All that Glitters Isn’t Simple



If a trust is treated as owned by the person setting it up (the "grantor") for income tax purposes, many beautiful things follow. The grantor can pay the income tax on the trust earnings thereby leveraging the growth of trust assets, typically outside the grantor's estate. The trust can transfer appreciated assets to the grantor, or the grantor can sell appreciated assets to the trust, all without income tax consequences. This planning must be done with care to avoid the Scylla and Charybdis of the gift and estate tax. But how is such tax elixir achieved? A common mechanism to achieve grantor trust status is for someone to be permitted to substitute non-trust property for trust property of equivalent value. The popularity of grantor trusts and this technique belies the complexity. Several recent IRS pronouncements address grantor trust status. They are important for those heading down the yellow brook road in search of grantor trust Oz.


Code Section 675 - Income Tax Consequences of Power to Substitute


Code Section 675(4)(C) is paraphrased as follows. The grantor is treated as the owner of any portion of a trust in respect of which a power of administration is exercisable in a non-fiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity. For purposes of this paragraph, the term "power of administration" means any one or more of the following powers…(C) a power to reacquire the trust corpus by substituting other property of an equivalent value. Sounds simple. Just add the right lingo into a trust, like a grantor retained annuity (GRAT) trust or defective grantor trust (IDGT) giving someone the right to substitute property in a non-fiduciary capacity. But there have been and remain lots of issues: ◙ Is the property held in a non-fiduciary capacity? This could turn on the facts in each case making a conclusion tough. So clearly, the grantor cannot be the trustee and hold this power. It is less clear that if the person given the power is an investment adviser, trust protector, etc. whether they could still hold this power in a non-fiduciary capacity, so caution would dictate not doing so.  ◙ Even if holding a power to substitute succeeds in characterizing the trust as a grantor trust for income tax purposes, does it taint the trust assets as includible in the grantor's estate? The conclusions that it didn't were often based on the case Estate of Jordahl v. Comr., but in that case the power was held in a fiduciary capacity. Apples and oranges.  ◙ OK, so give your college buddy the power avoiding the issues of your holding as grantor creating estate inclusion. But can how can he "reacquire" what he never owned to achieve the income tax status? But the statute above does say any person. Not clear. ◙ #The trustee must have a fiduciary duty to the beneficiaries, be held to a high standard of conduct, be required to administer the trust solely in the interest of the beneficiaries, act fairly, justly, honestly, in the utmost good faith and with sound judgment and prudence. The trustee must be subject to a duty of impartiality that requires the trustee to take into account the interests of all beneficiaries.


Rev. Rul. 2008-22 - Estate Tax Issues of Power to Substitute


The IRS said that the power to substitute won't cause estate inclusion under IRC 2036 or 2038 if certain requirements are met. That's big. Follow the Ruling's recipe and one of the big risks noted above is obviated. But not all that glitters is gold, there are still lots of landmines. In the ruling taxpayer set up an irrevocable trust for descendants.


The grantor expressly cannot be trustee of the trust. ◙ The trust document provides that the grantor has the power, exercisable at any time, to acquire any property held in the trust by substituting other property of equivalent value.  ◙ This power is exercisable in a non-fiduciary capacity, without the approval or consent of any person acting in a fiduciary capacity. ◙ The grantor has to certify in writing that the substituted properties are of equivalent value. ◙ Under state law the fiduciary has the obligation to ensure that the properties are of equivalent value. While the Ruling doesn't address this issue, the trust document could specify this requirement as well. If state law did not require this, will inclusion in the trust document suffice? This is perhaps the keystone of the Ruling - it is the fiduciary duty of the trustee that keeps the grantor's non-fiduciary power in check to thereby avoid an adverse tax result.  ◙ If the trust has two or more beneficiaries the trustee must have a duty to act impartially in investing and managing the trust assets, taking into account the differing interests of the beneficiaries. What happens if the assets include family business interests from which perquisites and salaries are paid is not clear. ◙ The trustee must prevent any shifting of benefits between the beneficiaries that could result from the substitution of property by the grantor. A common step in a GRAT is to "immunize" the GRAT after a run-up in asset values by substituting cash equivalents for the securities. Does immunization meet this criteria?  ◙ The trustee must have the discretionary power to acquire, invest, reinvest, exchange, sell convey, control, divide, partition and manage trust property in accordance with the standards provided by law. has an unrestricted discretionary power to acquire, invest, reinvest, exchange, sell, etc. trust property in accordance with standards provided by local law. Security GRATs are never really invested in accordance with local law, namely the Prudent Investor Act. To the contrary, security GRATs are intentionally invested in non-diversified portfolios whose risk levels are substantially higher than the overall risk level for the family's overall investments. IDGTs often hold business and real estate interests. How will this Ruling be applied with a trust investment adviser serving, or if the trust has restrictions on selling a family business? Perhaps this should be considered in the investment clauses of the trust document. While the trustee (or investment adviser if one is used) may prefer that trust investment provisions permit the holding of a non-diversified, highly volatile asset base, to confirm acceptability of the strategy used (i.e., to protect the trustee from a claim of improper investments), might such a provision conflict with the Rulings require of investment in accordance with "standards provided by local law"? ◙ The grantor cannot exercise the power in a manner that reduces the value of the trust property or increases the grantor's net worth. ◙ The nature of the trust's investments or the level of income produced by any or all of the trust's investments does not impact the respective interests of the beneficiaries, such as when the trust is administered as a unitrust. The entire intent of a GRAT is to increase the benefits to the remainder beneficiaries. Does that violate this concept? Arguably not since the interest of the grantor during the GRAT term is fixed.


Bottom line, if the grantor is not a fiduciary, and holds the above power to substitute, and the trust document and local law include the requirements of the Ruling, grantor trust status should be achievable for income tax purposes without causing estate tax inclusion, but risk and issues remain.


PLR 200846001 - Gift Tax Issues of Power to Substitute


A common planning approach is to set up a two year GRAT which has to be a grantor trust. After the two years are up, the assets remaining in the trust can be distributed outright to the heirs, typically children, or held in further trust for those heirs. That remainder trust, after the GRAT term, can also be structured to be a grantor trust. This will enable the grantor to continue to pay the income tax on the earnings of the post-GRAT kid's trust, thereby further leveraging the value in that trust for the children. This PLR (and remember private letter rulings can only be relied upon by the taxpayer to whom issued) had a different approach then the above Revenue Ruling. Here's the facts. Wife set up a GRAT and named Husband trustee. A different approach was used to achieve grantor trust status during the GRAT term and after. The power to substitute was used only for gift tax purposes, not to achieve grantor trust status for income tax purposes.


Grantor Trust During the GRAT Term: The trust document specified that the annuity amount could be paid to the Grantor from trust income or principal. This made the GRAT a grantor trust during the GRAT term. IRC Sec. 672(e)(1)(A) provides that the Wife/grantor will be deemed to hold any power held by her spouse. IRC Sec. 673(a) provides that the grantor shall be deemed the owner of a portion of the trust in which he holds a reversionary interest in income or corpus if the value of the interest exceeds 5% of the value of such portion. IRC Sec. 674(a) provides: "The grantor shall be treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income therefrom is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party." However, for this to succeed in creating grantor trust status the exceptions in IRC Sec. 674(b), (c), and (d) cannot apply. These powers of the husband as trustee were imputed to the wife as grantor, since husband was not an adverse party to the Wife/Grantor. IRC Sec. 672(e). This provision provides that the grantor is treated as holding any power or interest of   any individual who was the spouse of the grantor at the time of the creation of such power or interest.


Grantor Trust After the GRAT Term: The husband, as trustee, was given a broad power to expend trust assets for the Wife's/grantor's children, in such proportions as he deemed appropriate. IRC Sec. 674(a), see above.  Therefore, the Wife/Grantor was deemed to own the trust for income tax purposes.


Power To Substitute Doesn't' Create Gift Tax Issues: The power to substitute assets was held in a fiduciary capacity which could not create grantor trust status under IRC Sec. 675(4)(C) above which requires that the power be held in a non-fiduciary capacity. The IRS held that the power to substitute shares of publicly traded company 1 for shares of publicly traded company 2, or vice versa, would not create a gift tax on transfer so long as the share were properly valued and any value differential was made up in cash. The power to substitute also did not disqualify the GRAT.

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