Jeanne L. Newlon, Esq.
Venable LLP
On April 21, 2008, the IRS published Revenue Ruling 2008-22 (2008-16 I.R.B. 796) in which it held that the grantor's retention of a power, exercisable in a non-fiduciary capacity, to acquire property held in a trust by substituting power of equivalent value will not alone cause the trust property to be includible in the grantor's estate for Federal estate tax purposes. The Revenue Ruling set forth the following fact pattern:
In Year 1, D created and funded an irrevocable trust for the benefit of D's descendants. T is the Trustee of the trust. The trust agreement prohibits D from serving as a Trustee of the trust. Under the trust agreement, D has the power to acquire any property in the trust by substituting property of equivalent value. Such power is exercisable by D in a non-fiduciary capacity, without the approval or consent of any person acting in a fiduciary capacity. To exercise the power, D must certify in writing that the property to be substituted is of equivalent value to the property being acquired from the trust. State law provides that the Trustee has a fiduciary obligation to ensure that the properties being exchanged are of equivalent value. Furthermore, state law provides that, if a trust has two or more beneficiaries, the Trustee has a duty of impartiality. This means that the Trustee must invest and manage the assets in the trust objectively by taking into account any differing interests among the beneficiaries. Finally, under state law, the Trustee has the power, within the discretion of the Trustee, to manage and invest the trust property in accordance with the standards set forth by state law. D dies in Year 2. The issue is whether the retention of such power of substitution causes the assets of the trust to be included in D's estate for Federal estate tax purposes.
The power of substitution is often included in trust agreements so that the trust will be treated as a grantor trust for Federal income tax purposes. This means that the grantor pays the income tax on the income generated by the trust. One benefit of such treatment is that the trust principal will grow without reduction for payment of income tax.
Section 675(4) provides that a grantor "shall be treated as the owner of any portion of a trust in respect of which a power of administration is exercisable in a nonfidicuary capacity by any person without the approval and consent of any person in a fiduciary capacity." A power of administration includes a power to reacquire the trust principal by substituting other property of an equivalent value. Section 675(4)(c). Until the publication of Revenue Ruling 2008-22, there was a question as to whether such power of substitution caused the trust property to be included in the grantor's estate for Federal estate tax purposes.
There are two sections of the Code which could apply to cause estate inclusion. Under Section 2036(a), property is includible in a decedent's estate for Federal estate tax purposes if the decedent retained "the possession or enjoyment of, or the right to the income from, the property, or the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom". Section 2038 provides that where the decedent retained the right to alter, amend, revoke or terminate a trust, then the trust property will be includible in the decedent's estate for Federal estate tax purposes.
The issue of whether the substitution power caused estate tax inclusion was first addressed in Estate of Jordahl v. Comm'r, 65 T.C. 92 (1975), acq. in result, 1977-2 C.B. 1. In Jordahl, the decedent created an irrevocable trust under which he reserved a power to substitute property for property in the trust, so long as the substituted property is of equivalent value. The IRS argued that such a power caused the trust property to be included in the decedent's estate under Section 2038 because the power could be exercised to alter the beneficial interests in the trust. The Tax Court held in favor of the decedent's estate, stating that, because the decedent was bound by fiduciary standards, the decedent could not exercise the power to alter the beneficial interests in the trust. Accordingly, the trust property was not included in the decedent's estate.
The IRS contrasted Jordahl with the facts in the Revenue Ruling. The primary difference is that the decedent in Jordahl held the power of substitution in a fiduciary capacity where the decedent in the Revenue Ruling held the power in a nonfiduciary capacity and the decedent was expressly prohibited from serving as a Trustee of the trust. A trustee generally has a fiduciary duty to the trust and its beneficiaries, holding the trustee to a high standard of conduct. Where the grantor does not have any fiduciary duties, it is the responsibility of the trustee to ensure that the trust is being protected. This means that, with respect to the substitution power, the trustee is under a duty to ensure that the assets being substituted are of an equivalent value to those being removed from the trust.
Furthermore, under the facts given, D must certify in writing that the property to be substituted is of equivalent value to the property being acquired from the trust. The trustee also must prevent any shifting of benefits among the beneficiaries as a result of the substitution of property, as well as further assure that the properties exchanged are of equivalent value.
Accordingly, the IRS held that the power of substitution will not cause the trust property to be included in D's estate under Sections 2036 and 2038, provided that the trustee has a fiduciary obligation, under applicable law or the trust agreement, to ensure that the property being substituted is equivalent to the property being acquired by the grantor. Further, the trustee must have a fiduciary obligation, under applicable law or the trust agreement, to ensure that the power cannot be exercised in a way to shift benefits among the trust beneficiaries. The IRS further stated that the power of substitution "cannot be exercised in a manner that can shift benefits if (a) the trustee has both the power (under local law or the trust instrument) to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries; or (b) 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 (under local law or the trust instrument) or when distributions from the trust are limited to discretionary distributions of principal and income."
As a result of this Revenue Ruling, many practioners are now more comfortable including the power of substitution in trusts that are intended to be treated as grantor trusts for Federal income tax purposes. Furthermore, many are revising the language of such power to include some of the language in the holding of the Revenue Ruling to be sure that the power is intended not to cause estate tax inclusion.
Venable LLP
On April 21, 2008, the IRS published Revenue Ruling 2008-22 (2008-16 I.R.B. 796) in which it held that the grantor's retention of a power, exercisable in a non-fiduciary capacity, to acquire property held in a trust by substituting power of equivalent value will not alone cause the trust property to be includible in the grantor's estate for Federal estate tax purposes. The Revenue Ruling set forth the following fact pattern:
In Year 1, D created and funded an irrevocable trust for the benefit of D's descendants. T is the Trustee of the trust. The trust agreement prohibits D from serving as a Trustee of the trust. Under the trust agreement, D has the power to acquire any property in the trust by substituting property of equivalent value. Such power is exercisable by D in a non-fiduciary capacity, without the approval or consent of any person acting in a fiduciary capacity. To exercise the power, D must certify in writing that the property to be substituted is of equivalent value to the property being acquired from the trust. State law provides that the Trustee has a fiduciary obligation to ensure that the properties being exchanged are of equivalent value. Furthermore, state law provides that, if a trust has two or more beneficiaries, the Trustee has a duty of impartiality. This means that the Trustee must invest and manage the assets in the trust objectively by taking into account any differing interests among the beneficiaries. Finally, under state law, the Trustee has the power, within the discretion of the Trustee, to manage and invest the trust property in accordance with the standards set forth by state law. D dies in Year 2. The issue is whether the retention of such power of substitution causes the assets of the trust to be included in D's estate for Federal estate tax purposes.
The power of substitution is often included in trust agreements so that the trust will be treated as a grantor trust for Federal income tax purposes. This means that the grantor pays the income tax on the income generated by the trust. One benefit of such treatment is that the trust principal will grow without reduction for payment of income tax.
Section 675(4) provides that a grantor "shall be treated as the owner of any portion of a trust in respect of which a power of administration is exercisable in a nonfidicuary capacity by any person without the approval and consent of any person in a fiduciary capacity." A power of administration includes a power to reacquire the trust principal by substituting other property of an equivalent value. Section 675(4)(c). Until the publication of Revenue Ruling 2008-22, there was a question as to whether such power of substitution caused the trust property to be included in the grantor's estate for Federal estate tax purposes.
There are two sections of the Code which could apply to cause estate inclusion. Under Section 2036(a), property is includible in a decedent's estate for Federal estate tax purposes if the decedent retained "the possession or enjoyment of, or the right to the income from, the property, or the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom". Section 2038 provides that where the decedent retained the right to alter, amend, revoke or terminate a trust, then the trust property will be includible in the decedent's estate for Federal estate tax purposes.
The issue of whether the substitution power caused estate tax inclusion was first addressed in Estate of Jordahl v. Comm'r, 65 T.C. 92 (1975), acq. in result, 1977-2 C.B. 1. In Jordahl, the decedent created an irrevocable trust under which he reserved a power to substitute property for property in the trust, so long as the substituted property is of equivalent value. The IRS argued that such a power caused the trust property to be included in the decedent's estate under Section 2038 because the power could be exercised to alter the beneficial interests in the trust. The Tax Court held in favor of the decedent's estate, stating that, because the decedent was bound by fiduciary standards, the decedent could not exercise the power to alter the beneficial interests in the trust. Accordingly, the trust property was not included in the decedent's estate.
The IRS contrasted Jordahl with the facts in the Revenue Ruling. The primary difference is that the decedent in Jordahl held the power of substitution in a fiduciary capacity where the decedent in the Revenue Ruling held the power in a nonfiduciary capacity and the decedent was expressly prohibited from serving as a Trustee of the trust. A trustee generally has a fiduciary duty to the trust and its beneficiaries, holding the trustee to a high standard of conduct. Where the grantor does not have any fiduciary duties, it is the responsibility of the trustee to ensure that the trust is being protected. This means that, with respect to the substitution power, the trustee is under a duty to ensure that the assets being substituted are of an equivalent value to those being removed from the trust.
Furthermore, under the facts given, D must certify in writing that the property to be substituted is of equivalent value to the property being acquired from the trust. The trustee also must prevent any shifting of benefits among the beneficiaries as a result of the substitution of property, as well as further assure that the properties exchanged are of equivalent value.
Accordingly, the IRS held that the power of substitution will not cause the trust property to be included in D's estate under Sections 2036 and 2038, provided that the trustee has a fiduciary obligation, under applicable law or the trust agreement, to ensure that the property being substituted is equivalent to the property being acquired by the grantor. Further, the trustee must have a fiduciary obligation, under applicable law or the trust agreement, to ensure that the power cannot be exercised in a way to shift benefits among the trust beneficiaries. The IRS further stated that the power of substitution "cannot be exercised in a manner that can shift benefits if (a) the trustee has both the power (under local law or the trust instrument) to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries; or (b) 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 (under local law or the trust instrument) or when distributions from the trust are limited to discretionary distributions of principal and income."
As a result of this Revenue Ruling, many practioners are now more comfortable including the power of substitution in trusts that are intended to be treated as grantor trusts for Federal income tax purposes. Furthermore, many are revising the language of such power to include some of the language in the holding of the Revenue Ruling to be sure that the power is intended not to cause estate tax inclusion.
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