Summary: If a trust is treated as owned by the person setting it up ("grantor") for income tax purposes, good tax results follow. The grantor can pay income tax on trust earning allowing tax free growth of trust assets outside the grantor's estate. The grantor can sell appreciated assets to the trust, 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 a tax elixir obtained? A common mechanism to achieve this is to permit substitution of non-trust property for trust property of equivalent value. The popularity of grantor trusts belies the complexity faced by those heading down the yellow brick road in search of grantor trust Oz.
Code Section 675 - Income Tax Consequences of Power to Substitute.
Code Section 675(4)(C) provides that the grantor is treated as the owner of any portion of a trust for 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. "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 trust (GRAT) or a 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 not clear that if the person given the power is the investment adviser, trust protector, etc. whether they could still hold this power in a non-fiduciary capacity. Caution might 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 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 the power as grantor creating estate inclusion. But how can he "reacquire" what he never owned to achieve the income tax status? But the statute says "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; be subject to a duty of impartiality; and 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 win, but 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. If state law did not require this, will inclusion in the trust document suffice? This is the keystone of the Ruling - it is the fiduciary duty of the trustee that keeps the grantor's non-fiduciary power in check to 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 interest of the beneficiaries. What happens if the assets include family business interests from which perquisites and salaries are paid?
- 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. 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. Security GRATS are never really invested in accordance with the Prudent Investor Act. They are intentionally invested in non-diversified portfolios whose risk levels are substantially higher than the risk level for the family's overall portfolio. 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 restriction on selling a family business? While the trustee (or invest advisers) may prefer that trust investment provisions permit the holding of a non-diversified, highly volatile assert 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 Ruling's requirement 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? Maybe not since the grantor's interests during the GRAT term is fixed.
PLR 200846001 - Gift Tax Issues of Power to Substitute.
A common planning approach is to set up a 2 year GRAT which is a grantor trust. Proposals are pending to require a minimum 10 years for GRATs. After 2 years assets remaining in the trust can be distributed to the heirs, or held in further trust. The remainder trust which follows the GRAT term, can be structured as a grantor trust so the grantor continues to pay income tax on the trust earnings, leveraging the value in that trust for the kids. This PLR (private letter rulings can only be relied upon by the taxpayer to whom issued) had a different approach than the above Revenue Ruling. Here's the facts Joe Friday. 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. The trust document specified that the annuity amount could be paid to the Grantor from income or principal. This arguably made the GRAT a grantor trust during the GRAT term. The power to substitute assets was held in a fiduciary capacity which could not create grantor trust status under IRC Sec. 675(4)(C) which requires the power be held as non-fiduciary. The IRS held that the power to substitute shares of publicly traded company 1 for company 2 wouldn't create a gift tax on transfer if the shares were properly valued and any difference was made up in cash. The power to substitute also didn't disqualify the trust as a GRAT.
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