving descendant of the grantor (i.e., because of a will or intestacy, the grantor, the spouse of the grantor and their respective estates are permissible beneficiaries). (iv) Broadest form of nongeneral power of the descendant of the grantor to appoint the trust estate during life (i.e., the grantor, the spouse of the (v) Broadest form of general power of the descendant of the grantor to appoint the trust estate during life (i.e., the grantor, the spouse of the (vi) Broadest form of nongeneral power of the descendant of the grantor to appoint the trust estate by will (i.e., the grantor, the spouse of the (vii) Broadest form of general power of the descendant of the grantor to appoint the trust estate by will (i.e., the grantor, the spouse of the 9A.03(b) Powers and Interests That Cannot Transfer Trust Estate To, But Can Divert Trust Estate From, Grantor and Spouse of Grantor (1) Lapsing right of the descendant of the grantor to withdraw each contribution to the trust (Crummey power). (2) Nonlapsing right of the descendant of the grantor to withdraw the trust estate at stated age(s). (3) Lapsing right of the descendant of the grantor to withdraw five percent of the trust estate each year noncumulatively ("Give-Me- Five" or unitrust power).
Grantor-Trust Treatment 253 (4) Ability of the descendant of the grantor (i.e., the permissible distributee) to pay income to the descendant of the grantor according to an ascertainable standard. (5) Ability of the descendant of the grantor (i.e., the permissible distributee) to pay principal to the descendant of the grantor according to an ascertainable standard. (6) Ability of the spouse of the grantor to pay income to the descendant of the grantor according to an ascertainable standard. (7) Ability of the spouse of the grantor to pay principal to the descendant of the grantor according to an ascertainable standard. (8) Ability of a person other than the grantor, the spouse of the grantor and the descendant of the grantor (i.e., the permissible distributee) to pay income to the descendant of the grantor according to an ascertainable standard. (9) Ability of a person other than the grantor, the spouse of the grantor and the descendant of the grantor (i.e., the permissible distributee) to pay principal to the descendant of the grantor according to an ascertainable standard. (10) Ability of an independent trustee to pay income to the descendant of the grantor according to unlimited discretion. (11) Ability of an independent trustee to pay principal to the descendant of the grantor according to unlimited discretion. (12) Mandatory, current payment of income to the descendant of the grantor. (13) Mandatory, periodic payment of unitrust amount to the descendant of the grantor. (14) Mandatory, periodic payment of annuity amount to the descendant of the grantor. (15) Remainder, upon the death of the descendant of the grantor who is the primary beneficiary, to the then-living descendants, per stirpes, of the descendant. (16) Remainder, upon the death of the descendant of the grantor who is the primary beneficiary, to the then-living descendants, per stirpes, of the descendant's nearest ancestor who is the grantor or a descendant of the grantor and of whom one or more descendants then are living. 9A.04 DISTRIBUTIONS TO GRANTOR AND SPOUSE OF GRANTOR: CODE SECTIONS 673, 676 AND 677