Intentionally Defective (?) Grantor Trusts Owen@GivnerKaye.com 1
What We Will Cover [Part 1]: 1. How Did The Grantor Trust Rules Originate? P. 3 2. Common Examples of Grantor Trusts. P. 4 3. What Do We Usually Mean When We Say Grantor Trust? P. 5 4. Common Techniques Involving Grantor Trusts. P. 6 5. What Are The Ways In Which A Trust Can Be Taxed? P. 7 6. Benefit Of Techniques Involving Grantor Trusts. P. 8 7. Why Are Grantor Trusts Called (By Some) Defective? P. 9 8. Example (Diagram). P. 11 9. Gift Tax Issue. P. 12 10. Calculations. P. 13 11. What Powers/Interests Make A Trust Taxed To The Grantor? P. 16 12. What Powers/Interests Make Someone Else The Owner? P. 18 13. Foreign Trusts Have One Or More U.S. Beneficiaries. P. 19 14. What Powers Make A Grantor Trust That Is Excluded From The Estate? P. 20 15. Overlooked Consequences of Grantor Trust Status. P. 21 16. Turning Grantor Trust Status On And Off. P. 22 17. Proactive Use Of Swap Power. P. 23 18. Grantor Trust Tax Return Obligation. P. 25 19. Installment Sales With Grantor Trusts. P. 26 Owen@GivnerKaye.com 2 2
How Did The Grantor Trust Rules Originate? Income tax rates used to be as high as 91%, so taxpayers wanted to shift income from high bracket taxpayers to a lower bracket taxpayer while retaining controls over the trust. The initial tool was a revocable trust. Congress eliminated that with the earliest version of Section 676, entitled Power To Revoke. Then Congress added the earliest version of Section 677(b), entitled Obligations of support, taxing the grantor to the extent that trust income is actually used to discharge a support obligation. The most important development was Helvering v. Clifford (1934), in which Mr. Clifford funded an irrevocable trust for the benefit of his wife; was the trustee; had the power to make discretionary distributions; and received the assets back at the end of 5 years. That resulted in the so-called Clifford regulations (1946), under which the grantor was taxed if the assets would revert within 10 years or less or the grantor had any of a series of broad administrative powers. In 1954, the first modern Code adopted Sections 671 678. The TRA 1976 added Section 679, taxing a U.S. grantorifatrustisaforeigntrustand has any U.S. beneficiaries. All foreign trusts were treated as grantor trusts starting in 1996. Owen@GivnerKaye.com 3
Common Examples Of Grantor Trusts Living Trusts (A.K.A. Family Trusts; Revocable Trusts; Inter Vivos Trusts). Crummey Trusts. Life insurance trusts (ILITs). Grantor Retained Annuity Trust (GRAT) and Grantor Retained Unitrust (GRUT). Children s Trust (not always). Dynasty Trust (not always). Qualified Personal Residence Trust (QPRT). Charitable Lead Trust (not always). What about a Qualified Subchapter S Trust (QSST)? It s a Section 678 trust (taxed to someone other than the grantor). Owen@GivnerKaye.com 4
What Do We Usually Mean When We Say Grantor Trust? We are usually referring to a trust that is both owned by the grantor for income tax purposes and not owned by the grantor for transfer tax purposes. Owen@GivnerKaye.com 5
Common Techniques Involving Grantor Trusts The basic transaction is a transfer of an asset to a children s trust, in which the children s trust is a grantor trust. Instead of, or in addition to, a children s trust there might be a (i) grandchildren s trust; (ii) dynasty trust; and (iii) completed gift asset protection trust. What are the assets being transferred? Real estate. Tenancy in common interests in real estate. Limited partnership interests in family limited partnerships which own mostly real estate. Membership interests in LLCs which own mostly real estate. Stock in closely held, usually S, corporations. How are the assets transferred? QPRTs for principal and vacation residences. Outright gifts. installment sales. Part-gift, part-sales. Self-Cancelling Installment Notes (SCINs). Grantor Retained Annuity Trusts (GRATs seldom GRUTs). SCIN-GRATs. Private Annuities. Part-gifts, part-pas/grats/scins. Owen@GivnerKaye.com 6
What Are The Ways In Which A Trust Can Be Taxed? 1. Simple Trust (all income must be distributed to the beneficiary). 2. Complex Trust (trustee has discretion whether or not to distribute to the beneficiary). 3. Grantor Trust (taxed to the grantor). 4. Person other than grantor taxed (IRC Section 678). Owen@GivnerKaye.com 7
Benefit Of Techniques Involving Grantor Trusts Estate freeze transactions, e.g., GRATs, gifts, sales, rely on three factors to transfer wealth to children: (i) valuation discounts; (ii) investment return in excess of the AFR or Section 7520 rate; and (iii) grantor s payment of the income tax on the children s trust income. Financial projections of an estate freeze technique demonstrate that in the long run, i.e., over the life expectancy of the parent, the least important of the three factors is the size of the valuation discount. Now, with the taxpayer victories in Christensen (11/13/09 8 th Cir.), Petter (8/4/11 8 th Cir.), Hendrix (Tax Court 6/15/11) and Wandry (Tax Court 3/15/12), defined value gifts eliminate much of the concern about gift tax audit when using discounts. Owen@GivnerKaye.com 8
Why Are Grantor Trusts Called (By Some) Defective? [part one] Grantor trusts were originally used to shift taxable income to lower bracket taxpayers. The grantor trust rules were designed to prevent taxpayers from taking advantage of graduated income tax rates by creating multiple trusts that would function as separate taxpayers, while reserving interests in or powers over the trusts inconsistent with their tax independence. Income tax planning was designed to avoid the impact of those rules. Modern estate planners use grantor trusts to shift future appreciation in assets from the parents estate while forcing the parents to pay the income taxes. So the active use of rules that were previously avoided has been interpreted as, somehow, being defective : positively electing into rules that make a trust taxed to the grantor. Owen@GivnerKaye.com 9
Why Are Grantor Trusts Called (By Some) Defective? [part two] There is one other reason why people view Grantor Trusts as, somehow defective. This relates to the fact that the income tax laws and the transfer tax (gift, estate and generation skipping taxes) are completely different laws. As such, the concept of ownership is different for the two laws. Therefore, we have a trust a grantor trust which can be owned by the grantor under one law the income tax law and yet not owned by the grantor under the other group of laws the transfer tax laws. Most lawyers and CPAs are used to situations where trusts are treated the same way for both sets of laws. For example, a living trust while the parents are alive is owned by the parents for both income tax and estate tax purposes. Similarly, before modern estate tax planning began in roughly 1982, most irrevocable trusts were both not owned by the parents for income tax and estate tax purposes. Now, most irrevocable trusts drafted by sophisticated estate tax planners are taxed to the parents for income tax purposes and not owned by them for transfer tax purposes. 10 Owen@GivnerKaye.com 10
Uncle Sam Example Independent Trustee Step 5: Parents pay income tax Step 4: K-1 Issued to Parents Parents Children s Trust Step 1: Create Trust Step 2: Transfer Property Step 3: Property Generates Cash flow and taxable Income Income Producing Property 11 Owen@GivnerKaye.com 11
Gift Tax Issue The IRS originally considered the parents payment of the income taxes on the income of a grantor trust to be a gift to the children (the trust s beneficiaries). PLRs 9352004, 9444033 and 9504021. The IRS ultimately realized the error of its position, Rev. Rul. 2004-64, because the grantor, not the trust, is liable for the tax. The result is the same whether or not there is a reimbursement provision in the trust instrument or under local law and, if the trustee reimburses the grantor, it is not a gift from the children to the parents. For estate tax purposes, a reimbursement provision will not cause estate tax inclusion even if exercised unless there is an understanding between the grantor and the trustee or other facts, e.g., the grantor s power to remove the trustee and name the grantor as the trustee. If there is an express or implied understanding, then there will be inclusion under Section 2036(a)(1). Having a discretionary tax reimbursement clause is still a good safety valve. 12 Owen@GivnerKaye.com 12
Calculations [part 1] Married Individuals Filing Trusts Joint And Returns Estates Taxable Income $125,000 $125,000 Federal Tax* $ 37,764 $ 48,655 $ 10,891 more *not counting exemptions 13 Owen@GivnerKaye.com 13
Calculations [part 2] Starting 5% Cash and 40% Initial Trust Corpus Taxable Income Income Tax Parents Estate $1,000,000 $10,000,000 $1,000,000 $50,000 $20,000 $ 9,980,000 $1,050,000 $53,500 $21,000 $ 9,959,000 $1,103,500 $55,175 $22,070 $ 9,936,930 $1,158,675 $57,934 $23,174 $ 9,913,756 $1,216,609 $60,830 $24,332 $ 9,889,424 $1,277,439 $63,872 $25,549 $ 9,863,875 $1,341,311 $67,066 $26,826 $ 9,837,049 $1,408,377 $70,419 $28,168 $ 9,808,881 $1,478,796 $73,940 $29,576 $ 9,779,305 $1,552,736 $77,637 $31,055 $ 9,748,250 +552,736 (10 years) $630,373 (11 years) ($251,750) ( $251,750) 14 Owen@GivnerKaye.com 14
Calculations [part 3] Starting 5% Cash and 40% Initial Trust Corpus Taxable Income Income Tax Parents Estate $1,630,373 $ 81,519 $32,607 $ 9,715,643 $1,711,892 $ 85,946 $34,238 $ 9,681,405 $1,786,838 $ 89,432 $35,737 $ 9,645,668 $1,876,270 $ 93,814 $37,525 $ 9,608,143 $1,970,084 $ 98,504 $39,402 $ 9,568,741 $2,068,588 $103,429 $41,372 $ 9,527,369 $2,172,017 $108,601 $43,440 $ 9,483,929 $2,280,618 $114,031 $45,612 $ 9,438,317 $2,394,649 $119,732 $47,893 $ 9,390,524 $2,514,381 $125,719 $50,288 $ 9,340,236 +1,514,381 (20 years) $1,640,100 (21 years) ($659,864) ( $659,764) Do the parents want to now turn grantor trust status off??? 15 Owen@GivnerKaye.com 15
What Powers Or Interests Make A Trust Taxed To The Grantor? [part 1] Section 673(a) reversion worth more than 5% Section 674(a) Section 675(1) Section 675(2) Section 675(3) Section 675(4)(A) Section 675(4)(B) Section 675(4)(C) power of disposition of income or principal exercisable by grantor/nonadverse party without approval of an adverse party grantor/nonadverse party without approval of an adverse party to deal with or dispose of trust income or assets for less than adequate consideration grantor/nonadverse party borrow without adequate interest or security except independent trustee pursuant to general lending power grantor borrows and has not repaid without adequate interest/security power to vote securities in which trust s votes are significant power to control or veto trust investments when assets are stock in which trust s votes are significant power to reacquire trust corpus by substituting assets of equivalent value 16 Owen@GivnerKaye.com 16
What Powers Or Interests Make A Trust Taxed To The Grantor? [part 2] Section 676 Section 677(a)(1) Section 677(a)(2) Section 677(a)(3) grantor or nonadverse party can give assets back to grantor income without approval of an adverse party may be distributed to grantor or grantor s spouse income without approval of an adverse party may be held or accumulated for future distribution to grantor or grantor s spouse income without approval of an adverse party may be used to pay premiums on life of grantor or spouse if the trust is silent or only allows principal to be used, it is not a grantor trust. Section 677(b) income is actually applied to discharge grantor s support obligation 17 Owen@GivnerKaye.com 17
What Powers Or Interests Make Someone Other Than The Grantor The Owner? Section 678(a)(1) power exercisable solely by himself to vest income or principal in himself Example: Crummey withdrawal power. Rev. Rul. 81-6. Reg. Section 1.671-3(a)(3) suggests a fractional approach. Grantor transfers $130,000 to Trust in 2011; Child has right to withdraw $13,000 for 30 days in 2011; and the trust earns $12,000 in 2011. Amount subject to withdrawal divided by FMV of trust X trust income = Child s share of income: $13,000 divided by $130,000 X $12,000 = $1,000 taxable to child. Section 678(a)(2) Section 678(b) Comfort: Section 678(c) previously released or modified such a power and after the release retains a Section 671-677 power Exception: doesn t apply if the grantor is taxable PLRs 200729005 200729016 provide some comfort that having Crummey powers in grantor trusts will not prevent the trust from being a wholly grantor trust. Only applies to extent income is actually applied to discharge person s support obligation 18 Owen@GivnerKaye.com 18
Foreign Trusts Having One Or More U.S. Beneficiaries Section 679(a)(1) Exceptions: Traps: Presumption: U.S. person who transfers property to a foreign trust is treated as the owner for his taxable year of the portion of the trust attributable to the property if for the year there is a U.S. beneficiary of any portion of the trust. Transfers by reason of transferor s death. Transfers for fair market value. Applies if NRA grantor becomes resident within 5 years of transfer to trust. Applies if trust later becomes a foreign trust. If someone has discretion to appoint beneficiaries, it has a U.S. beneficiary. U.S. beneficiary unless no income or principal may be paid or accumulated to a U.S. person (i) during the year and (ii) on termination. 19 Owen@GivnerKaye.com 19
What Powers Make A Trust Taxed To The Grantor But Keep The Trust Outside The Grantor s Taxable Estate? Section 674(a) Section 675(2) Grantor/nonadverse party s power to add a charitable beneficiary. Grantor/nonadverse party has power to allow grantor to borrow without paying adequate interest or security. (But require adequate interest to avoid gift tax problem. Section 7872.) Section 675(4)(C) Power to reacquire trust corpus by substituting assets of equivalent value (sometimes called the swap power ). Section 677(a)(3) Power to use trust income to pay premiums on the life of the grantor or spouse. 20 Owen@GivnerKaye.com 20
Overlooked Consequences Of Grantor Trust Status 1. Increases the phase outs of the grantor s medical expense and itemized deductions because they are based on AGI. 2. Grantor s additional income can cause AMT exposure. 3. Grantor trust status can continue after technique has expired and continue to reduce grantor s estate, necessitating a flip switch. 4. Grantor can be taxed on large capital gain when children s trust sells assets acquired by means of gift, SCIN, GRAT, private annuity, etc. 5. Children s Trust has grantor s basis (versus DOD FMV had asset been included in grantor s estate). 6. Life insurance trusts: avoid transfer for value rule of Section 101(a)(2) because a grantor trust is treated the same as the grantor. 21 Owen@GivnerKaye.com 21
Turning Grantor Trust Status On and Off PLR 9304017: the IRS ruled that the trusts were grantor trusts where the trustee had the power to add one or more beneficiaries. The trusts allowed the trustee to renounce this power irrevocably if done so in writing, which would eliminate the power of control over beneficial enjoyment of trust property, which would turn off grantor trust status. CCA 200923024 in which conversion of nongrantor trust to grantor trust status was approved. Mild Caveat: Notice 2007-73 Transaction of Interest in which options in securities are used to manipulate taxable income. 22 Owen@GivnerKaye.com 22
Proactive Use Of Swap Power [part 1] 1. Near Death Swap To Use Section 1014 Step-Up To DOD FMV. Mom and Dad sold Building worth $1,000,000, with basis of $100,000, to children s trust. Dad is near death when building is worth $1,500,000. Mom and Dad exercise power under the trust and Section 675(4)(c) to exchange $1,500,000 of cash for the building. Dad dies while Mom and Dad own the Building. As a result, the Building now has a basis of $1,500,000. The children s trust can now buy the building from Mom for $1,500,000 and, of course (i) Mom recognizes no gain or loss on the sale; and (ii) the children s trust s basis is $1,500,000. 23 Owen@GivnerKaye.com 23
Proactive Use Of Swap Power [part 2] 2. Near Death Swaps To Preserve Loss. Mom and Dad own stock worth $1,000,000 with a basis of $2,000,000. Dad is near death. Mom and Dad exercise power under the children s trust and Section 675(4)(C) to exchange the stock for $1,000,000 of cash held by the children s trust. On Dad s death, Mom and Dad do not own the stock, so it does not step-down in basis to the DOD FMV. 3. Swaps Due To 3 Year Rule For Life Insurance. Dad owns insurance policy with a face amount of $3,000,000 and a FMV of $100,000. He exchanges it for $100,000 held by his children s trust. This way if Dad dies within 3 years, despite IRC Section 2035, the policy will not be included in his taxable estate. IRC Section 2035(d). 24 Owen@GivnerKaye.com 24
Grantor Trust Tax Return Obligation Certain grantor trusts may take advantage of exceptions to the fiduciary return filing and trust TIN requirements. A TIN need not be obtained for a trust that is taxable to a single individual as a grantor trust under 671-679 if the Regs. 1.671-4(b)(2)(i)(A) alternative reporting method is used. Regs. 301.6109-1(a)(2). The trustee must furnish the TIN of the person taxable as the trust owner to the payors and the trust owner must report the income on his individual return; no 1041 is filed. If the grantor is a trustee or cotrustee, the trustee has no further obligation. If the grantor is not a trustee or co-trustee, the trustee must furnish the grantor with a statement that: (1) shows all items of trust income, deduction, and credit for the taxable year; (2) identifies the payor of each income item; (3) provides the grantor with the information necessary to take the items into account in preparing his return; and (4) informs the grantor that the items shown on the statement must be included in computing the grantor's taxable income on his return. If a revocable trust is taxable to H and W who file a joint return, the spouses may use this method. Regs. 1.671-4(b)(8). A TIN must be obtained for the trust for the first taxable year in which it is not treated as taxable to a single individual (or spouses filing jointly) or the trustee chooses not to report under the Regs. 1.671-4(b)(2)(i)(A) method. Regs. 301.6109-1(a)(2). 25 Owen@GivnerKaye.com 25
Installment Sales With Grantor Trusts If the client survives to the repayment of the note, all is good. However, if the client dies before the note is repaid, there are a great many uncertainties. Most commentators believe that because payments from the trust are not IRD, there is no basis for reporting the gain on a Form 1041 (grantor s death should not cause recognition of the gain from the sale). What is the trust s basis in the assets it purchased from the now deceased grantor? Section 1012 provides that it is the purchase price. Others argue for a stepped-up basis under Section 1014. Others argue Section 1015 (gift basis). Are post-death payments on the note IRD and, therefore, taxable to the beneficiaries when they receive the payments? Most say no because the payments would not be income to the grantor under Rev. Rul. 85-13 and, therefore, could not be IRD. 26 Owen@GivnerKaye.com 26
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