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Grantor Trusts – Part III of IV – Reversionary Interests and Powers to Control Beneficial Enjoyment

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.

As we discussed briefly in the Second Post in this Series, if Uncle Bill created a trust, it will be treated as a grantor trust under the Code if any of the following apply:

    • Bill holds a reversionary interest in the assets of the trust;[1]
    • Bill controls the beneficial enjoyment of the assets of the trust or its income;[2]
    • Bill retains certain administrative powers over the trust;[3]
    • Bill retains the power to alter, amend, modify, terminate, or “revoke” the trust;[4] or
    • Bill receives distributions from the trust.[5]

Without further ado, and because much ado has been made already, let us now turn to a discussion of Pinocchio’s strings (that is, “substantial retained dominion or control” over a trust).

The Reversionary Interest String – IRC § 673

Uncle Bill will be treated as the grantor of the trust if he has a reversionary interest in either the principal (principal) or the income of the trust, so long as when the trust is created the value of the reversionary interest exceeds 5% of the value of the trust.[6] (Your fearless editors urge you to note, for your own sake, that the every single one of the Treasury Regulations relating to reversionary interests no longer are good law…and haven’t been good law since 1986.  Thanks for nothing, Treasury Department.)[7] If the reversionary interest applies only to a portion of the trust, then Bill will only be treated as the grantor of that portion to which the reversionary interest applies.[8] The value of Bill’s reversionary interest is determined under the Code by assuming “the maximum exercise of discretion” in favor of the Bill—meaning that, if the trustee has discretion to distribute the remainder interest entirely (effectively, a revocation of the trust), IRC § 673(c) assumes that the trustee will be as generous as it is permitted to be by the trust instrument.

Example: Uncle Bill creates a trust that benefits his sons, Leroy, Jethro, and Jedediah, for 5 years. Under the terms of the trust, Bill’s idiot boys will receive income from the trust for 5 years, after which their income interest terminates, reverting back to Uncle Bill, who would then be entitled to discretionary distributions of income and principal for his health, support, education, and maintenance (commonly referred to by the acronym “HEMS”). Under IRC § 673(c), we must assume that the trustee would exercise his discretion to distribute as much of the trust’s income and principal as would be reasonable under this discernible standard.

So, how does one calculate this 5% interest? Astute question, friend.

The 5% reversionary interest is calculated using standard actuarial principles, which is to say through reference to the IRS’s published actuarial tables. Using the immediately preceding example, the value of the Bill’s reversionary interest after the expiration of the term of years is determined by assuming the maximum exercise of discretion in favor of the grantor, which is to say, the interest is calculated by considering the maximum amount that Bill could receive at the effective termination of the trust. Stated another way, the interest is calculated in consideration of the amount that Bill would receive if the trustee were to distribute the entirety of the trust (income and principal) to Bill.[9]

Pursuant to IRC § 7520(a), any remainder or reversionary interest is determined under the tables prescribed by the IRS and by using an interest rate equal to 120 percent of the Federal midterm rate in effect under IRC § 1274(d)(1) for the month in which the valuation date falls.

Example: Bill created the trust and transferred assets to it in January 2018. At this time, the midterm rate was 2.18%.[10] Therefore, 120% of this rate would be 2.6%. Because the interest that we’re valuing is a reversionary interest that takes effect following a term of years, we would then look to “Table B,”[11] which is published by the IRS pursuant to Treas. Reg. § 20.2031-7(d)(6).[12] The Table B “remainder” factor that corresponds to a reversionary interest taking effect after five years is .879555. Thus, Bill’s reversionary interest is nearly 88% of the value of the interest conveyed to the trust in 2018. Even using my (admittedly) poor mental math skills, 88% is greater than 5%; therefore, the trust would be a grantor trust as to Bill, based on IRC § 673(c).

Looking at Table B, we see that, when interest rates are low, a longer term of the trust will be necessary to fall below the 5% threshold; conversely, in a higher interest rate environment, a shorter term of the trust will yield a reversionary interest that falls below the 5% interest threshold. With rates as low as they are (at the time this article was written), it is nigh impossible to reach the 5% threshold within the grantor’s lifetime. As such, the 5% threshold will likely only ever be met if the reversion is made to the grantor’s estate…unless interest rates take a precipitous hike in the future.

If the value of Bill’s reversionary interest is less than 5% of the trust at its inception, and ownership is not imputed to him under IRC § 673, Bill will not be taxed on the ordinary income of the trust. However, Bill may, nevertheless, be treated as an owner under IRC § 677(a)(2) if he has a reversionary interest in the principal of the trust.[13] In the latter case, items of income, deduction, and credit allocable to principal, such as capital gains and losses, will be included in the portion of the trust that Bill is treated as owning.

There is a limited exception to the general rule under IRC § 673 in the event that reversionary interest takes effect at the death of a minor when you will descendent beneficiary. Specifically, if the beneficiary (a) is a lineal descendent of the grantor, and (b) holds all of the present interests in the trust (or a portion thereof), then the grantor will not be treated as the owner of the trust (or the portion thereof), solely by reason of the reversionary interest—so long as the reversionary interest only takes effect upon the death of the beneficiary before the beneficiary attains the age of 21.[14]

Example: Uncle Bill created a trust for the benefit of Jethro’s illegitimate love child, Wilbur, who at the time of the trust’s creation is a sickly young lad of 6 years. Bill, hedging his bets, does not believe that Wilbur will make it past his 21st birthday. As such, the trust instrument states that the income and principal of the trust will revert to Bill if Wilbur dies before he attains the age of 21. Bill will not be treated as the grantor of the trust under IRC § 673, because the reversionary interest will only take effect upon Wilbur’s death prior to reaching the legal drinking age in the state of Maine. If Wilbur does die before his 21st birthday, and the trust reverts to Bill, meaning that Bill is then entitled to discretionary distributions of income and principal, he will be treated as the owner of the trust once the reversionary interest is triggered.

Power to Control Beneficial Enjoyment – IRC § 674

In general, if Uncle Bill creates a trust in which he retains the power to dispose of or affect the beneficial enjoyment of the trust’s income or principal, whether for himself or for others, that trust will be treated as a grantor trust.[15] This general rule is, as most general rules are under the Code, subject to a number of exceptions,[16] which exceptions are, themselves, subject to certain limitations.[17] Broadly speaking, the term “power of disposition” used in IRC § 674(a) includes any power to direct the enjoyment of the benefits of the trust, no matter the capacity in which the power is held.[18]

Example: Uncle Bill creates a trust, which provides that his offspring are to receive discretionary distributions of income for their respective lives unless (or until) they piss Bill off to such a degree that he cuts them off—the degree of pissed-offedness to be solely within Bill’s unfettered discretion—then Bill will have retained a power to control the beneficial enjoyment of the trust, and the trust will be considered a grantor trust under IRC § 674.

The simplest example of IRC § 674 is a trust in which Uncle Bill has the power to distribute (or retain if he sees fit) the income or principal of the trust without the consent of an “adverse party.” Though we discussed when a party may be considered “adverse” at some length above, to recap the definition of the term briefly, a party will be adverse to the grantor, if that party has a “substantial beneficial interest” in the trust, which interest could be affected by the grantor.[19] Thus, Bill’s kids in the previous example would all be adverse to Bill, because their receipt of income (a “substantial beneficial interest” in the trust) may be adversely affected (read: terminated) if, in Bill’s unfettered discretion, a child (or children) somehow manages to irritate Bill above and beyond what he deems acceptable.

The Eight Enumerated Exceptions of IRC § 674(b)

There are eight enumerated exceptions contained in IRC § 674(b) and two additional exceptions regarding independent trustees contained in IRC § 674(c) and (d), which, if such an exception applies, means that the power retained by the grantor will not, in and of itself, cause the trust to be treated as a grantor trust.

First Enumerated Exception

The first exception is that the income of a trust will not be considered as taxable to the grantor merely because, in the discretion of any person (other than a grantor who is not then acting as a trustee or co-trustee), such income may be used for the support of a beneficiary (other than the grantor’s spouse), whom the grantor is legally obligated to support—except to the extent that it is in fact used for that purpose.[20] Stated differently, Bill will not be treated as the owner of a trust (meaning that the trust will not be treated as a grantor trust) merely because a trustee or Bill (as trustee) possesses the power to use the trust’s income to discharge his legal obligation of support. However, to the extent that Bill does actually use the trust’s income to discharge a legal support obligation (described more fully in IRC § 677(b)), then Bill will be taxed on such income.[21]

Example: Though he vehemently denies it, Bill allegedly sired a child just before he married Aunt Ethel 35 years ago. The poor bastard’s mother, Lou Ann (not to be confused with Jethro’s wife, Lee Ann), managed to convince the judge of Bill’s paternity without the aid of a paternity test. The litigation lasted for the better part of 22 years, and Bill consequently owes a substantial amount of past-due child support. Bill creates a revocable trust, over which he is the trustee. The trust instrument provides that Bill may use the income of the trust to pay the poor bastard’s child support arrearages. (You note, here, that despite asking the child’s name on numerous occasions, Bill and Ethel will only refer to him as “the poor bastard,” and so you are a bit hamstrung with this decidedly archaic naming convention.) To the extent that Bill actually makes such payments, Bill will be taxed on the income of the trust that is distributed to the child.

Two additional points must be made as to this first exception. If the power to distribute the income is not held by Bill in a fiduciary capacity (i.e., as a trustee), the mere possession of the power to distribute the income will cause Bill to be taxed on the trust income—whether or not it is actually used to satisfy a legal support obligation. This is because IRC § 674(b)(1) only applies to a grantor when serving as a trustee. Second, if the distribution that satisfies the grantor’s support obligation is made, not from income, but instead from the trust’s principal, IRC § 674(b)(1), likewise, is inapplicable—and the tax consequences will be governed by the normal rules of subchapter J (IRC §§ 661-662).

Second Enumerated Exception

The second exception deals with a power that affects the beneficial enjoyment of trust income only after the occurrence of an event.[22] Thus, Bill will not be treated as the grantor of the trust if he holds a power, which affects the beneficial enjoyment of the income of the trust, if the exercise of the power can only affect the beneficial enjoyment of the income of a trust received after the expiration of a period of time which, if it were a reversionary interest, would be protected from grantor trust status if the reversionary interest were 5% or less under IRC § 673.[23]

Example: Bill creates a trust for the benefit of his legitimate daughter Jennie for 20 years, after which Bill will have the discretion to add beneficiaries to the trust. Although Bill may only exercise this power after 20 years has elapsed, Bill will still be treated as the grantor of the trust from its inception under IRC § 674(b)(2), because the value of his reversionary interest in the trust is greater than 5% under IRC § 673.

Third Enumerated Exception

The third exception applies to purely testamentary powers. A power held by any person to control the beneficial enjoyment of trust income, exercisable only by will, does not cause a grantor to be treated as an owner under IRC § 674(a), if such power is held by the grantor or a nonadverse party.[24] However, this exception does not apply to income accumulated for testamentary disposition by the grantor or to income which may be accumulated for such distribution in the discretion of the grantor or a nonadverse party, or both, without the approval or consent of any adverse party.[25]

Example: Uncle Bill creates a trust that provides that the trust’s income will be accumulated during Bill’s life, and at his death, Bill may appoint the accumulated income in his will. Under these circumstances, Bill will be treated as the grantor of the trust from its inception. Similarly, if the trust provided that Aunt Ethel, instead, held the testamentary power of appointment, and such power of appointment could be exercised without the approval of the children (or other adverse parties), then Bill would be treated as the grantor of the trust at its creation. If, however, Bill creates a trust naming Remus as trustee, and the trust gives Remus the power to appoint the principal of the trust betwixt and between Bill’s children at Remus’ discretion, Bill will not be treated as the grantor of the trust (at least under IRC § 674(b)(3)).

Furthermore, if a trust instrument provides that the income is payable to another person for his life, but the grantor has a testamentary power of appointment over the remainder, and, under the trust instrument and local law, capital gains are added to principal, the grantor is treated as the owner of a portion of the trust and capital gains and losses are included in that portion.[26]

Fourth Enumerated Exception

The fourth exception applies to a power to allocate the income or principal of a trust among charitable beneficiaries. Bill will not be taxed as the trust’s owner if he retains a power to allocate the trust’s principal or income among charitable beneficiaries, so long as (a) such charitable beneficiaries are irrevocably designated; and (b) such charitable beneficiaries are described in IRC § 170(c).[27] If, however, Bill also retained the power to designate noncharitable beneficiaries of the same income or principal of the trust, this exception to the general rule of IRC § 674(a) would not apply.

Example: Uncle Bill creates an irrevocable trust in favor of his three favorite charities, each of which militantly support the preservation of wildlife and the right to bear arms against said wildlife. Bill retains the right to decide which charities will receive distributions from the trust, as well as how much each charity will receive—so long as Bill’s “charities” qualify as such under IRC § 170. (For a discussion of Bill’s attempts at creating “charities” that run afoul of IRC § 170 and its regulations, one need only look here…or here…) If Bill created a trust naming Remus as trustee, giving Remus the ability to “sprinkle” the trust’s income amongst certain (qualifying) charities, then Bill would likewise not be treated as the grantor of the trust.[28]

Fifth Enumerated Exception

The fifth exception deals with the power to distribute the trust’s principal. The power to distribute the principal of the trust will not, alone, create either (a) to or for a beneficiary or beneficiaries or to or for a class of beneficiaries (whether or not income beneficiaries) provided that the power is limited by a reasonably definite standard which is set forth in the trust instrument; or (b) to or for any current income beneficiary, provided that the distribution of principal must be chargeable against the proportionate share of principal held in trust for the payment of income to the beneficiary as if the principal constituted a separate trust.[29] A power does not fall within the powers described in this paragraph if any person has a power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive the income or principal, except to provide for after-born or after-adopted children.[30]

If the power is limited by a reasonably definite standard set forth in the trust instrument itself, the power may extend to distributions of principal to any beneficiary, beneficiaries, or class of beneficiaries (whether income beneficiaries or remaindermen) without causing the grantor to be treated as an owner under IRC § 674.[31] The discretionary standard must be “clearly measurable,” and the holder of the power must be legally bound to distribute only in accordance with the standard.[32] For instance, a power to distribute trust principal to beneficiaries under the HEMS standard; for “reasonable support and comfort;” or to enable a beneficiary “to maintain his accustomed standard of living;” or to meet an emergency, would be limited by a reasonably definite standard.[33] It should be noted that a power to distribute principal for the “pleasure, desire, or happiness” of a beneficiary is not limited by a reasonably definite standard.

Note: In practice, there is a very thin line between providing for a beneficiary’s “support and comfort” and the beneficiary’s plenary “happiness.” Nevertheless, the Code and Treasury Regulations draw the line, and, so, when drafting a trust, it is important to be mindful of this distinction.

The Treasury Regulations note that all facts and circumstances must be considered when reviewing the standard, and the fact that the governing instrument is phrased in discretionary terms is not in and of itself determinative that a reasonably definite standard exists. If the power to distribute principal is not limited by a reasonably definite standard, the exception applies only if distributions of principal may be made solely in favor of current income beneficiaries, and any principal distributions to the current income beneficiary must be chargeable against the proportionate part of principal held in trust for payment of income to that beneficiary as if it constituted a separate trust.[34]

Let’s look at a few examples to see how this fifth exception to the general rule of IRC § 674 plays out.

Example 1: Uncle Bill creates a trust, which provides for payment of the income to the Bill’s brother, Elmer, and for payment of the principal to the Aunt Ethel’s step-nephew, Jim-Bob (or, James-Robert, if he’s feeling particularly formal). Bill reserves the power to distribute the principal to pay medical expenses that may be incurred by Elmer (which medical expenses and/or funeral expenses are all but a certainty, given Elmer’s fervent distrust of squirrels and his track record with Vietnam-era improvised explosive devices) or Jim-Bob (which medical expenses are less likely, given that taxpayers generally foot the bill for healthcare in the hoosegow).

Bill will not be treated as an owner of the trust by reason of this power because IRC § 674(b)(5)(A) excepts a power, exercisable by any person, to invade principal for any beneficiary, including a remainderman, if the power is limited by a reasonably definite standard, which is set forth in the trust instrument. However, if the power were also exercisable in favor of a person, for example, Bill’s son Leroy (whose medical expenses from the unfortunate “run-in” with a bull moose during mating season continue to mount),[35] who was not otherwise a beneficiary of the trust, IRC § 674(b)(5)(A) would not be applicable.

Example 2: As in Example 1, Bill creates a trust for the benefit of Elmer (income) and principal (Jim-Bob). Instead of reserving a power for medical expenses, Bill reserves the power to distribute any part of the principal to Elmer and Jim-Bob for their “happiness.” This is, Bill admits, a bit of a cop‑out for Elmer, for whom happiness means a rocking chair, an iced down case of Coors Lite, and a .22 long rifle with a laser sight. Happiness may be more expensive a proposition for Jim-Bob, as evidenced by the fading tattoo on his left calf, which reads “Money can’t buy happiness, but it can damn sure buy me a boat.”*

*It should be noted that before his latest trip to prison, Jim-Bob heard the country song “Buy Me a Boat” by Chris Janson, and he swiftly asked you to “sue that freeloading sonofabitch for infringing on [Jim-Bob’s intellectual property] rights as a red-blooded, God-fearin’, tax paying American.” You explained that (a) copyright infringement was not in your wheelhouse, (b) you weren’t sure that Jim-Bob could prove a nexus between the tattoo, which he does not *technically* remember getting, and the song, and (c) no son of Bill and Ethel had never paid a penny to Uncle Sam (aside from mandatory criminal restitution). Much to your inevitable disgust, you couldn’t help but perform a fair bit of research on whether a tattoo could be considered copyrighted material (finding that, yes, it likely could). Nonetheless, when Jim-Bob was pinched for trafficking in allegedly “stolen” car mufflers, the thirteen months (one for each of the eleven mufflers found in his possession, and two for laconically flipping the judge the bird as his heretofore eleven-month sentence was being read out) that Jim-Bob spent “up the river” (without a boat, you note bemusedly) put a kybosh on his delusions of a payday (which, Jim-Bob assured you, would be squandered immediately on a nice Boston Whaler).

Bill will be treated as the owner of the trust, as IRC § 674(b)(5)(A) would not apply, insofar as the power to distribute is not limited by a reasonably definite standard.

Example 3: Bill creates a trust that provides for payment of the income to his idiot boys Jethro, Jedediah, and Leroy in equal shares for 10 years, after which time the principal is to be distributed amongst Bill’s grandchildren, if any (and if there is a merciful God, there won’t be), in equal shares. Bill reserves the power to pay over to each son up to one-third of the principal during the 10-year period, but any such payment shall proportionately reduce subsequent income and principal payments made to the son receiving the pay-out of principal. Thus, if one-third of the principal is paid to Jedediah to pay for the legal fees to defend against the trumped-up charges of embezzling funds from Ned’s Tire Rack, all the income from the remaining two-thirds is thereafter payable to the Jethro and Leroy. Bill will not be treated as an owner under IRC § 674(a) by reason of this power because it qualifies under the exception of IRC § 674(b)(5)(B).

Note: It’s important to note, however, that this fifth exception does not apply if any person has a power to add to the list of beneficiaries entitled to receive the income or principal of the trust, except where the action is to provide for after-born or after-adopted children. However, this exception-to-the-exception does not apply to a power held by a beneficiary to substitute other beneficiaries to succeed to his interest in the trust, because such substitute beneficiary would be an adverse party as to the exercise or non-exercise of such power. The limitation does not apply, for example, to a power in a beneficiary of a non-spendthrift trust to assign his interest to another. Nor does the limitation apply to a power under IRC § 674(b)(3), which power is exercisable only through the power-holder’s will.

Sixth Enumerated Exception

The sixth exception relates to the power to distribute or apply income to or for any current income beneficiary or to accumulate the income for such beneficiary.[36] The power to withhold income temporarily is subject to two alternate provisos. First, any accumulated income must ultimately be payable to (a) the beneficiary from whom distribution or application is withheld, (b) to his estate, or (c) to his appointees or takers-in-default—provided that the beneficiary’s power of appointment is a “general” power under IRC § 2041(b)(1), meaning that the power of appointment does not exclude from the class of possible appointees any person other than the beneficiary, his estate, his creditors, or the creditors of his estate.[37] Alternatively, any accumulated income must, at the termination of the trust, ultimately be payable to the current income beneficiaries according to their irrevocably specified shares.[38]

Even if a trust provides that if any beneficiary does not survive a date of distribution, which could reasonably occur within the beneficiary’s lifetime, this sixth exception will still apply, so long as the share of the deceased beneficiary is paid to his appointees or a designated taker-in-default, whose share has been irrevocably specified.[39] Finally, this sixth exception does not apply if the power to withhold income temporarily if the grantor (or any other person) has the power to add to the list of beneficiaries that are designated to receive the income or principle, except where such action is to provide for after-born or after-adopted children.

Example: Uncle Bill creates a revocable inter vivos trust for the benefit of his daughters, Jennie and Moon (neé Jaime). Bill reserves the right to accumulate income for either or both daughters, and at Bill’s death (when the trust becomes irrevocable), any accumulated income is to be paid in shares specified by the trust instrument to Jennie or Moon, their respective estate, or to anyone that they may have appointed in their wills (assuming that the appointment is a “general” power of appointment, and not a special power of appointment under IRC § 2041(b)(1)). The trust instrument does not allow Bill or any other person to add additional income beneficiaries, except in the event that Jennie or Moon give birth to, or otherwise acquire (adopt) any children at a later date. Under the Code and Treasury Regulations, Bill will not be considered an owner of the trust, simply because he possesses this power to temporarily withhold income under the terms of the trust.

The exception in IRC § 674(b)(6) does not apply if the power is, in substance, one that simply shifts ordinary income from one beneficiary to another.[40] Thus, a power will not qualify for this sixth exception if ordinary income may be distributed to Jennie and Moon, or may be added to the trust’s principal, which is ultimately payable to Moon’s son, James-Robert (no blood relation to Ethel’s step nephew of the same name), a remainderman, who is not a current income beneficiary.[41] However, IRC § 674(b)(6)(B) does permit a limited power to shift ordinary income among current income beneficiaries, as shown in the following example.

Example: Uncle Bill creates a trust providing that the income shall be paid in equal shares to the Jennie and Moon, but Bill reserves the power to withhold from either beneficiary any part of that beneficiary’s share of income and to add it to the principal of the trust until the Jennie (the younger of the two daughters) reaches the age of 45 or dies. When Jennie reaches turns 45 (or, God forbid, kicks the proverbial bucket), the trust will terminate, and the principal (with the accumulated income that was added thereto) is to be divided equally between Jennie and Moon or their estates. Although exercise of this power may permit the shifting of accumulated income from one beneficiary to the other (since the principal with the accumulations is to be divided equally), the power is excepted under IRC § 674(b)(6)(B). If, however, the trust provides that when Jennie reaches the age of 45 or shuffles off this mortal coil, all accumulated income is to be paid to James-Robert, this sixth exception would not apply.

Note: It’s important to note, however, that like the fifth exception, the sixth exception (power to withhold income temporarily) does not apply if any person has a power to add to the list of beneficiaries entitled to receive the income or principal of the trust, except where the action is to provide for after-born or after-adopted children. However, this exception-to-the-exception does not apply (meaning that the grantor will not be treated as the owner of a trust) to a power held by a beneficiary to substitute other beneficiaries to succeed to his interest in the trust, in part because such substitute beneficiary would be an adverse party as to the exercise or non-exercise of such power. The limitation likewise does not apply, for example, to a power in a beneficiary of a non-spendthrift trust to assign his interest to another. Nor does the limitation apply to a power under IRC § 674(b)(3), which power is exercisable only through the power-holder’s will.

Seventh Enumerated Exception

The seventh exception relates to the power to withhold income during the disability of a beneficiary.[42] IRC § 674(b)(7) provides an exception for a power which generally permits ordinary income to be withheld during the legal disability of an income beneficiary or while he is under the age of 21.[43] Specifically, if the power to withhold income is exercisable only during the existence of a legal disability of any current income beneficiary or the period during which any income beneficiary is under the age of 21, then the grantor of the trust would not be considered the owner thereof under the general rule of IRC § 674(a). It is not necessary that the income must ultimately be payable to the income beneficiary from whom it was withheld, his estate, or his appointees. Instead, the accumulated income may be added to the principal of the trust and ultimately distributed to others.

Example: Uncle Bill, as he is wont to do, creates a trust to pay income to Moon when she is still knee-high-to-a-grasshopper,[44] reserving the power to accumulate income and add it to the principal of the trust before Moon reaches the age of 21. The trust also provides that the income will be paid to Moon during her life, and at their death, the trust will terminate and will be distributed to James-Robert (and any children that Moon may acquire later by adoption or accident of birth). Because of the sixth exception contained in IRC § 674(b)(6), Bill will not ipso facto be treated as the owner of the trust simply because he reserved this power.

Note: As with the fifth exception and the sixth exception, the seventh exception does not apply if any person has a power to add to the list of beneficiaries entitled to receive the income or principal of the trust, except where the action is to provide for after-born or after-adopted children. However, this exception-to-the-exception does not apply to a power held by a beneficiary to substitute other beneficiaries to succeed to his interest in the trust, because such substitute beneficiary would be an adverse party as to the exercise or non-exercise of such power. The limitation does not apply, for example, to a power in a beneficiary of a non-spendthrift trust to assign his interest to another. Nor does the limitation apply to a power under IRC § 674(b)(3), which power is exercisable only through the power-holder’s will.

Eighth Enumerated Exception

The eighth exception relates to the power to allocate receipts and disbursements as between principal and income.[45] Stated simply, if Bill creates a trust and reserves the power to allocate receipts and disbursements between principal and income, and even the power expressed in “broad language,” this power, by itself, will not cause Bill to be treated as an owner of the trust under the general rule of IRC § 674(a).

Two Additional Exceptions to IRC § 674(a)

Two other exceptions apply to the general rule of IRC § 674(a), both of which are related to powers held by independent trustees or trustees other than the grantor or his spouse.[46]

The first exception related to independent trustees provides that a grantor will not be treated as the owner of any portion of a trust, the beneficial enjoyment of the principal or the income of which is subject to a power of disposition, so long as this power is solely exercisable by an independent trustee or independent trustees and without the approval or consent of any other person.[47] In this context, an “independent trustee” is a trustee, who is not the grantor, the grantor’s spouse, and, in the case of multiple trustees, no more than half of whom are related or subordinate parties “subservient to the wishes of the grantor” as further defined in IRC § 672(c) and its corresponding Treasury Regulations.[48]

The powers to which IRC § 674(c) apply are powers (a) to distribute, apportion, or accumulate income to or for a beneficiary, beneficiaries, or a class of beneficiaries (or to distribute, etc., income within this class), or (b) to pay out principal to or for a beneficiary, beneficiaries, or a class of beneficiaries.[49] It does not matter, for purposes of IRC § 674(c) whether or not these beneficiaries are also income beneficiaries of the trust. This means that if Uncle Bill creates a trust, income to Aunt Ethel for her life, and appoints a corporate trustee with the power to distribute income to Bill and Ethel’s children while Ethel is living, Bill will not be considered an owner of the trust by virtue of IRC § 674(c). Similarly, if Bill creates a trust and appoints an independent trustee, who has the power to allocate, without restriction, the amounts of income to be paid to or accumulated for to each son annually, and at the trustee’s complete, unfettered discretion. Such a power does not cause Bill to be treated as the owner of the trust under IRC § 674(a).

Note: An independent trustee’s power does not fall within this first exception if the trustee (or any other person) has a power to add to the list of permissible beneficiaries designated to receive the income or principal, except where such action is to provide for after-born or after-adopted children.[50]

The second exception related to independent trustees, contained in IRC § 674(d), provides that a grantor will not be treated as the owner of any portion of a trust, the beneficial enjoyment of the principal or the income of which is subject to a power of disposition, so long as the power to allocate income is limited by an ascertainable standard, and the holder of the power is not the grantor or his spouse.[51] This second exception is subtly different from the first exception, insofar as the trustee or trustees could be related or “subservient” and insofar as the power must be subject to an ascertainable standard, such as the HEMS standard. Thus, if Uncle Bill creates a trust, income to his idiot boys, Leroy, Jethro, and Jedediah during their lives, and appoints Cousin Elmer (a related party through his blood kinship with Bill’s spouse, Ethel) as trustee with the power to distribute income for the health, education, maintenance, and support of all of Bill’s male descendants, Bill will not be treated as the owner of the trust under the general rule of IRC § 672(a).

If Bill reserves a power to remove, substitute, or add trustees (other than a power exercisable only upon limited conditions which do not exist during the taxable year, such as the death or resignation of, or breach of fiduciary duty by, an existing trustee), this power may prevent a trust from qualifying under IRC § 674(c) or (d).[52]

Example: Uncle Bill creates a trust and reserves an unrestricted power to remove an independent trustee and substitute any person including himself as trustee, the trust will not qualify under IRC § 674(c) or (d).

On the other hand, if Bill’s power to remove, substitute, or add trustees is limited, so that its exercise could not alter the trust in a manner that would disqualify it under IRC § 674(c) or (d), the power itself does not disqualify the trust.

Example: Uncle Bill creates a trust and reserves the power in the grantor to remove or discharge an independent trustee on the condition that he substitute another independent trustee. This power will not prevent a trust from qualifying under IRC § 674(c). Things get a bit stickier with IRC § 674(d), but so long as Bill doesn’t have the power to name himself or Ethel as trustee, and so long as the not-so-independent trustee’s powers of distribution, etc., are subject to ascertainable standards, then Bill should not be treated as the owner of the trust under IRC § 674(a) through the application of IRC § 674(d).

Note: It’s important to note, that these independent trustee exceptions contained in IRC § 674(c) and (d) do not apply if any person has a power to add to the list of beneficiaries entitled to receive the income or principal of the trust, except where the action is to provide for after-born or after-adopted children. However, this exception-to-the-exception does not apply to a power held by a beneficiary to substitute other beneficiaries to succeed to his interest in the trust, because such substitute beneficiary would be an adverse party as to the exercise or non-exercise of such power. This limitation does not apply, for example, to a power in a beneficiary of a non-spendthrift trust to assign his interest to another. Nor does this limitation apply to a power under IRC § 674(b)(3), which power is exercisable only through the power-holder’s will.


Footnotes:

[1] IRC § 673.

[2] IRC § 674.

[3] IRC § 675.

[4] IRC § 676.

[5] IRC § 677

[6] See IRC § 673(a).

[7] It is critically important, at this juncture, to note that the entirety of the Treasury Department is currently perched securely atop your fearless editor’s list of most hated beings on the planet (hovering, for now, just above Hitler and the kid who called me fat in the third grade…I still remember, Josh…). This vitriol that presently engulfs me is the consequence of Treasury’s unwillingness to amend, revise, or replace Treasury Regulations that have not applied since they were superseded by the Tax Reform Act of 1986. You’ve had thirty-four years to remedy this issue, Treasury. THIRTY-FREAKING-FOUR YEARS.

Apparently, Treasury’s time eating bon bons and watching their “stories” on daytime TV was more important than the time it took for me to research and realize that the Treasury Regulations under IRC § 673 (that is Treas. Reg. §§ 1.673(a)-1 through 1.673(d)-1) and elsewhere do not reflect statutory changes made by the Tax Reform Act of 1986 to IRC § 673. See Pub. L. No. 99-514 (codified at IRC §§ 2001-2663) (1989).

To put it in context, the last time that the Treasury Regulations were actually any use to anyone, the Soviet Union was alive and kicking (and Chernobyl was still operating according to commie code); neither The Simpsons nor Full House (the original, not the reboot) had been televised (and David Hasselhoff would not don his red swim trunks in Baywatch until three years later); Ronald Reagan had not yet yelled at Mikhail Gorbachev to “tear down this wall” (like an angry old man yells at kids on his lawn); Euro Disney had not broken ground; no “Miracle” had yet occurred on the ice of Lake Placid, NY; Prozac (which, granted, might be the answer to said vitriol) had not yet gone on the market; no one had ever thought to utter the phrase “Yippie-kay-yay, Mother…” as Diehard would only come out two years later; Michael Jordan would not win an NBA title until five years hence; Microsoft Word was yet a glimmer in Bill Gate’s left eye; a pound of bacon cost $1.75 (As for a pound of broccoli? Why, that would have set you back a mere 39¢); a Plymouth Colt could be had for $4,999 (and a Ford Mustang, for $7,450); the Dow Jones closed at a staggering high of 1,895; and your fearless editor was barely able to walk—not on account of inebriation (and certainly not on account of of crack cocaine, which only appeared on the streets two years after the Tax Reform Act of 1986—or so I discovered when conducting the research needed to substantiate and contextualize this rant), nor for any other untoward reason—but on account of the fact that I was only TWO YEARS OLD.

Meanwhile, back at the proverbial ranch, the 1986 statutory changes wholly eliminated the old “10-year rule” (which provided that an individual will be treated as a grantor if the interest reverted to the grantor within 10 years of the date of the inception of the trust). Further, it eliminated the exception for reversionary interests taking effect at the income beneficiary’s death. This 10-year-rule was replaced in IRC § 673 in favor of the present 5% approach to reversionary interests. See Tax Reform Act of 1986 (P.L. 99-514, §1402(a)). For whatever reason (we think sheer laziness on the part of Treasury is most likely), the Treasury Regulations were not changed accordingly.

If you are unaware of the sweeping statutory changes made to IRC § 673, it is wholly, utterly, absolutely, and unabashedly impossible to jive the post-1986 Code with the Treasury Regulations, which are as stale and useless as an unopened bottle of New Coke, which, for what it’s worth, came out in 1985… (Ask me how I know, and I will spin a tale of anguish incurred and time wasted…)

As a sidenote, your fearless editor owes dear Stephen T. Dyer a beer (or a case, thereof) for finally clarifying this incomprehensible disconnect between the Code and the outdated, unrevised, and utterly derelict Treasury Regulations.) See Stephen T. Dyer, Planning with Grantor Trusts, Nov. 15, 2018, 12, n. 89.

[8] Id.

[9] IRC § 673(c).

[10] See https://www.irs.gov/pub/irs-drop/rr-18-01.pdf.

[11] See https://www.irs.gov/pub/irs-tege/sec_3_table_b_2009.xls.

[12] If the reversionary interest, instead, took effect on the death of some person (such as the beneficiary), we would look to “Table S,” instead. See https://www.irs.gov/pub/irs-tege/sec_1_table_s_2009.xls.

[13] Treas. Reg. § 1.673(a)-1(a)(2); see also Treas. Reg. § 1.671-3; Treas. Reg. § 1.677(a)-1(g), Ex. 2.

[14] IRC § 673(b).

[15] IRC § 674(a); Treas. Reg. § 1.674(a)-1(a).

[16] IRC § 674(b)-(d).

[17] Treas. Reg. § 1.674(d)-2.

[18] Treas. Reg. § 1.674(a)-1; IRS PLR 200730011; IRS PLR 9625021.

[19] IRC § 671(a); Treas. Reg. § 1.672(a)-1(a).

[20] Treas. Reg. § 1.674(b)-1(b)(1); IRC § 674(b)(1); see also IRC § 677(b) (stating that a legal obligation of support does not, itself, trigger grantor trust status).

[21] IRC § 674(b)(1).

[22] IRC § 674(b)(2); Treas. Reg. § 1.674(b)-1(b)(2).

[23] Once again, the Treasury Regulations are wholly worthless, as they describe a situation in which the reversionary interest comes into effect after a term of years. See, statement regarding the righteous indignation of your dear editor, supra at fn. 7.

[24] IRC § 674(b)(3); Treas. Reg. § 1.674(b)-1(b)(3).

[25] Id.

[26] Id.; see also Treas. Reg. § 1.671-3.

[27] IRC § 674(b)(4); Treas. Reg. § 1.674(b)-1(b)(4).

[28] See, e.g., PLR 9604015.

[29] IRC § 674(b)(5)(A)-(B).

[30] IRC § 674(b)(5) (flush language).

[31] Treas. Reg. § 1.674(b)-1(b)(5)(i).

[32] Id.

[33] Id.

[34] Treas. Reg. § 1.674(b)-1(b)(5)(ii).

[35] Pun absolutely, unabashedly intended.

[36] IRC § 674(b)(6); Treas. Reg. § 1.674(b)-1(b)(6).

[37] IRC § 674(b)(6)(A).

[38] IRC § 674(b)(6)(B).

[39] IRC § 674(b)(6) (flush language). It should be noted, however, that if either the grantor or his estate is named as the deceased beneficiary’s appointee or taker-in-default, this sixth exception would not apply, and the default grantor trust rules of IRC § 674(a) would apply.

[40] Treas. Reg. § 1.674(b)-1(b)(6) (flush language).

[41] Id.

[42] IRC § 674(b)(7); Treas. Reg. § 1.674(b)-1(b)(7).

[43] See also Treas. Reg. § 1.674(b)-1(b)(7).

[44] Meaning that they are young, if you don’t speak Southern.

[45] IRC § 674(b)(8); Treas. Reg. § 1.674(b)-1(b)(8).

[46] IRC § 674(c) (power held by independent trustees); Treas. Reg. § 1.674(c)-1 (same); IRC § 674(d) (power held by non-grantor or non-grantor spouse trustee); Treas. Reg. § 1.674(d)-1 (same).

[47] IRC § 674(c); Treas. Reg. § 1.674(c)-1.

[48] Id.

[49] IRC § 674(c)(1)-(2); Treas. Reg. § 1.674(c)-1.

[50] IRC § 674(c) (flush language).

[51] IRC § 674(d); Treas. Reg. § 1.674(d)-1.

[52] Treas. Reg. § 1.674(d)-2(a).

 


 

Briefly Taxing’s Primer on Grantor Trusts

 


 

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