Lifetime Giving With Intentionally Defective Irrevocable Grantor Trusts

From the December 13, 1999 Massachusetts Lawyers Weekly
By Leo J. Cushing

Most estate plans will include a lifetime giving program, particularly for property likely to appreciate in value. A transfer of property can be risky since children and grandchildren may be sued, have creditor problems and even die.

For these reasons, one or more irrevocable trusts often become donees. While these trusts easily can be drafted in a way so as to keep the trust assets from being includible in the grantor's estate, often too little attention is paid to the income tax ramifications and the significant estate and gift tax savings resulting from properly designed intentionally defective irrevocable grantor trusts.

The Income Tax Dilemma

The dispositive provisions of a typical interviewers irrevocable trust established by a grantor for the benefit of his or her issue would provide as follows:

"The Trustee, in the Trustee's sole and absolute discretion, may pay to or apply for the benefit of the class consisting of the issue of the Donor and the Donor's spouse of all generations, so much of the income and principal as the Trustee deems advisable."

Simple enough, but there is an income tax trap for the unwary.

Let's assume that on Jan. 1 the grantor transfers $650,000 to the trust, the maximum amount allowable without paying any gift taxes. During the year, the trust earns 7 percent or $45,500 in taxable income.

During the year ending Dec. 31, the trustee does not make any distributions of income or principal to the beneficiaries and does not take advantage of a special 65-day rule that allows a trustee to make a distribution during the first 65 days of the following year and have the distribution count for the prior year.

Since no distributions of either income or principal were made, the $45,500 earned by the trust would be taxable to the trust.

Unfortunately, the income tax rates applicable to the trust are punitive and the trust is entitled to an exemption of only $100. IRC Sect. 642(b).

Additionally, individuals are entitled to standard deductions, exemptions and perhaps itemized deductions. Assuming the individual has taxable income of $75,000, the tax liability on the $45,500 of trust income would be only $13,950.

The prudent trustee might consider making a distribution of trust property during the year to one or more of the beneficiaries which, for federal income tax purposes, would have the effect of shifting the income tax burden from the trust to the recipient.

This rule would apply whether the distribution was considered principal or income since a distribution of property will carry out income to the extent of the trust's distributable net income. IRC Sect. 642(c).

Such a distribution, however, normally is inconsistent with the grantor's intention that the income be accumulated within the trust and not distributed to the beneficiaries unless "needed."

If the trust had been drafted as an intentionally defective irrevocable grantor trust (IDIT), the income would be taxable to the grantor whether or not distributed to the beneficiaries or accumulated by the trust. IRC Sect. 671.

From an estate and gift tax point of view, the grantor's payment of the income tax liability attributable to the IDIT's income is like a gift but is not a gift for gift tax purposes since the grantor legally is obligated to pay the liability.

In effect, the trust assets grow income tax free with the grantor reducing his estate by the amount of the income taxes paid without making a gift. In this example, the tax free gift would be $13,950 and the income tax savings would be $3,065.

Other Benefits Of Grantor Trust Status

* S corporations. A grantor trust is an eligible S corporation shareholder provided the grantor is the deemed owner of both income and principal of the IDIT. IRC Sect. 1361(c)(2)(A)(i).

While a non-grantor trust also may be an eligible S corporation shareholder by electing to be an Electing Small Business Trust, all S corporation income allocated to the trust will be taxed at the highest applicable rate of 39.6 percent. IRC Sect. 641(c).

If the trust was an IDIT, the income allocated to the trust will be taxable to the grantor at the grantor's applicable tax rate.

Again, the grantor is in effect making a gift to the trust of the income tax liability without making a taxable gift and the S corporation stock owned by the trust is not includible in the grantor's estate.

* Grantor's home. If the property transferred to the IDIT was the grantor's home, the sale of the home by the IDIT would be eligible for the new $250,000 capital gain tax exclusion ($500,000 in the case of a married couple filing jointly). See Rev. Rul. 66-159 and Rev. Rul. 85-45.

Additionally, neither the property nor the sale proceeds would be includible in the grantor's estate provided the grantor pays rent for use and occupation. Estate of Maxwell, 98 T.C. 39 (1992).

The payment of rent by the grantor to the IDIT is non-taxable since transfers between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul. 85-13. Like the payment of income taxes on IDIT income, the payment of rent reduces the grantor's estate without any gift tax consequences.

If the property in the IDIT has appreciated in value but has a low tax basis, the grantor may repurchase the property from the trust for cash just prior to death to obtain a step-up in basis. Under new regulations governing a Qualified Personal Residence Trust (QPRT), this benefit was thought to be too good and is now limited to non-QPRT trusts.

* Installment notes. The transfer of an installment note to an IDIT is not a disposition of the note triggering an acceleration of any deferred gain. Rev. Rul. 74-613.

* GRATs & GRUTs. A lifetime giving program may include either a grantor retained annuity trust (a GRAT) or a grantor retained uni-trust (a GRUT).

Both the GRAT and the GRUT require the trust to make payments to the grantor during the retained term. If the cash flow from the property transferred to the trust is insufficient to cover the annuity, the trust may consider using the property (such as S corporation stock or a family limited partnership interest) to satisfy the payment obligation.

In the case of a non-grantor trust, the use of appreciated property would be considered a taxable event to the trust, with the trust being deemed to have sold the asset for fair market value on the date of transfer.

If the trust is an IDIT, no gain is recognized. PLR 9535026; PLR 9519029.

* Selling assets to a defective grantor trust. One of the most popular current estate planning techniques involves the sale of assets tax free to an IDIT. Rev. Rul. 85-13; PLR 9535026; PLR 9519029. Let's take a look.

In our example, we assumed that the grantor transferred $650,000 to the trust and therefore is without any additional exclusion amount to shelter future gifts this year in excess of $10,000 per year per donee.

The grantor, however, has significant other assets which are likely to appreciate in value, so additional planning is necessary.

One suggestion would be to "sell" the property to the IDIT. The IDIT pays for the property with a promissory note, which has the effect of "freezing" the grantor's estate while shifting all future appreciation attributable to the property sold to the IDIT for the younger generations free of estate and generation skipping taxes.

The promissory note must bear interest at the appropriate applicable federal rate (AFR) but this rate is minimal. According to Frazee v. Commissioner, 98 T.C. 37 (1992) the following rates would apply:

1. Use short-term AFR if maturity is three years or less.

2. Use mid-term AFR if maturity is more than three years but not more than nine years.

3. Use long-term AFR if maturity is more than nine years.

Note that the current rate for a 10-year note for December 1999 is 6.47 percent. See also PLR 9535026.

If the trust is an IDIT, the grantor does not recognize any gain on the "sale" and the payment of interest by the IDIT to the grantor is income tax free.

This technique might be referred to as "zero" estate tax planning because the note itself is a "depreciating" asset, and the payments received by the grantor from the trust will be used primarily to pay the trust's income taxes which arise by virtue of the income generated by the property "sold" to the trust.

This technique might be considered for venture capitalists and owners of eCommerce businesses. The venture capitalist and the eCommerce would "sell" partnership interests or pre-IPO stock to the IDIT, which will have the effect of freezing the estate on the date of the sale.

If the grantor wishes to retain a measure of control over the assets sold, the assets can be bundled in a limited partnership followed by a "sale" of limited partnership interests to the IDIT.

In many cases, the sale price and therefore the amount of the note will be significantly less than the underlying value of the property sold since the limited partnership units would be discounted for lack of control, lack of marketability and built-in capital gain.

* What if the grantor runs out of money? Careful planning is necessary because the grantor's obligation to pay income taxes on trust income may be too burdensome. This problem could give new meaning to the term "die broke."

If a grantor does not wish to pay the trust's income taxes, recent rulings have allowed the use of a so-called income tax reimbursement clause.

In PLR 199922062, the IDIT provided that the trustees were required to distribute any amount necessary to satisfy any federal and state income tax liability incurred by the grantor as a result of establishing a defective grantor trust.

The amount to be distributed was equal to the excess of the grantor's personal income tax liability over his personal income tax liability, computed as if he was not the owner of the trust.

The IRS ruled that the mandatory distribution does not constitute a retention of the right to income which would cause the trust assets to be includible under IRC Sect. 2036(a).

The IRS noted that if the trustee was required to make distributions to reimburse the grantor for any income tax liability not attributable to the trust assets, the grantor would have had a retained income interest making the assets includible in the grantor's estate under IRC Sect. 2036(a).

* Income tax reimbursement clause not needed. In PLR 9444033, the IRS states that if there were no income tax reimbursement provisions, an additional gift to the remainderman would occur when the grantor paid tax on any income that would otherwise be payable from the corpus of the trust.

This portion of the ruling was dicta because the trust in question did contain an income tax reimbursement clause. Less than one year later, in PLR 9543049, the dicta in PLR 9444033 regarding the gift tax consequences of the reimbursement clause in the trust was withdrawn.

The IRS, however, has suggested that it will not issue a favorable ruling as to grantor trust status unless the IDIT contains an income tax reimbursement provision.

State law also should be considered. If state law provides a right of reimbursement to the grantor for income taxes paid, the failure to recover the tax payment from the IDIT probably will be considered a gift.

Some practitioners suggest giving the trustee of an IDIT a discretionary right to reimburse the grantor for income taxes paid on the trust's income, but there is no clear authority.

In Massachusetts, the trustee's failure to reimburse the grantor arguably would be considered a deemed gift.

Under Massachusetts law, the grantor's creditors, including the IRS, can reach trust assets by reason of a trustee's discretionary power to pay trust assets to the grantor. Rev. Rul. 76-103; Rev. Rul. 77-378; Ware v. Gulda, 331 Mass. 68 (1954); State Street Bank & Trust Co. v. Reiser, 7 Mass. App. 633 (1979).

Since creditors can reach trust assets to the extent of the trustee's discretionary power, the amount of any discretionary income tax reimbursement probably would be includible in the decedent's estate if death occurs while the discretionary power remains outstanding, and would be considered a complete gift upon expiration of the power, depending upon how the reimbursement clause is drafted.

The gift would be a gift of a future interest and not a present interest, resulting in the use of unified credit.

* How to obtain grantor trust status. In drafting an IDIT, the objective is to make the trust defective as to both income and principal but excludible for estate tax purposes.

IRC Sect. 671 provides that when the grantor or another person is treated as the owner of any portion of a trust, they shall be included in computing the taxable income and credits of the grantor or the other person, those items of income, deduction and credits against tax of the trust which are attributable to that portion of the trust to the extent that such item would be taken into account in computing the taxable income or credits against the tax of an individual.

IRC Sect. 673 through IRC Sect. 678 specifies the circumstances under which one or more grantors will be treated as the owner of all or a portion of the trust.

In Rev. Rul. 85-13, the IRS ruled that if a grantor is treated as the owner of an entire trust, the grantor is the owner of the trust assets for federal income tax purposes.

* Grantor or spouse as discretionary beneficiary. IRC Sect. 677(a)(1) provides that the grantor shall be treated as the owner of any portion of a trust who's income without the approval or consent of any adverse is, or, in the discretion of a grantor or non-adverse party or both may be distributed to the grantor or the grantor's spouse.

Unfortunately, in Massachusetts, as is the case is most other jurisdictions with the exception of perhaps Alaska and Delaware, which now permit self-settled trusts to be established free of creditor rights, the grantor cannot be a discretionary beneficiary and achieve estate tax excludability since the assets in the trust are considered available to satisfy the grantor's creditors. See State Street Bank & Trust Co. v. Reiser, supra; Ware v. Gulda, supra; Rev. Rul. 76-103; Rev. Rul. 77-387.

A grantor, however, may wish to include his or her spouse as a discretionary beneficiary in an irrevocable trust primarily to allow for indirect access to the trust assets.

The grantor's spouse may be a discretionary beneficiary without causing estate tax inclusion even if, under state law, the grantor could not be a discretionary beneficiary.

There is no estate tax rule imputing the spouse's beneficiary status to the grantor for estate tax purposes, but grantor trust rules do contain such a rule.

Under IRC Sect. 677(a)(1), if the grantor's spouse is eligible to receive distributions of income or principal in the discretion of a trustee, the grantor will be considered the owner of the entire trust provided the trustee is not an adverse party.

IRC Sect. 672 defines an adverse party as any person having a substantial beneficial interest in the trust, which would be adversely affected by the exercise or non-exercise of the power that such person possesses with respect to the trust.

In general, a beneficiary of a trust would be an adverse party. For this reason, a child who is a beneficiary of the trust should not be the trustee. The trust would be a grantor trust as to the grantor for so long as the grantor's spouse is living and married to the grantor.

If the spouse is not a beneficiary, under IRC Sect. 674(a) and IRC Sect. 674(c), the spouse or a related or subordinate person may be named as trustee with unlimited discretion to distribute income and principal among the beneficiaries.

* Powers of administration. A so-called 675(4)(c) power of administration has been the most popular clause used to create an IDIT and assure estate tax excludability.

IRC Sect. 675(4)(c) provides that the grantor shall be treated as the owner of any portion of a trust in respect of which the grantor has a power of administration exercisable in a nonfiduciary capacity to reacquire the trust corpus by substituting other property of an equivalent value.

In Estate of Jordahl v. Commissioner, 65 T.C. 92 (1995); acq. 1977-2, the Tax Court held that the possession of this right to substitute assets was not a power to alter, amend or revoke the trust for purposes of IRC Sect. 2038.

The Jordahl case involved the substitution of insurance policies and the court ruled that the ability of the individual to substitute an insurance policy in a trust for assets of equivalent value cannot be seen as a right to the economic benefits of that insurance policy.

The court held that in the case of an insurance policy, the asset substituted should be another insurance policy with equal cash surrender value face amount and comparable premiums. The insured did not possess incidents of ownership in the policy under IRC Sect. 2042 held in an IDIT solely because the insured has the right to substitute assets of similar value to those policies.

* Avoiding transfer for value rules. An estate plan may involve the sale of an insurance policy to a trust to avoid the three-year rule of inclusion under IRC Sect. 2035(a), but it is important to avoid the transfer for value rules of IRC Sect. 101.

IRC Sect. 101(a) provides that the death benefit payable under an insurance policy will be income tax free unless the policy was acquired in a "transfer for value" by assignment or otherwise.

In the case of a "transfer for value," the amount excluded from gross income will not exceed an amount equal to the sum of the actual value of the consideration paid and premiums paid, or other amounts subsequently paid by the transferee.

There are exceptions to this rule and the death benefit will remain tax free if the sale was (a) to the insured, (b) to a partner of the insured, (c) to a partnership in which the insured is a partner; or, (d) to a corporation in which the insured is a shareholder or officer. IRC Sect. 101(a)(2)(B).

Focusing on the exception for transfers to the insured, it would seem logical that if a grantor trust is ignored for income tax purposes, a sale of an insurance policy to an IDIT would be considered a transfer to the insured.

Unfortunately, in PLR 9413045, the IRS refused to issue such a ruling. The reason stated was that the "request involves an area that is under extensive study" and therefore "we are unable to rule on this issue."

This theory, however, had been successfully argued in Swanson v. Commissioner, 518 F2d 59 (8th Cir. 1975), but the trust in Swanson was essentially a revocable trust rather than an irrevocable trust designed to exclude the life insurance policy from the grantor's estate.

Apart from a true sale, the IRS has ruled that a transfer of a life insurance policy subject to a loan is a transfer of the policy for value to the extent of the loan. Rev. Rul. 69-187. As a result, a taxable gain will result if a life insurance policy with a loan in excess of basis is "gifted" to a person other than an IDIT.

All of these problems can be avoided simply by making the IDIT a partner with the insured in a bona fide partnership prior to the sale of the policy. PLR 9328010.

* Power to pay insurance premiums. Most life insurance trusts with non-family member trustees are grantor trust. Under IRC Sect. 677(a)(3), the grantor is treated as the owner of any portion of a trust for income tax purposes if the income, without the approval or consent of any adverse party is, or in the discretion of the grantor or non-adverse party or both may be applied to the payment of premiums on policies of insurance on the life of the grantor or on the grantor's spouse.

While the Internal Revenue Code does not specifically require that the trust actually own insurance on the life of the grantor or the grantor's spouse, two old cases decided under an earlier version of IRC Sect. 677(a), Iverson v. Commissioner, 3 T.C. 756 (1944), and Weil v. Commissioner, 3 T.C. 579 (1944); acq. 1944 C.B. 29, held that the grantor will be treated as the owner of the trust income only if premiums actually are paid from that income.

The current version of IRC Sect. 677(a)(3) and private letter rulings do not seem to make actual ownership of a life insurance policy a prerequisite. PLR 8126047; PLR 8118051; PLR 8112087; and PLR 8103074.

* Power to add beneficiaries. Grantor trust status as to both income and principal can be achieved by giving a non- adverse trustee a power to add beneficiaries, other than after born or after adopted children. IRC Sect. 674(b)(6)(B).

The power to add beneficiaries should not be retained by the grantor since this clearly would cause estate tax includability under IRC Sect. 2036. The power should be granted to a non-adverse party, meaning a trustee other than a family member who is a beneficiary of the trust.

* The power to borrow without adequate interest or security. Another power commonly used is a power exercisable by the grantor or non-adverse party, or both, which enables the grantor to borrow the corpus or income, directly or indirectly, without adequate interest or without adequate security, except to a trustee other than the grantor, is authorized under the general lending power to make loans to any person without regard to interest or security. IRC Sect. 675(2); PLR 9525032.

Again, this power should not be exercisable by the grantor even though, for income tax purposes, this is permissible. The power should be held by a non-adverse party such as the trustee or some other third party who does not have a substantial beneficial interest in the trust.

Both the power to borrow and the power to add beneficiaries will achieve grantor trust status as to both income and principal without regard to whether the power actually is utilized.

Recent rulings under IRC Sect. 675(4)(c) suggest that grantor trust status will be determined only on a case by case basis, depending upon whether the power to reacquire actually was used. Regs. 1.675-1(b)(4); PLR 9437022; PLR 9437023; PLR 9352004; and PLR 9352007.

* Crummey Powers. Many irrevocable trusts contain so-called "Crummey" powers. These powers are designed to convert the grantor's gift to an irrevocable trust from a gift of a future interest to a gift of a present interest eligible for the $10,000 annual exclusion.

A typical Crummey power will provide that a beneficiary of the trust has the right to withdraw some portion of the gift, usually up to $10,000 for a limited period of time.

Under IRC Sect. 678(a)(1), the Crummey powerholder would be considered the grantor since a person other than the grantor shall be treated as the owner of any portion of a trust with respect to which such person has the power exercisable solely by himself to vest the corpus or income therefrom in himself. PLR 8701007; PLR 9034004.

The typical Crummey power will lapse after 30 days, in which case IRC Sect. 678(a)(2) will apply. IRC Sect. 678(a)(2) provides that a person other than the grantor (the Crummey powerholder) will be treated as the owner of the trust with respect to which such person has partially released or otherwise modified such a power and, after the release or modification, retains such control as would, within the principles of IRC Sect. 671 through IRC Sect. 677, inclusive, subject a grantor of a trust to treatment as the owner thereof.

These provisions would make the former Crummey powerholder the grantor since, after expiration of the right to withdraw, the powerholder is a discretionary beneficiary under the provisions of IRC Sect. 677(a)(1).

Fortunately, from a record keeping perspective, IRC Sect. 678(b) provides that the powerholder will not be considered the owner if the original grantor of the trust is otherwise treated as the owner under other provisions of the grantor trust rules.

Therefore, if the original grantor, or any other party acting in a nonfiduciary capacity, has the power to substitute assets of an equivalent value, including those over which a Crummey power may be outstanding, the IRC Sect. 678(b) exceptions will apply and the grantor will be taxed on the income earned by the IDIT even while the power to withdraw remains outstanding.

Prior to these rulings, the Internal Revenue Service in PLR 8142061 and PLR 8545076 had ruled that the powerholder who allowed the power to withdraw to lapse would be considered a new grantor who recontributed the property over which the powerholder had the right to withdraw to the trust.

In such a case, the powerholder would not be deemed to have allowed the power to lapse and the exception under IRC Sect. 678(b) would not apply. This would create an accounting nightmare since the powerholder would be taxed on a fractional share of income from the trust while the grantor would be taxed on the remaining trust income.

* Can grantor trust status be released by the grantor? In theory, a grantor should be able to waive grantor trust status by releasing the power which caused the trust to be an IDIT without causing estate tax includability since the trust assets were not includible even with the grantor trust provision.

Nevertheless, having a grantor retain a right to release the power may be considered a retained right to affect beneficial enjoyment under IRC Sect. 2036. For this reason, the power to release should be given to a person other than the grantor.

While these rules may seem complicated and cumbersome, significant income, estate and gift tax advantages can be achieved with proper IDIT planning.

Leo J. Cushing, a CPA and attorney, practices at Cushing & Dolan in Boston.