In Part I of this series on Grantor Trusts, we look at the nature of trusts in general. In Part II, we shift to a look at grantor trusts, and a few definitional rules. In Part III and Part IV, we take a deep dive into the interests that a grantor may retain that will cause a trust to be treated as a grantor trust as well as instances in which a person other than the grantor will be treated as the owner of a trust under the grantor trust rules.
There are numerous flavors of grantor trusts that can be created for tax and estate planning purposes, with combinations limited only by the grantor’s imagination, the practicality of the tax planner, and the Code and Treasury Regulations.
The simplest and most common grantor trust is the revocable living (inter vivos simply meaning “during life”) trust, which is created by a grantor during his life. because the grantor retains the ability to revoke the trust during his life, the assets of the trust will be included in the grantor’s estate at his death under IRC § 2038.
A “grantor retained annuity trust” or “GRAT” is a type of irrevocable trust that allows the grantor to draw income during the grantor’s life. once the grantor dies, or the annuitization period ends, any remaining assets in the trust are passed to its beneficiaries.
An intentionally defective grantor trust (“IDGT”) is another type of revocable trust, which treats the grantor as the owner of the assets for income tax purposes, but not for estate tax purposes. Thus, the grantor will pay income tax on income generated by the trust’s assets during his life, but the assets will exist separately from his estate when he passes away. IDGTs are used to help minimize estate and gift tax liability. Although the trust is irrevocable, because an IDGT is a grantor trust (meaning that the grantor has retained certain powers over the disposition of the assets), it is often more “flexible” than even a revocable inter vivos trust, and the estate tax savings offer an even greater benefit to that of a revocable inter vivos trust.
History of Grantor Trusts
Ironically, the grantor trust rules were first developed in the late 1960s in an effort to curb the “abusive” use of trusts to shift income into lower tax brackets. Because the individual and trust tax rates graduated at the same rate, wealthy individuals could set up multiple smaller trusts and avoid the higher individual rates. Many such trusts reverted back to the grantor, and so the tax savings potential was substantial. Thus, the grantor trust rules were developed to trace the income generated by the assets back to the grantor. In 1986, however, the marginal tax rates for trusts were substantially compressed to the present levels.
Modern Uses of Grantor Trusts
Though no longer used to shift income into lower tax brackets, the grantor rules continue to apply. Somewhere along the way (probably even before the 1986 changes came into effect), tax and estate planners saw the opportunity to utilize grantor trusts to their clients’ advantage. For instance, revocable grantor trusts can be used to avoid probate. Because legal title to the grantor/decedent’s property was either placed in trust or transfers to the trust at the grantor’s death, no probate assets (or at least very few) remain to go through the probate process, which is simply the legal process to transfer title of a decedent’s assets.
Aside from avoiding probate, grantor trusts are most often used nowadays in the context of intra-family planning as a technique to avoid the compressed tax bracket applicable to trusts. Instead of contributing an asset to a trust and reaching the top marginal tax bracket very quickly, donors may still utilize the asset protection and management advantages of a trust but may structure such trust so that the trust’s income will be taxed to the grantor (or even, in some cases, to the beneficiary) if the marginal tax rate applicable to the grantor (or beneficiary) is lower than that of the trust, as it often will be.
Grantor trusts also utilize the concept of “leveraged” gifts. If a grantor creates a trust for the benefit of a beneficiary, and if the beneficiary and trust do not have to pay tax on the income derived from the assets contributed to the trust, it is as if the grantor is providing an additional gift each year that the grantor pays taxes on the trust’s income. If the income accumulates within the trust, and such income is ultimately distributable to the beneficiary, such income will be distributed tax free to the beneficiary—without the beneficiary ever having paid taxes on the income.
Finally, because the IRS treats a grantor trust as a “look through” entity, a grantor trust may hold stock of an S corporation (as if the grantor held the stock directly). Even though for tax purposes the grantor is treated as holding stock directly, for asset protection purposes the stock is titled in the name of the trust. Thus, in the event that the grantor/shareholder is sued, divorces, files bankruptcy, or becomes part of a guardianship proceeding, the stock is essentially insulated and protected from such legal proceedings.
There are a number of other uses for grantor trusts, such as Medicaid and long-term care planning, and we may write about these in a separate article. However, for purposes of this article, we did not want to get too far into the weeds on how to use a grantor trust; rather, we wanted to focus mainly on when a trust will be considered to be a grantor trust.
So, Who is this Grantor?
The threshold question we must first explore is deceptively simple: Who is the Grantor? Like most questions in tax law, the answer is not so very straightforward.
The term “grantor” is not defined in the Code. Instead, we must look to the Treasury Regulations for the definition of this *rather* critical term. Specifically, Treas. Reg. § 1.671-2(e) provides that a grantor includes any person to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer of property (including cash) to a trust. A “gratuitous transfer” is any transfer other than one made in consideration for fair market value. Thus, if Uncle Bill creates a trust, contributes property to it, and does not receive fair market value consideration for the contribution of property to the trust, such transfer will be considered “gratuitous.”
If a person creates or funds a trust on behalf of another person, both persons will be treated as grantors of the trust. However, a person who creates a trust but makes no gratuitous transfers to the trust is not treated as an owner (grantor) the trust (or any portion thereof) under the grantor trust rules (IRC §§ 671-678). Finally, a person, who funds a trust with an amount that is directly reimbursed to such person within a reasonable period of time and who makes no other transfers to the trust that constitute gratuitous transfers, is not treated as a Grantor.
Example: Uncle Bill creates a trust for the benefit of dear Aunt Ethel, his wife, and funds it with the proceeds from selling his controlling share of German ostrich farm (Riesenvögel, A.G., which, translated loosely, means “Big Ass Birds, Incorporated”). Both Bill and Ethel would be considered grantors of the trust.
If Bill creates a trust for the benefit of Aunt Ethel, but the sale of Riesenvögel fell through at the last minute (due to an unfortunate translation error and a group of “sensitive” Austrian hedge fund managers), and the trust is not funded, then neither Bill nor Ethel will be considered grantors of the trust. Finally, if Bill funds Ethel’s trust with a loan, which the trust pays back to Bill within a year, then Bill will not be treated as the trust’s grantor.
Attribution rules apply to grantor trusts. Thus, under IRC § 672(e), Uncle Bill is treated as holding any power or interest that Aunt Ethel holds. Specifically, a grantor will be treated as holding any power or interest held by (a) any individual who was the spouse of the grantor at the time of the creation of such power or interest; or (b) any individual who became the spouse of the grantor after the creation of such power or interest, but only with respect to periods after such individual became the spouse of the grantor.[1] An individual, who is legally separated from his spouse under a decree of divorce or an order of separate maintenance, shall not be considered as married for purposes of the grantor trust rules.[2] Much has been written about the spousal attribution rules.
This attribution rule was enacted in 1986 to curb the use of “spousal remainder trusts,” which were trusts that paid income to a beneficiary (such as the Grantor’s child) for a term of years and then, at the end of the term, the remainder would pass to the Grantor’s spouse. Although, as discussed below, if Uncle Bill personally held the remainder interest (a reversionary interest), the trust would be considered a grantor trust under IRC § 673; however, if Ethel held the interest, under the pre-1986 rules, the trust would not have been treated as a grantor trust.
As a result of the 1986 changes to the Code, under IRC § 673, Bill will be treated as the owner of any portion of a trust in which he has a reversionary interest in either the principal or the income if, at the time of the transfer to the trust, the reversionary interest has a value exceeding 5% of the value of the portion that may revert. Applying IRC § 672(e)(1)(A), if Ethel has a remainder interest in the trust that exceeds 5% of the value of the trust at the time of the transfer to the trust, Bill will be treated as the owner of the trust.
The Underlying Principle of Grantor Trusts (a/k/a One Wildly Stretched Pinocchio Metaphor)[3]
Funding a trust is only the first step on the path of becoming a grantor. The “principle underlying” the grantor trust rules is that, in general, the income of a trust, over which the grantor (or another person) has retained substantial dominion or control, should be taxed to the grantor (or the other person) rather than to the trust that receives the income or to the beneficiary to whom the income may be distributed.[4] Because “substantial retained dominion or control” does not flow mellifluously off of one’s tongue, these retained rights are often simply referred to as “strings.”
Using a marionette-qua-trust as a metaphor, these strings in the puppeteer’s (Grantor’s) hands allow Geppetto to manipulate the marionette (the trust and its assets) in a number of ways.[5] To stretch the metaphor to its outer limits, sometimes Geppetto will craft the marionette, but the puppeteer will let one of the audience members pull Pinocchio’s strings. In this case, the audience member (generally a trust beneficiary) will be treated as the owner (grantor) of the trust.[6] So, what are these strings?
The Retained Interests (Pinocchio’s Strings)
We will discuss each of these “strings” in the next post in substantial detail, with a plethora of examples. For now, though, let’s look at them from a very high level. Uncle Bill will be deemed to have retained substantial dominion or control (read: will be deemed to hold the Pinocchio’s strings) under five specific sets of rules contained in IRC § 673 through IRC § 677.
Thus, if Uncle Bill holds any of the following strings (presented in their most basic form), he will be treated as the owner of the trust, and the trust will be treated as a grantor trust:
-
- Bill holds a reversionary interest in the assets of the trust;[7]
- Bill controls the beneficial enjoyment of the assets of the trust or its income;[8]
- Bill retains certain administrative powers over the trust;[9]
- Bill retains the power to alter, amend, modify, terminate, or “revoke” the trust;[10] or
- Bill receives distributions from the trust.[11]
Before we discuss Pinocchio’s five strings, we need to first define certain terms that are used in IRC § 673 through IRC § 677 when discussing retained interests.
Grantor Trust Definitions and Rules in a Nutshell
IRC § 672 provides the rules and definitions that are used throughout the rest of the grantor trust sections of the Code. IRC §§ 672(a)-(c) define the key terms “adverse party,” “nonadverse party,” and “related or subordinate party.” The rules describing when conditions precedent must be satisfied to exercise a beneficial (economic) interest are found in IRC § 672(d). Important rules addressing the role of the grantor’s spouse are described in IRC § 672(e). Finally, rules addressing grantor trusts with domestic beneficiaries and foreign grantors are found in IRC § 672(f).
Adverse and Nonadverse Parties
The presence of an “adverse party” in the trust may insulate the trust from grantor trust treatment if a power of the grantor may be exercised only in conjunction with or with the consent of this adverse party. On the flip side of this adverse party coin, if a nonadverse party holds certain powers over a trust (including the power to give consent)—even if the grantor does not hold such power—the grantor may be treated as the owner of the trust. It is the party’s interest in the trust that we care about.
It should be noted that, under the Code, it is not enough that Uncle Bill and Cousin Elmer’s relationship has soured (to the point that Bill symbolically spits at the feet of anyone who even mentions Elmer’s name in his earshot) subsequent to the creation of the trust of which Bill is the grantor and Elmer is a beneficiary. Elmer’s beneficial (economic) interest in the trust must be adverse to an exercisable power held by Bill.
At its most basic, an “adverse party” is a person with a “substantial beneficial interest” in the trust, which economic interest would be adversely affected by the exercise or non-exercise of the power that the party possesses over the trust.[12] Rather unhelpfully, the Treasury Regulations define “substantial beneficial interest” as an interest in the trust, the value of which, in relation to the total value of the trust property subject to the power, is “not insignificant.”[13]
Thanks for nothing, guys. This is about as helpful as a “Mind the Gap” sign to Stevie Wonder and has the same definitional quality as the picture of “Me and Daddy” I have in my office that was scrawled by my three-year-old son on a sheet of printer paper in red crayon before his fine motor skills had yet caught up with his creativity. You had one job, Treasury. One job.
Forshame.
As you can imagine, numerous cases have turned on what “not insignificant” means. Generally, the courts have held that where the beneficiary’s interest is wholly discretionary (meaning that making distributions is left up to the judgment of the trustee), the beneficiary likely does not have a substantial beneficial interest.[14] Similarly, where the interest of the beneficiary is contingent (and this contingency is remote enough), the interest is not substantial.[15] Remoteness, like significance and pornography,[16] is in the eye of the beholder (or the purview of the courts, as it were).
On the obverse side of the coin, a “nonadverse” party is defined simply as a party, who is not an adverse party.[17] The Treasury regulations provide that attribution rules (such as those found in IRC § 318) do not apply to “attribute” adversity to a related party. Thus, even if Elmer’s interest in the Bill’s trust were actually adverse to Bill’s interests, Elmer’s common law wife Lou Anne would not be considered an adverse party—no matter how much the black eye she gave to Bill two Thanksgivings ago to “protect Elmer’s honor” might suggest otherwise. (For those who have followed Briefly Taxing’s accounts of Bill’s life, this Thanksgiving, was two years subsequent to the infamous “turkey leg incident,” in which it was Aunt Ethel dealing the coup-de-grace to Bill’s right eye.)
Critically, a trustee is not an adverse party merely because of his interest as trustee.[18] If, however, the trustee also has the power to distribute income or principal to himself (thereby making the trustee an income beneficiary), then the trustee would be an adverse party to the grantor (assuming that the trustee and grantor are not the same person, as is the case with most revocable trusts).[19] Having a right to reasonable fees or commissions as a fiduciary does not, itself, convey a beneficial interest in the trust to the trustee.[20]
Example: Uncle Bill creates a trust and names Aunt Ethel’s jailbird step-nephew Jim-Bob as trustee (for some unknown reason). The trust provides that the Jim-Bob has the power to distribute all of the income and principal of the trust to himself. This would, clearly, make Jim-Bob adverse to Bill, the grantor of the Trust.[21] Alternatively, if the trust provided Jim-Bob with purely administrative powers and did not bestow upon the convicted felon discretion with respect to the beneficial interests in the trust, Jim-Bob will not be considered an adverse party—even if Jim-Bob were also a beneficiary of the trust.
Still, one questions the motives and wisdom behind choosing Jim-Bob, whose notoriety for poor decisions is not a well-kept secret in the family, for a task more complex than working on a line assembling squirrel feeders, a job from which he was fired no less than three times for gross incompetence.
Under most circumstances, a beneficiary will be an adverse party to an economic interest held by the grantor (such as the right to distributions or a reversionary interest in the principal of the trust).[22] If, however, the beneficiary’s right to share in the income or principal of a trust is limited to only a part, he may be an adverse party only as to that part.[23]
Example: Uncle Bill creates a trust, with his children Leroy, Jethro, Jedediah, and Jennie as equal income beneficiaries. Bill cannot revoke the trust without Jennie’s consent, after all, she is the only one of his brood with half an ounce of sense. Bill would be treated as the Grantor of the trust only as to three-fourths of the trust (his idiot boys’ shares). Items of income, deduction, and credit attributable to that three-fourth portion of the trust will be included in determining Uncle Bill’s income tax (if he actually files this year).
The interest of a beneficiary entitled to only the ordinary income of a trust may or may not be adverse with respect to the grantor’s exercise of a power over principal.[24]
Example: Uncle Bill creates a trust payable to Jennie for life, with a power to Jennie to appoint the principal to Bill either during his life or through Jennie’s will. Assuming that Jennie’s power of appointment is not a “general” power of appointment, as defined by IRC § 2041(b)(1), Jennie’s interest in the trust is adverse to Bill during his life, but is not adverse to Bill (with respect to the return of the principal) after Jennie’s death. Stated differently, Jennie’s interest is adverse only as to ordinary income of the trust. Her interest is not adverse as to income allocable to the principal of the trust, such as capital gains. Assuming that Bill has retained no other strings (under IRC § 674, IRC § 676, or IRC § 677), Bill would not be taxed on the ordinary income of the trust, but he would be taxed (under IRC § 677) on the income allocable to the trust’s principal since Jennie has the discretion to accumulate such principal-related income for a future distribution to Bill.
The interest of a remainderman is adverse to the exercise of any power over the principal of a trust, but not to the exercise of a power over any income interest preceding his remainder.[25]
Example: Uncle Bill creates a trust which provides for income to be distributed to Jennie for 10 years and then for the principal to go to Jethro, if he is then living and not incarcerated (the prior condition being far more likely than the latter, given Jethro’s track record with “the law”).
Bill also gives Jethro a power to revest the principal of the trust in Bill. This power to revest, which is exercisable only by Jethro, makes Jethro an adverse party. It should be noted, however, that if Bill, instead, gave Jethro a power only to distribute part or all of the ordinary income of the trust to Bill, Jethro may or may not be considered adverse as to the trust’s income. In this case, if Jethro were determined to be a nonadverse party, the ordinary income would be taxable to Bill as the grantor.
Related or Subordinate Parties
A related or subordinate party is, by definition, a nonadverse party.[26] Such a party may be the grantor’s spouse if living with the grantor; the grantor’s parents, issue, or siblings; an employee of the grantor; a corporation or any employee of a corporation in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; or a subordinate employee of a corporation in which the grantor is an executive.[27] Unlike other attribution rules (such as IRC § 267(b) or IRC § 318), other relatives, such as step-brothers and step-sisters, nieces, nephews, cousins, grandparents, grandchildren, and in-laws are not included in the definition of related or subordinate parties contained in the Code or Treasury Regulations.
For purposes of IRC § 672(f), which deals with the applicability of the grantor trust rules to computing the income of a foreign person, IRC § 674 (Power to Control Beneficial Enjoyment), and IRC § 675 (Administrative Powers), a related or subordinate party is presumed to be subservient to the grantor in respect of the exercise or non-exercise of the powers conferred on such party.[28] The (presumed) subservient party bears the burden of proving non-subserviency (which, I suppose, would be independence) by a preponderance of the evidence.
If Uncle Bill possesses a power to remove a trustee and appoint a successor, who is not related or subordinate (like a corporate trustee), then Bill will not be considered to have retained a power to affect the beneficial enjoyment of the trust property. Thus, the assets of his trust would not be included in his gross estate under IRC § 2036 or IRC § 2038.[29] If, however, Bill retained the power to appoint himself as successor trustee, all bets are off, and the assets would be included in his estate under either IRC § 2036 or IRC § 2038.[30]
Cousin Elmer will be considered as having a power described in the grantor trust rules (which power, if held by Bill, as grantor, would make Elmer the owner of the trust), even if the exercise of the power is subject to a condition precedent or if the power only takes effect on the expiration of a certain period of time.[31] However, even if Elmer has such a grantor trust power, Bill will not be treated as the owner of the trust (by reason of Elmer holding such a power), if Elmer’s exercise of the power could only affect Bill’s beneficial enjoyment of income received after the expiration of a period of time such that, if the power were a reversionary interest, Bill would not be treated as an owner under IRC § 673 (e.g., if the value of Bill’s reversionary interest were 5% of the trust at its inception under IRC § 673(a)—a rule that we’ll discuss at greater in just a moment).[32] So, what the heck does this last sentence mean? Let me give you an example.
Example: Before their détente, Uncle Bill created a trust for the benefit of his seven-and-a-half-fingered Cousin Elmer, and Bill retained a power to revoke the trust, which power would take effect only after the expiration of 2 years from the date of exercise. As such, Bill will be treated as an owner of the trust from the inception of the trust.
However, if Bill retained a power to revoke the trust, exercisable at any time, which power was valued at less than 5% of the trust at its inception under IRC § 673(a), the power to revoke (which is a reversionary interest by another name) would not cause Bill to be treated as the grantor of the trust with respect to the trust’s ordinary income.[33]
Footnotes:
[1] IRC § 672(e)(1)(A)-(B).
[2] IRC § 672(e)(2).
[3] Which, is a great mental image in and of itself…
[4] Treas. Reg. § 1.671-2(b).
[5] See IRC §§ 673-677.
[6] See IRC § 678.
[7] IRC § 673.
[8] IRC § 674.
[9] IRC § 675.
[10] IRC § 676.
[11] IRC § 677
[12] IRC § 671(a); Treas. Reg. § 1.672(a)-1(a).
[13] Treas. Reg. § 1.672(a)-1(a).
[14] Holt v. United States, 669 F. Supp. 751 (W.D. Va. 1987), aff’d, 842 F.2d 1291 (4th Cir. 1988); Barker v. Commissioner, 25 T.C. 1230 (1956); Chase National Bank v. Commissioner, 225 F.2d 621 (8th Cir. 1955).
[15] Id.
[16] See Jacobellis v. Ohio, 378 U.S. 184, 197 (1964) (J. Stewart concurring). Jacobellis is a Supreme Court decision handed down in 1964 involving whether the state of Ohio could, consistent with the First Amendment, ban the showing of the Louis Malle film The Lovers (Les Amants), which the state had deemed obscene and pornographic. Not venturing an attempt to define “pornography,” Justice Potter Steward stated only “I know it when I see it, and the motion picture involved in this case is not that.”
[17] IRC § 671(b); Treas. Reg. § 1.672(b)-1.
[18] Treas. Reg. § 1.672(a)-1(a).
[19] Treas. Reg. § 1.672(a)-1(b).
[20] Reg. 1.672(a)-1(a); Reinecke v. Smith, 289 U.S. 172 (1933); Duffy v. United States, 487 F.2d 282 (6th Cir. 1973), cert. denied, 416 U.S. 938 (1974).
[21] See Estate of Paxton v. Commissioner, T.C. Memo. 1982-464.
[22] Id.
[23] Id.
[24] Treas. Reg. § 1.672(a)-1(c).
[25] Treas. Reg. § 1.672(a)-1(d).
[26] Treas. Reg. § 1.672(c)-1.
[27] IRC § 672(c); Treas. Reg. § 1.672(c)-1.
[28] IRC § 672(c) (flush language).
[29] Rev. Rul. 95-58; Estate of Wall v. Commissioner, 101 T.C.300 (1993).
[30] Id.
[31] IRC § 672(d); Treas. Reg. § 1.672(d)-1.
[32] Treas. Reg. § 1.672(d)-1. See also IRC § 674(b)(2); IRC § 676(b); IRC § 677(a) (last sentence).
[33] See also IRC § 676(b) (Power Affecting Beneficial Enjoyment Only After Occurrence of Event).
Briefly Taxing’s Primer on Grantor Trusts
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