Grantor Trusts – Part IV of IV – Retained Powers and Non-Grantor Owners

Posted on July 5, 2021

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.

Reserved Administrative Powers – IRC § 675

There are four administrative powers, which will cause a trust to be treated as a grantor trust, each of which are contained in IRC § 675. In effect, IRC § 675 provides that the grantor is treated as the owner of any portion of a trust if, under the terms of the trust (or through “circumstances attendant on its operation,” which is just Taxish for “how the trust is actually administered”) administrative control is exercisable primarily for the benefit of the grantor rather than the beneficiaries of the trust.^[1] It should be noted that if a grantor is caught with his hand in the administrative cookie jar (that is, if a grantor retains a power to amend the administrative provisions of a trust, which is broad enough to permit an amendment that would cause the grantor to be treated as the owner of the trust, or a portion thereof, under IRC § 675), then the grantor will be treated as the owner the trust or the portion thereof from its inception.^[2]

Even though a power is exercisable by a trustee, and this power is described in “broad language” in the trust instrument, this is not, alone, indicative of the fact that the trustee is authorized to purchase, exchange, or otherwise deal with or dispose of the trust property or income for less than an adequate and full consideration in money or money’s worth.^[3] However, such authority may be indicated by the actual administration of the trust.^[4]

The Power to Deal with the Trust for Less than Full and Adequate Consideration

Under IRC § 675(1), Bill will be treated as the owner of a trust if he creates or reserves a power—exercisable by Bill or a nonadverse party, or both, and without the approval or consent of any adverse party—which power permits Bill or any other person to purchase, exchange, or otherwise deal with or dispose of the trust’s assets, i.e., the principal or income therefrom for less than an adequate consideration. Importantly, nothing in IRC § 675(1) prohibits Bill or a nonadverse party from dealing with trust assets—so long as such dealings are for adequate consideration, like purchasing trust assets at fair market value or entering into a lease with trust-held real property at a fair rental price. One must be cautious, however, not to upset the proverbial grantor-trust applecart (by, say, reacquiring trust assets by substituting assets of equal value, which is a no-no under IRC § 675(4)(C)).

Example: Uncle Bill creates a trust and provides that Aunt Ethel can use the trust as her personal slush fund, meaning that she can purchase trust owned real estate for pennies on the dollar, sell trust-owned securities for a pittance to finance Jedediah’s legal fees, etc. What’s more, Ethel has the power to authorize her baby boy Leroy to do the same. Any one of these powers given to Ethel would cause grantor trust treatment under IRC § 675(1).

The Treasury Regulations, rather unhelpfully, add that whether the existence of the power will, in and of itself, make the power holder an adverse party to the grantor depends on the particular circumstances.

Note: This “wait and see” approach does not warm the cockles of a tax attorney’s heart. We (and our clients) like definite answers. Indeed, the very appearance of the word “shall”—in an obscure regulation or an erstwhile forgotten section of the Code—produces a feeling (in many, otherwise well-meaning, tax practitioners) akin to a warm blanket in front of a crackling fire on a cold winter’s night. Tax law, as you might imagine, is not the most sensitive (read: touchy-feely) appendage of the law.

If, to stretch this metaphor beyond its limits, tax law were an appendage, it would be the elbow of the law…necessary, capable of sensation, but generally just prone to being run into a doorframe, eliciting an inaudible (but well-understood) curse under the law’s collective breath.

Indeed, in a recent survey,^[5] the IRS stated that it was not presently aware that it has (or ever had) a collective administrative conscience with respect to “equitable” matters, even if those “patchouli-scented hippies” in Congress made equitable considerations part of the law.^[6]

The Power to Borrow Trust Funds without Adequate Interest or Security

Under IRC § 675(2), Bill will be treated as the owner of a trust if he creates or reserves a power—once again, exercisable by Bill or a nonadverse party, or both—which power enables Bill to borrow from the principal or income of the trust, directly or indirectly, without adequate interest or without adequate security. However, this power will not cause grantor trust status to be inferred (in and of itself) if a trustee (other than the grantor acting alone) is authorized under a general lending power to make loans to any person without regard to interest or security.^[7] A general lending power in the grantor, acting alone as trustee, under which he has power to determine interest rates and the adequacy of security is, similarly, not, in and of itself, a definitive indicator that the grantor has power to borrow the corpus or income without adequate interest or security.^[8] Once again, it depends on the actual administration of the trust.

Note: The very existence of the power, not the exercise of such power, to borrow without adequate interest or adequate security, when held by the grantor or the grantor’s spouse will cause grantor trust status to attach—regardless of whether the power is actually exercised.^[9] Further, if a trustee has the power to make an unsecured or below-market loan to the grantor—even if no such loan is made—the trust will be treated as a grantor trust.^[10] This is so, even if the trustee only ever makes a loan to the grantor that does provide for sufficient market-rate interest or adequate security.^[11]

Borrowing Trust Funds without Prompt Repayment

Under IRC § 675(3), Bill will be treated as the owner of a trust if he (or his spouse, Ethel) borrows trust funds and fails to completely repay the loan, including any interest, before the beginning of the taxable year. If, however, the loan (a) provides for sufficient interest and adequate security, and (b) the loan is made by an independent trustee (i.e., other than Bill or Ethel, and other than a related or subordinate trustee, who is deemed “subservient” to the grantor under IRC § 672(c)), then the mere borrowing (at arm’s-length) by Bill or Ethel will not trigger grantor trust treatment.^[12]

General Powers of Administration

Under IRC § 675(4), Bill will be treated as the owner of a trust if he creates or reserves a “power of administration” that Bill (or any other person) may exercise in a non-fiduciary capacity (i.e., not as a trustee), without the approval or consent of any person in a fiduciary capacity (i.e., without the trustee’s stamp of approval). So, what in the Sam hell is a “power of administration,” you may ask…

The term “powers of administration” refers to any one or more of three specifically enumerated powers:^[13]

- A power, exercisable in a nonfiduciary capacity, to vote or direct the voting of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant (from the viewpoint of voting control);
- A power, exercisable in a nonfiduciary capacity, to control the investment of the trust funds either by directing investments or reinvestments, or by vetoing proposed investments or reinvestments, to the extent that the trust funds consist of stocks or securities of corporations in which the holdings of the grantor and the trust are significant (once again, from the viewpoint of voting control); or
- A power, exercisable in a nonfiduciary capacity, to reacquire the trust principal by substituting other property of an equivalent value.

Example 1: Bill’s trust holds 75% of the voting power of Stunning Sheila’s Emus, Bill’s wildly successful (you’ve seen the books and still don’t believe it) emu farm. If the trust instrument gives Bill the nonfiduciary power—without the approval of a trustee—to exercise this voting right, thereby compelling the hostile takeover of the German ostrich farm, Riesenvögel, A.G.,^[14] then Bill would be considered the owner of the trust—even if no vote is ever taken.

Example 2: If Bill possesses the nonfiduciary power to compel the trust to invest in the stock of Riesenvögel, A.G., which (after the aforementioned hostile takeover) is wholly owned by the trust, then Bill will be treated as the owner of the trust—even if Bill never actually compels the trust to so invest.

Example 3: If Bill possesses the nonfiduciary power to sell the emu farm to an independent third-party (or to Jedediah for that matter), and then to lease it back from the purchaser, the IRS has held that this is a reacquisition and substitution of trust property, which will result in grantor trust status.^[15] Similarly, if Bill sells 24% of the stock of the emu farm to Remus (retaining the majority share in trust, because Remus—though a dear friend—is about as trustworthy as a drunk leprechaun), and Bill thereafter substitutes 24% of the stock of Riesenvögel, A.G. (even if the stock of the German ostrich farm were equivalent in value), the existence (not simply the exercise) of this power, held by Bill as a non-trustee, would result in grantor trust status.

The Power to Revoke – IRC § 676

At its most basic, IRC §676 provides that a grantor of a trust will be treated as the owner of that trust if he has the power (exercisable only by the grantor, a non-adverse party, or both) to return or to “revest” legal title and ownership of the trust’s assets or a portion thereof to himself. Although IRC § 676 is entitled “Power to Revoke,” revocation is only one method to reinvest title of the trust’s assets in the grantor. As the Treasury Regulations observe, if the grantor has such a power of revesting, the grantor is treated as the owner of the trust, regardless of whether the power is a power to revoke, to terminate, to alter, to amend, or to appoint.^[16]

If, however, this power of revocation could only ever affect the beneficial enjoyment of the income of the trust after the occurrence of an event, such that a grantor would not be treated as the owner under IRC § 673 (i.e., if the power were a reversionary interest valued at 5% of the trust or more), neither will the grantor be treated as the owner under IRC § 676(b).^[17] The grantor, however, may be treated as the owner of the trust, if, he does not immediately relinquish the power after the occurrence of such event.^[18]

Example: Uncle Bill creates a trust for the benefit of Remus. In an effort to keep Remus on the straight and narrow path towards righteousness (and away from Raiford Federal Penitentiary, just outside of Starke, Florida), Bill’s new trust gives Remus income until his death or until he is incarcerated once more, whichever is first, with Bill having a power of appointment to “sprinkle” the trust’s assets among beneficiaries (including himself) as he saw fit. The trust also allows Bill to terminate the trust unilaterally if Remus goes to prison. It’s difficult to say how much Bill’s interest in the trust would be at its inception, but given that Remus is in his early seventies, the actuarial tables suggest that Bill’s interest is much greater than 5%; thus, the exception in IRC § 676(b) would likely not apply, and the trust would be treated as a grantor trust.

Would the result be different in the previous example, if Remus were fingered, convicted, and sentenced for three years for the theft of an ATM (said ATM having been found, rather inexplicably, in Remus’ third floor loft in Old Orchard Beach without a single dollar missing)? In this case, Bill’s right to terminate the trust and his power of appointment would trigger grantor trust status under IRC § 676(a).

Income for the Benefit of the Grantor (or the Grantor’s Spouse) – IRC § 677

Income Held or Distributed for Grantor or Grantor’s Spouse

Going back to what seems like days ago, the principle of grantor trusts is that if a grantor has enough control over the trust and its finances, then he will be treated as the owner of the trust, and the trust’s income will be taxed to the grantor. It makes sense then that if Bill and/or a nonadverse trustee can distribute principal or income to Bill or Ethel (without the approval or consent of any adverse party), Bill has a substantial vested interest in the trust’s assets.^[19]

Example: Uncle Bill creates an irrevocable trust, which provides that the trust’s ordinary income is to be payable to him and Ethel for life, and that on his death the principal of the trust should be distributed to Remus. Except for the right to receive income, Bill retained no right or power that would cause him to be treated as an owner under the grantor trust rules of IRC §§ 671-677. Nevertheless, since Bill and Aunt Ethel have the right to distributions of income during their lifetime, the trust is a grantor trust.

Income Accumulated for Grantor or Grantor’s Spouse

Similarly, if Bill or another nonadverse party (or both, if they are acting in cahoots) determines in their discretion that the trust income should be held or accumulated for future distribution to Bill or Ethel, this power to accumulate income (not the exercise thereof) in favor of Bill or Ethel makes Bill the owner of the trust.^[20]

Example: Bill creates a trust which provides that the ordinary income is payable to his adult Jethro for ten years and a day (or until his untimely death, if sooner). On the second day of the tenth year or on Jethro’s confirmed date of death, the principal is to revert back to Bill. Bill also retained a discretionary right to receive $5,000 of ordinary income each year; however, absent the actual exercise of this right, all the ordinary income is to be distributed to Jethro. Bill retained no other right or power which would cause him to be treated as an owner under the grantor trust rules.

Income Paying for Life Insurance (On Grantor or Grantor Spouse’s Life)

The third prong of the general rule, whether the income of a trust is applied for the grantor’s benefit, provides that if the income of the trust is applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor’s spouse, without the approval or consent of an adverse party, and subject to the discretion of the grantor and/or a nonadverse party.^[21] However, if the policy of insurance is irrevocably payable to a charity (under IRC § 170), then this rule does not apply.^[22]

Example: Uncle Bill creates an irrevocable trust that holds three policies of insurance. The first is a whole-life policy on his life for the benefit of Ethel, the second is a whole-life policy on Ethel’s life for Bill’s benefit, and the third is a full life policy on Bill’s life for the benefit of “Flightless, Not Plightless, Inc.,” an IRC § 501(c)(3) organization, which also qualifies under IRC § 170. At present, the primary effort of FNP is to provide financial support for the New Zealand Government’s kākāpō recovery and breeding effort.^[23] The trust contains additional assets, and the trustee pays the premiums of the policies from the income derived from those assets. The kākāpō recovery life insurance policy would, in any event, not subject to grantor trust treatment under IRC § 677(a)(3). If approval and consent from adverse parties was not required, to make payments of the premiums, then the trustee’s payment of the premiums of the other two policies would make the trust a grantor trust.

Obligations of Support

The income of a trust won’t be considered taxable to the grantor under IRC § 676(a) or under any other provision in the grantor trust rules merely because such income (in the discretion of another person, the trustee, or the grantor acting as trustee or co-trustee,) may be applied or distributed for the support or maintenance of a beneficiary—other than the grantor’s spouse—whom the grantor is legally obligated to support or maintain, except to the extent that such income is so applied or distributed.

Let’s look (in much simple terms) at IRC § 677(b) related to the grantor’s application of trust income to the grantor’s own legal support obligations and the unique tax structuring involved.

Example 1: Jedediah sired a love child at some point in 2015.^[24] He challenged the paternity in court, but upon seeing the child’s rocking mullet just chilling under his low-brimmed trucker hat, Jed decided that, whether the kid was blood or not, he was pretty damn cool, and he could Jed daddy or whatever he wanted. Jed was not a bad father—to no one’s greater surprise than Jed, himself—and, compared to the child’s mother (who had named the child Ferris after all), Jed was practically a yogi-level child rearing doula. Jed sold some of his stock in the emu farm, and he put the sales proceeds in an irrevocable trust to (a) grow over a term of years, and (b) to pay Jed’s court-ordered child support for Ferris. Although the entirety of the trust will not be treated as a grantor trust, the $1,200 Jedediah pays towards Ferris’ child support will be treated as taxable income within the trust.

Example 2: Returning to one of our examples from earlier in the article, you will remember that Bill likewise sired a child out of wedlock, whose name escapes you right now, because everyone on your mother’s side of the family just refers to the now thirty-five-year-old man-child as “the poor bastard.” Bill’s arrearages of child support. Bill files a petition to modify the child support obligation. He agrees to fund a trust equivalent in future value to the amount of child support presently due. Bill will select an independent trustee, who has the power to accumulate distributions, and at the end of 25 years, the trust will terminate, and it will be distributed to the poor bastard. During the first 10 years no distributions were made, and the income taxes were paid by the trust in accordance with IRC § 677(b). In year 11, the trustee distributes all of the accumulated income. Any income generated in year 11 will be taxed to Bill, as it was used to discharge his legal obligation to support the poor bastard.

Person other than Grantor Treated as Substantial Owner of Trust – IRC § 678

A person other than the grantor will be treated as the owner of any trust (or portion thereof) under two conditions: (1) if such person has the power, exercisable solely by himself, to vest the principal or income of the trust in himself;^[25] or (2) if such a person had the power to vest income in himself, such power was modified or partially released, but the person retains enough control over the trust that if he were the grantor of the trust, he’d be treated as the owner under IRC §§ 671-677.^[26] We will refer to the power in IRC § 678(a)(1) as the “§ 678 withdrawal power” and the power in IRC § 678(a)(2) as the “modified § 678 withdrawal power.”

A § 678 withdrawal power will cause the holder of the withdrawal power to be treated as owning the trust (or part of the trust) even if it is never exercised, and even if it is paid to someone other than the holder. The rules related to the § 678 withdrawal power are intended to prevent a beneficiary from severing his deemed ownership of a trust by modifying or releasing a § 678 withdrawal power while still retaining a significant degree of control over the trust assets.

Example: In 2018, Bill created a trust for the benefit of his idiot boys, Jethro, Jedediah, and Leroy. Bill named Jethro as trustee and gives Jethro the power to sprinkle the trust income and principal amongst the brothers in his sole discretion. Additionally, Bill gives Jethro a general power of appointment^[27] over the trust assets. In the Fall of 2019, Jethro gave up (relinquished) this power of appointment, which was an effective § 678 withdrawal power. Subsequent to this release of the § 678 release power, Jethro retained the right to allocate income and principal among the beneficiaries, including himself, without regard to any definite standard. Thus, even though Jethro released the power that would have caused inclusion under IRC § 678(a)(1), the retained power to revest the income and principal to himself (that is, revest the assets of trust in himself) would have caused grantor trust status if Jethro were the grantor of the trust. As such, under IRC § 678(a)(2), Jethro is treated as the owner of the trust’s assets…unless Bill is treated as an owner of the assets, too…which we discuss, well, now.

As alluded to at the end of the previous example, IRC § 678(a) does not apply to attribute ownership of a trust to a person (other than the grantor), who holds a self-vesting § 678 power of withdrawal or a modified § 678 withdrawal power, if the grantor of the trust is treated as the owner under the grantor trust rules.^[28] Stated differently, no matter the powers given to a beneficiary, if a grantor is treated as the owner of the trust under the grantor trust rules, the powerholder-beneficiary is not an owner of the same trust or portion of the trust. Thus, IRC § 678 will not apply to attribute ownership of a trust to a person (other than the grantor), who holds a self-vesting power over the income of the trust if that person renounced or disclaimed the interest within a reasonable amount of time after he first became aware of its existence.^[29]

Example: In 2020, Uncle Bill created another trust for the benefit of himself and his idiot boys, Jethro, Jedediah, and Leroy for life. Bill named Remus as trustee and gave Remus the power to sprinkle the trust income amongst Bill and the brothers in his sole discretion for their respective lives and to distribute principal to Bill “for the sole purpose of making [Bill] happy.” Bill structured the trust that at Jethro’s death, he would be able to appoint 1/3 of the assets of the trust to anyone he wanted in his will. At the time that Jethro accepts this general power of appointment, he would be considered an owner of 1/3 of the assets of the trust; except that Bill’s retention of the interest in the income stream, and the use of a non-ascertainable standard for the distribution of principal—both with a nonadverse trustee—would make Bill the owner of the trust’s income and principal. Thus, under IRC § 678(b), Jethro will not be treated as an owner, despite the power of appointment.

It is important to note that IRC § 678(a) does not apply if the powerholder does not exercise the self-vesting power (or modified vesting power) solely by himself.^[30] Thus, if Jethro needed the consent of Leroy and Jedediah to distribute money to himself, IRC § 678(a) would not make Jethro an owner of the underlying trust. One of the more common occurrences of this wrinkle is when a grantor or beneficiary needs the approval of the trustee to exercise a power that would otherwise invoke IRC § 678.

Finally, IRC § 678(a) does not apply to a power that enables the holder, in a fiduciary capacity, to apply the income of the trust to the support or maintenance of a person whom the holder is obligated to support, except to the extent the income is so applied.^[31]

Example: Uncle Bill creates a trust for the benefit of his grandson, James Robert. Bill names James Robert’s mother, Jennie, as the trustee and provides that Jennie can distribute income to James Robert based on the HEMS standard. Jennie, though not the grantor of the trust under IRC § 678(c) because she holds the power in a fiduciary capacity, Jennie would be taxed on any income distributed to James Robert from the trust.

Footnotes:

[1] Treas. Reg. § 1.675-1(a).

[2] Id.

[3] Treas. Reg. § 1.675-1(c).

[4] Id.

[5] OK…so, no “official” survey or census was taken, but I deal with IRS agents (generally revenue officers, who are the Federal government’s version of bill collectors that aim for the kneecaps of a taxpayer and settle on hitting somewhere that will leave a mark), who insist on being referred to only by their last name and first initial, lest any shred of humanity (or, more practically problematic, gender) be betrayed, on a weekly basis…so take that for what it’s worth. I’m looking at you, husky-voiced RO, A. Jerque—who corrects your pronunciation from “Ger-qway” to “Just Jerk.”

[6] See, e.g., IRC § 6015(f) (“equitable” innocent spouse relief). Also, could you imagine the celerity with which I could have finished this article if I hadn’t taken so many sardonic frolics and detours? Yeah…me neither. After all, you’re just as guilty for reading this footnote as I am for writing it…

[7] Treas. Reg. § 1.675-1(b)(2).

[8] Id.

[9] See, e.g., IRS PLR 200840025.

[10] See, e.g., IRS PLR 199942017.

[11] Id.

[12] Treas. Reg. § 1.675-1(b)(3).

[13] See IRC § 675(4); Treas. Reg. § 1.675-1(b)(4)(i)-(iii).

[14] Which, as before, loosely translates from German to “Big Ass Birds, Incorporated,” if you were curious.

[15] See Rev. Rul. 54-9.

[16] Treas. Reg. § 1.676(a)-1.

[17] IRC § 676(a) (flush language).

[18] IRC § 676(b); Treas. Reg. § 1.676(b)-1.

[19] IRC § 677(a)(1).

[20] IRC § 677(a)(2).

[21] IRC § 677(a)(3).

[22] Id.

[23] Kākāpōs (caw-caw-poes) are the largest parrot, and also the only flightless parrot in the world. According to an article that you read in the Washington Post, a kākāpō has the body of a goose, the face of an owl, and the waddle of a duck. In 1977, there were 18 kākāpō thought to be living, all dudes. But lo and behold, a second population was found—and this one had ladies. There are now 202 kākāpō in New Zealand and growing. For more on the kākāpō recovery effort (and to see how cute they are as adults (and how ugly they are as chicks)), click here. Knowing his soft spot for all flightless birds, you sent the article to Bill, who has become a zealous advocate for the recovery efforts.

[25] IRC § 678(a)(1).

[24] A bit more background: In one of Jedediah’s brief and irregular stints on the “outside,” he met a girl named whose nickname was Feral Carole. Ol’ Jed was particularly taken by the dichotomy of Carole’s fully inked left arm and her left, which was untouched like a freshly racked canvas. Sometime between (a) swearing to Carol and on everything that was good and holy to him (which was a short list: a 1976 Camaro, the Lord and Savior, and the Playboys that he had been collecting since he was seven), that he would never do anything to allow prison bars to separate their love, and (b) agreeing to be the driver when Carol made the rear panel of her ex-husband’s white Tahoe look like Swiss cheese, that Jedediah sired a son. Jed was unaware of Ferris’ existence until the paternity suit five years later.