All that Glitters Isn’t Simple

Summary:

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

Code
Section 675 – Income Tax Consequences of Power to Substitute

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

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

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

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

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

PLR
200846001 – Gift Tax Issues of Power to Substitute

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

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

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

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