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The Un-Intentionally Defective Grantor Trust

December 19, 2016, The New Jersey Law Journal

A “grantor trust” is like a good trusts and estates attorney -- clever, dynamic, and extraordinarily useful.  Is it possible, however, that some grantor trusts had no intention of ever being one?

A grantor trust is a trust where the grantor, or in some cases another person, is treated as the owner of the trust for federal income tax purposes.  Items of income, deduction, and credits of a grantor trust are included in computing the taxable income of the grantor.  The current statutes governing grantor trusts are found in Sections 671 through 679 of the Internal Revenue Code (“IRC”).  These statutes and the related regulations are affectionately referred to as the “grantor trust rules”.  An early version of the grantor trust rules was enacted in the 1920s.  The rules were designed to prevent taxpayers from transferring to a trust income producing assets that would be taxed at a high rate if retained by the taxpayer to potentially lower rates under prior law if owned by the trust.

The grantor trust rules are found in an entirely separate section of the IRC from the gift and estate tax rules and, in many cases, the grantor trust rules follow a very different logic than the gift and estate rules.  This enables practitioners to design trusts that are not included in the estate of the grantor for estate tax purposes but which are grantor trusts for income tax purposes so the grantor pays the income tax.  In Rev. Rul. 2004-64, the IRS ruled that the grantor’s payment of the income tax on the income of the grantor trust is a “gift tax free” transfer to the trust.  This estate planning benefit is tremendous.  In addition, since a grantor trust is disregarded for income tax purposes, there is no capital gain when the grantor sells an appreciated asset to the grantor trust.  Ironically, although the grantor trust rules were created to prevent a perceived abuse, the benefits of grantor trusts often lead practitioners and their clients to intentionally establish them.  Such trusts are referred to as “Intentionally Defective Grantor Trusts” or “IDGTs”.  On the other hand, many grantors do not want, nor do they expect, to pay the income tax on assets they have transferred to a trust.  In those cases, practitioners must be careful not to un-intentionally create a grantor trust.

Common Grantor Trust Provisions

There are numerous provisions that cause grantor trust status with respect to all or part of a trust’s income or corpus.  Certain provisions, however, are favorites among trusts and estates attorneys to intentionally cause grantor trust status.  A few of these are:

Power to Borrow Without Adequate Interest or Adequate Security.  Under IRC § 675(2), a grantor is treated as the owner of any portion of a trust with respect to which there is a power exercisable by the grantor or a nonadverse party, or both, that enables the grantor to borrow trust corpus or income without adequate interest or adequate security.  IRC § 672(b) provides that a “nonadverse party” is any party who is not an “adverse party” and, under IRC § 672(a), an “adverse party” is any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust.

Power to Substitute Property of Equivalent Value.  A grantor is treated as the owner of any portion of a trust with respect to which there is a power exercisable in a nonfiduciary capacity by any person to reacquire the trust corpus by substituting other property of an equivalent value.  IRC § 675(4).

Income for Benefit of Grantor.  Under IRC § 677, the grantor is treated as the owner of any portion of a trust whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be:  (i) distributed to the grantor or the grantor’ spouse; (ii) held or accumulated for future distribution to the grantor or the grantor’s spouse; or (iii) applied to the payment of premiums on life insurance policies on the grantor or the grantor’s spouse.  Practitioners should be careful not to assume that an irrevocable life insurance trust (or “ILIT”) is automatically a grantor trust because it owns life insurance on the life of the grantor.  This would be a mistake when an adverse party must approve or consent to the trust’s income being used to pay life insurance premiums.

Traps for the Unwary and the Un-IDGT

There are other sections of the IRC, less obvious than those discussed above, that cause grantor trust status.  Care must be taken to avoid these sections when grantor trust status is not intended.

Power to Control Beneficial Enjoyment.  Under IRC § 674(a), the grantor is treated as the owner of any portion of a trust where the beneficial enjoyment of the corpus or income 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.  This section of the IRC could cause many trusts to be grantor trusts.  To complicate the situation, it is very important to note that for purposes of the grantor trust rules, a grantor is treated as holding any power or interest held by his or her spouse.  IRC § 672(e).

There are some key exceptions to the Power to Control Beneficial Enjoyment under IRC § 674(a):

  • Power to Distribute Corpus – Pursuant to IRC § 674(b)(5), IRC § 674(a) does not apply to a power to distribute corpus (A) if the power is limited by a “reasonably definite standard” or (B) to any current income beneficiary if the distribution of corpus is chargeable against the proportionate share of corpus held in trust for the payment of income to the beneficiary as if the corpus constituted a separate trust.  A “reasonably definite standard” is a clearly measurable standard where the holder of the power is legally accountable.  Treas. Reg. § 1.674(b)-1(b)(5)(i) provides that reasonably definite standards include a power to distribute corpus:  for the education, support, maintenance, or health of the beneficiary; for the beneficiary’s reasonable support and comfort; to enable the beneficiary to maintain his accustomed standard of living; or for an emergency. 

If IRC § 674(b)(5) applies, the trust is not a grantor trust with respect to corpus even if the trustee is a nonadverse trustee or the grantor’s spouse.  Note, however, that the exception under IRC § 674(b)(5) does not apply to income.

• Certain Powers of Independent Trustees – Pursuant to IRC § 674(c), IRC § 674(a) does not apply to a power solely exercisable by a trustee or trustees, none of whom is the grantor, and no more than half of whom are related or subordinate parties who are subservient to the wishes of the grantor – (1) to distribute, apportion, or accumulate income; or (2) to pay out corpus.

A related or subordinate party is any nonadverse party who is (1) the grantor’s spouse if living with the grantor or (2) the grantor’s father, mother, issue, brother or sister, an employee of the grantor, a corporation or any employee of a corporation in which the stock holdings of the grantor are significant from a viewpoint of voting control, and a subordinate employee of a corporation in which the grantor is an executive.  IRC § 672(c).

• Power to Allocate Income If Limited by a Standard – Pursuant to IRC § 674(d), IRC § 674(a) does not apply to a power solely exercisable by a trustee or trustees, none of whom is the grantor or spouse living with the grantor, to distribute, apportion, or accumulate income to or for a beneficiary or beneficiaries, or to, for, or within a class of beneficiaries, if such power is limited by a “reasonably definite external standard” which is set forth in the trust instrument.  In connection with determining a “reasonably definite external standard”, Treas. Reg. § 1.674(d)-1 refers to Treas. Reg. § 1.674(b)-1(b)(5), which is discussed above.

In sum, a grantor may have un-intentionally created a grantor trust depending on who the trustees are and what powers they have, even in cases where the more obvious grantor trust powers are not included.  For example, if a grantor establishes a “sprinkle” trust for the benefit of his children and appoints his spouse as trustee who can make distributions for the best interests of the children, he has created a grantor trust.  So, who can be trustees without causing grantor trust status?

  • Adverse parties.
  • What about nonadverse parties (other than the grantor’s spouse)?

Yes, as to corpus if under IRC § 674(b)(5) the power is limited by a “reasonably definite standard” or if the power is exercisable in favor of an income beneficiary and the distribution is chargeable against the proportionate share of corpus held in trust for the payment of income to the beneficiary.

Yes, as to income if under IRC § 674(d) the power is solely exercisable by a trustee or trustees, none of whom is the grantor or spouse living with the grantor, and if such power is limited by a “reasonably definite external standard”.

Yes, as to corpus and income if at least half the trustees are not related or subordinate to the grantor.  In this case, a distribution standard broader than a “reasonably definite standard” may be used.  IRC § 674(c).

  • What about a spouse acting as a trustee?

If the distribution of principal is limited by a reasonably definite standard, it is not a grantor trust with respect to corpus pursuant to IRC § 674(b)(5).

The trust will be a grantor trust with respect to income unless the income is automatically paid out or required to be accumulated (not discretionary).

Note that since grantor trust status can hinge on the identity of the trustee, grantor trust status can be changed by changing trustees.

Grantor trusts have great benefits and are widely used in estate planning.  Nevertheless, grantor trusts are not ideal for every situation and there are times when a grantor trust is not intended.  Whether intentionally drafting a grantor trust or drafting a trust that is not intended to be a grantor trust, great care must be taken.  Beware of the complexity of the rules, the numerous traps, and steer clear of the Un-Intentionally Defective Grantor Trust.