Drafting Grantor Trust Powers with an Exit Strategy

Volume 27 No. 2

by

Brandon A. S. Ross is an associate at the law firm of Proskauer Rose, LLP in Boca Raton, Florida, in the firm’s Personal Planning Department.

Proposals for increasing taxes on wealthy Americans have sounded the alarm for estate planners to ensure that their clients have the flexibility to terminate grantor trust status for their irrevocable trusts to allow clients to decrease their tax burden.

Over the last couple of years, many proposals for higher taxes on wealthy Americans have been introduced, the most public of which being the “Buffett Rule,” a minimum 30% income tax rate for millionaires. The most alarming proposal for estate planners is the 2013 Greenbook Proposal (the “Greenbook Proposal”), which proposes that the income tax and transfer tax laws applicable to grantor trusts be coordinated so that (1) the grantor of the grantor trust would have to include the trust assets in his or her estate on his or her death, (2) the distributions from the grantor trust would be subject to gift tax during the grantor’s lifetime, and (3) the trust assets would be subject to gift tax on a conversion from a grantor trust to a nongrantor trust during the grantor’s lifetime. See General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals 77, www.trea sury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2013.pdf. Although the Greenbook Proposal seems far from becoming law, it does highlight that grantor trusts are on the government’s radar for future legislative changes.

These proposals for increasing taxes on wealthy Americans have sounded the alarm for estate planners to ensure that their clients have the flexibility to terminate grantor trust status for their irrevocable trusts to allow clients to decrease their tax burden. Alternatively, providing a discretionary tax reimbursement clause in the irrevocable trust agreement or decanting the trust are other options best discussed in a separate article. This article will discuss how to combat potential burdensome taxes by highlighting the most commonly used powers to cause grantor trust status, emphasizing the release of these grantor trust powers, and suggesting sample provisions for the granting and releasing of these powers.

Grantor Trusts

A grantor trust is a trust for which the grantor (that is, the creator of the trust or anyone who gratuitously transfers property to the trust) is treated as the owner of all or a portion of the trust assets for income tax purposes and is deemed to own all or a portion of the income tax items of the trust assets (for example, gain, loss, deductions, and credits). See IRC § 671; see, e.g., IRC § 677(a)(3) (treating the creator of the trust as the grantor of the trust income actually used to pay premiums on life insurance policies on the life of the grantor or grantor’s spouse). A nongrantor trust is a separate taxable entity subject to income tax at very compressed tax rates, rather than the more historically favorable income tax rates for individuals that apply to grantor trusts. See IRC § 1(e).

Grantor trust status for irrevocable trusts has been sought for decades to take advantage of three primary benefits of grantor trust status, other than the favorable income tax rates: (1) the grantor effectively could make a gift in the amount of the income tax liability of the trust assets to the beneficiaries of the trust by paying the income tax related to the trust assets without being deemed to make a gift to the trust beneficiaries that would be subject to gift tax; (2) the grantor could sell assets to the trust for fair market value without recognition of gain or imposition of gift tax; and (3) the grantor, shortly before death, could purchase or exchange low basis assets for high basis assets without imposition of income tax.

Grantor trust status generally is achieved by the grantor, the grantor’s spouse, or a nonadverse party holding certain powers over the administration of the trust and the trust assets. An “adverse party” is any person who has a substantial beneficial interest in the trust (including a general power of appointment) that would be adversely affected by the exercise or nonexercise of the power that he or she possesses with respect to the trust. A “nonadverse party” is any person who is not an adverse party. See IRC § 672(a).

Because the grantor may be treated as the owner of only a portion of the trust assets, depending on the portion of the trust assets to which the power causing grantor trust status applies, it may be prudent to use multiple powers causing grantor trust status. See IRC § 671; Treas. Reg. § 1.671-3(a)(2). Equally prudent is choosing the powers that are easily released to terminate grantor trust status. If the income tax liability of a grantor trust becomes too onerous or the income, gift, and estate taxes become coordinated by legislation stemming from the Greenbook Proposal, then the grantor may want to terminate grantor trust status before any new law becomes effective.

Absent legislation similar to the Greenbook Proposal, converting a grantor trust to a nongrantor trust generally should not have any adverse tax consequences because transactions between grantor trusts and their grantors are disregarded for income tax purposes. See Rev. Rul. 85-13; CCA 2009-23-024 (June 5, 2009). If the liabilities of the trust are greater than the basis of the trust assets, however, the grantor will recognize gain on the difference. See Treas. Reg. § 1.1001-2(a)(1). The most useful powers that cause grantor trust status for irrevocable trusts are the powers that do not cause estate tax inclusion and are easily released to terminate grantor trust status. The power to add charitable beneficiaries, the power of the grantor to borrow without adequate security, and the power of the grantor to substitute assets for equivalent value are the most commonly used powers to cause grantor trust status.

Power to Substitute Assets of Equivalent Value

The most useful and reliable grantor trust power is the grantor’s power to substitute his or her own assets for trust assets of equivalent value. If the grantor can reacquire trust corpus by the substitution of other property of equivalent value in a nonfiduciary capacity without the consent of any fiduciary of the trust, the grantor will be treated as the owner of the trust property. See IRC § 675(4). The trustee of the trust must have the fiduciary obligation to ensure that the property substituted is of equivalent value. See Rev. Rul. 2008-16. The grantor’s nonfiduciary substitution power combined with the fiduciary’s obligation to ensure that the exchanged assets are of equivalent value will be referred to as the “Substitution Power.”

Recently, the Substitution Power was reaffirmed as a reliable power to cause grantor trust status, even for life insurance, when the IRS ruled that a grantor’s retention of a nonfiduciary power to reacquire an insurance policy by substituting other assets of equivalent value would not cause inclusion in the grantor’s gross estate. See Rev. Rul. 2011-28. Although there should not be a concern with exercising the Substitution Power over life insurance, a few other estate tax inclusion issues need to be avoided when using the Substitution Power. The Substitution Power should not be exercisable over any stock described in IRC § 2036(b) because this power would cause such stock to be included in the estate. In addition, to guard the grantor against an argument that trust property is includable in his or her estate because of a retained beneficial interest in the trust property, the trust agreement should prohibit any exercise of the Substitution Power that would shift the beneficial interests in the trust. See IRC § 2036.

Releasing the Substitution Power

The grantor should have the specific authority to release the Substitution Power to enable the termination of grantor trust status. The grantor’s control over the termination of the Substitution Power makes this grantor trust power the most useful. If the grantor wants to release the Substitution Power, the grantor needs only to inform the trustee. The grantor does not need to rely on anyone else to release this power, and there is no chance that the Substitution Power could be released prematurely by the death of a powerholder during the grantor’s lifetime. When the power is released, the release should be irrevocable, and the grantor should not have the ability to reacquire the Substitution Power. Otherwise, the release could be deemed to be illusory and likely would not be effective.

Because of the recent approval by the IRS of the Substitution Power in a revenue ruling and the grantor’s complete control over the power’s release, it may be that planners could rely solely on the Substitution Power to control grantor trust status. Given the complexity of the grantor trust provisions, however, conservative planners may want to include other powers to ensure grantor trust status over the entire trust.

Power to Borrow from the Trust Without Adequate Security

Another useful power to cause grantor trust status is providing the grantor or the grantor’s spouse with a power to borrow from the trust without adequate security, but with adequate interest. The grantor will be treated as the owner of the trust property over which a power can be exercised by the grantor or a nonadverse party to make a loan to the grantor or the grantor’s spouse, without adequate interest or adequate security. See IRC § 675(2). The borrowing power should be over both income and principal to ensure that the power causes grantor trust status for the entire trust.

This Borrowing Power, unlike the Substitution Power, can cause the value of the trust assets to be includable in the grantor’s estate. If the grantor is able to borrow from the trust without adequate security, this power can be deemed a retention of beneficial interest over the trust assets that would cause the value of the trust assets to be includable in the grantor’s estate. The estate inclusion risk of this borrowing power may be mitigated by charging an interest rate premium on the loan to compensate for the inadequate security. In practice, determining an appropriate interest premium to compensate for the risk of a loan without security may be hard, though local banks can be helpful to make this determination.

At a minimum, the trust agreement should require adequate interest for any loan to the grantor or the grantor’s spouse because otherwise there may be a gift to the borrower. The interest rate would have to be at least the minimum rate allowed under IRC § 7872 to avoid any gift tax consequences. See Rev. Rul. 95-58. The trust agreement should have a nonadverse trustee who is not related or subordinate to the grantor (an “Independent Trustee”) determine the interest rate for the loan. A “related or subordinate party” is a nonadverse party who is the grantor’s spouse (if the spouse is living with the grantor) or the grantor’s mother, father, descendant, sibling, employee, or employee of a corporation of which the grantor and the trust have significant voting control. See IRC § 672(c). Accordingly, a power that is useful to cause grantor trust status is the power for the grantor or the grantor’s spouse to borrow without any security, but with adequate interest (the “Borrowing Power”).

If the grantor is married and living with his or her spouse, the grantor’s spouse can hold the Borrowing Power. Importantly, grantor trust status can be caused by certain powers held by the grantor’s spouse (see IRC § 672(e)), and estate tax inclusion for the grantor would not be caused by the Borrowing Power being held by his or her spouse. See IRC §§ 2036, 2038 and 2041. If the grantor’s spouse held the Borrowing Power, instead of a trustee, the grantor’s spouse presumably would exercise or release the Borrowing Power at the grantor’s request. If the grantor’s spouse holds the Borrowing Power, the trust agreement should direct the Independent Trustee to make the loan as requested by the grantor’s spouse.

Releasing the Borrowing Power

If the grantor’s spouse holds the Borrowing Power, he or she should have the specific authority to release it to enable the termination of grantor trust status. When the grantor’s spouse releases the power, the release should be irrevocable, and the spouse should have no ability to control the reacquisition of the Borrowing Power. Otherwise, the grantor’s spouse can be deemed to continue to possess the power after the release.

The primary drawback of the grantor’s spouse holding the Borrowing Power is that he or she may predecease the grantor (like any other individual powerholder), resulting in a premature termination of grantor trust status. To avoid such a premature termination of grantor trust status, a successor powerholder should be appointed under the trust agreement.

A more cautious approach to having an individual hold the Borrowing Power is giving an Independent Trustee the authority to exercise the Borrowing Power in favor of the grantor. In other words, under the trust agreement, the Independent Trustee would be authorized to lend all or a portion of the trust property to the grantor without any security, but with adequate interest. But, if the trustee released this power, the trustee could be found to have breached his or her fiduciary duty to the beneficiaries of the trust because the release would cause the trust to become a separate taxable entity with less funds to be distributed to the beneficiaries than if the grantor were paying the related income tax.

The grantor can induce the release of the Borrowing Power by authorizing the Independent Trustee to earn a power under the trust agreement that gives the Independent Trustee more discretion to act in the best interests of the trust beneficiaries than before this release. See Ronald D. Aucutt, Installment Sales to Grantor Trusts, 4 Bus. Entities No. 2, 28 (Mar./Apr. 2002). If the Independent Trustee must release multiple powers to terminate grantor trust status, then earning a new power may be contingent on the release of any and all of the grantor trust powers causing nongrantor trust status. The Independent Trustee could earn the power to change the established shares of the beneficiaries of the trust or mandatory distributions to the beneficiaries when the shares or distributions are initially fixed. See id. Because many trust agreements do not have mandatory distribution provisions, the best power for the Independent Trustee to earn may be the ability to make distributions to the trust beneficiaries in the Independent Trustee’s absolute discretion when the distributions are limited to an ascertainable standard. See id. The receipt of one of these powers by the Independent Trustee should provide the Independent Trustee with better flexibility to act in the best interests of the trust beneficiaries to combat an argument that the Independent Trustee would breach his, her, or its fiduciary duty by releasing a power that would convert the trust to a nongrantor trust.

The utility of the Borrowing Power hinges on the Independent Trustee starting with a limited distribution authority, which may be contrary to the grantor’s intent. The grantor may be satisfied, however, if the limitation were an ascertainable standard of health, education, maintenance, or support. In this case, the distribution authority still would be fairly broad and would become even broader when the Independent Trustee earned the power to make distributions by releasing all of the grantor trust powers.

Similar to when the Borrowing Power is held by the grantor’s spouse, the Independent Trustee should have the power to determine the interest rate, including the ability to require a premium for the risk of making the loan without security. An interest rate premium can combat an argument that the grantor has a retained beneficial interest in the trust property because he or she can borrow assets without security.

Power to Add a Charitable Beneficiary

Another useful power to cause grantor trust status is the power of the grantor or a nonadverse party to add beneficiaries to the trust. Generally, the grantor will be treated as the owner of trust property over which the beneficial enjoyment is subject to a power of disposition by the grantor or a nonadverse party, or both, without the consent of an adverse party. See IRC § 674(a). Although this power of disposition is subject to many exceptions that would keep the trust from being deemed a grantor trust, if the grantor or a nonadverse party can add a charity or charities as beneficiaries of the trust income and principal (the “Charity Power”), the entire trust will be a grantor trust. See IRC §§ 674(a), 674(b)(5), 674(b)(6), 674(b)(7), 674(c) and 674(d).

The Charity Power is often provided to a nonadverse party who is not a beneficiary of the trust, such as the grantor’s spouse or sibling. If the grantor’s spouse holds the Charity Power, the grantor will be deemed to hold this power for income tax purposes, as noted above. See IRC § 672(e). The spouse should not contribute any property to the trust while holding the Charity Power because the spouse then would become a grantor of the trust, and the property contributed to the trust by the spouse would be includable in his or her estate. If the spouse plans to contribute property to the trust, a sibling or family member of the grantor who is not a beneficiary of the trust or other nonadverse party could hold the Charity Power. If a beneficiary of the trust held and exercised the Charity Power, the beneficiary may be deemed to have made a gift by that exercise. See IRC § 2514. Another choice for the holder of the Charity Power is a nonadverse party that is not a beneficiary of the trust, such as the grantor’s sibling. Like the Borrowing Power, the Charity Power would cease on the death of the individual holding such power. Thus, a succession of powerholders of the Charity Power would be appropriate to defeat any premature cessation of grantor trust status caused by an individual powerholder’s death.

Releasing the Charity Power

Like the other grantor trust powers, the specific authority to release the Charity Power should be held by the powerholder. If the grantor’s spouse or sibling holds the Charity Power, the release is as simple as informing the trustee of the release of the power. If the Charity Power is released, the release should be irrevocable and the powerholder should not have the ability to reacquire the power. Otherwise, this ability could cause the release to be deemed ineffective. The ease of release by the grantor’s spouse or sibling makes the Charity Power a useful grantor trust power.

The examination of these most commonly used powers to cause grantor trust status for irrevocable trusts reveals that the Substitution Power may be the most useful because its release would be the easiest for the grantor to control. But, because the Substitution Power may not be sufficient to ensure grantor trust status for conservative estate planners, the Borrowing and Charity Powers can provide practitioners with a belt and suspenders approach to creating grantor trust status that does not require extensive steps for the termination of grantor trust status.

Implementing the Grantor Trust Powers

Below are suggested provisions for trust agreements implementing the grantor trust powers discussed above, with the important provisions for termination of grantor trust status:

Article I

Grantor Trust Status

(A) Grantor’s Power to Reacquire Trust Assets. With respect to each trust created under this agreement, the Grantor shall have the power, exercisable at any time in a nonfiduciary capacity, without the approval or consent of any person in a fiduciary capacity, to reacquire trust principal by substituting other property of an equivalent value, determined as of the date of such substitution (referred to in this Article as “the Substitution Power”), subject to the following:

(1) Any stock described in Internal Revenue Code § 2036(b) that the Grantor has transferred to the trust for purposes of Internal Revenue Code § 2036(b) may not be reacquired by the Grantor.

(2) Property shall not be deemed of equivalent value if it causes a shift of beneficial interests in any trust under this agreement by any means (directly or indirectly), including, without limitation, by enhancing the economic interests of the current beneficiaries to the detriment of the remainder beneficiaries or vice versa, or by conferring an uncompensated economic benefit on the Grantor.

(3) The Grantor must certify in a writing delivered to the Trustee that the property proposed to be substituted and the trust property to be reacquired by the Grantor are of equivalent value. The Trustee shall have a fiduciary obligation to ensure that the property proposed to be substituted and the trust property to be reacquired by the Grantor are of equivalent value. If the Grantor and the Trustee do not agree that the property proposed to be substituted is of equivalent value with the property to be reacquired by the Grantor, the Trustee may in the Trustee’s discretion obtain an independent appraisal and, if the Grantor and the Trustee do not agree to use the value determined by the independent appraisal, the Trustee may in the Trustee’s discretion seek a judicial determination by a court of competent jurisdiction that the requirement of equivalent value is satisfied. The reasonable expenses of such independent appraisal or judicial determination shall be borne equally by the Grantor and Trustee.

(4) Any exercise of the Substitution Power shall be effected by a written instrument signed by the Grantor and delivered to the Trustee.

(5) The Grantor shall have the authority to release the Substitution Power with respect to any or all trusts established under this agreement. The Grantor shall release such power in accordance with Subdivision (D) of this Article.

(B) Grantor’s Spouse’s Borrowing Power.

(1) The Grantor’s spouse shall have the authority to borrow all or any portion of the trust income and/or principal, without any security, but with adequate interest, from any trust established under this agreement (referred to in this Article as “the Borrowing Power”). Any exercise of the Borrowing Power shall be effected by a written instrument signed by the Grantor’s spouse and delivered to the Trustee. The Grantor’s spouse shall have the authority to release the Borrowing Power with respect to any or all trusts established under this agreement. The Grantor’s spouse shall release the Borrowing Power in accordance with Subdivision (D) of this Article.

(2) If the Grantor’s spouse exercises the Borrowing Power over all or some portion of a trust or trusts under this agreement, the Independent Trustee of such trust(s) shall make the loan of the portion of the trust income and/or principal to the Grantor’s spouse without any security, but with adequate interest, as directed by the Grantor’s spouse. The Independent Trustee making the loan shall determine the adequate interest for the loan, which shall be at least the applicable federal rate pursuant to Internal Revenue Code § 1274(d) and, in the Independent Trustee’s absolute discretion, may include a premium to account for the inadequate security for the loan.

[ALTERNATIVE: (B) Independent Trustee’s Power to Lend to Grantor. The Independent Trustee of a trust under this agreement shall have the authority to lend all or any portion of the trust income and/or principal to the Grantor without any security, but with adequate interest, from any trust established under this agreement (referred to in this Article as “the Borrowing Power”). The Independent Trustee making the loan shall determine the adequate interest for the loan, which shall be at least the applicable federal rate pursuant to Internal Revenue Code § 1274(d) and, in the Independent Trustee’s absolute discretion, may include a premium to account for the inadequate security for the loan. The Independent Trustee shall have the authority to release the Borrowing Power with respect to any or all trusts established under this agreement. The Independent Trustee shall release the Borrowing Power in accordance with Subdivision (D) of this Article.]

(C) Grantor’s Spouse’s Power to Add University as a Beneficiary. The Grantor’s spouse shall have the authority to add University as a beneficiary of any trust established under this agreement (referred to in this Article as “the Charity Power”). If the Grantor’s spouse exercises the Charity Power with respect to a trust under this agreement, the Independent Trustee of such trust shall have the power to make distributions of net income and/or principal to University in the absolute discretion of the Independent Trustee in any amount as the Independent Trustee deems advisable. The Grantor’s spouse shall have the authority to release the Charity Power with respect to any or all trusts established under this agreement. The Grantor’s spouse shall release such power in accordance with Subdivision (D) of this Article.

[ALTERNATIVE: (C) Designator’s Power to Add University as a Beneficiary. The Grantor’s sibling (referred to in this Article as “the Designator”) shall have the authority to add University as a beneficiary of any trust established under this agreement (referred to in this Article as “the Charity Power”). If the Designator exercises the Charity Power with respect to a trust under this agreement, the Independent Trustee of such trust shall have the power to make distributions of net income and/or principal to University in the absolute discretion of the Independent Trustee in any amount the Independent Trustee deems advisable. The Designator shall have the authority to release the Charity Power with respect to any or all trusts established under this agreement. The Designator shall release such power in accordance with Subdivision (D) of this Article.]

(D) Termination of Grantor Trust Status.

(1) The Grantor may release the Substitution Power for any or all trusts established under this agreement and with respect to all or a specific portion of such trust for which a power is being released. Any such release shall be effected by a written instrument signed by the Grantor and delivered to the Trustee describing the power being released, the trust to which the release applies, and the extent of the trust property to which the release applies. Any such release, once given, shall be irrevocable.

(2) The Grantor’s spouse may release the Borrowing Power and/or the Charity Power for any or all trusts established under this agreement and with respect to all or a specific portion of such trust for which such power is being released. Any such release shall be effected by a written instrument signed by the Grantor’s spouse and delivered to the Trustee describing the power being released, the trust to which the release applies and the extent of the trust property to which the release applies. Any such release, once given, shall be irrevocable.

[ALTERNATIVE: (2) The Independent Trustee may release the Borrowing Power for any or all trusts established under this agreement and with respect to all or a specific portion of such trust for which such power is being released. If the Independent Trustee releases the Borrowing Power with respect to an entire trust established under this agreement, the Independent Trustee shall receive the power to make distributions to one or more of the current beneficiaries of such trust in the best interests of such beneficiaries in the absolute discretion of the Independent Trustee. The Designator may release the Charity Power for any and all trusts established under this agreement and with respect to all or a specific portion of such trust for which such power is being released.]

(3) If each of the Substitution Power, the Borrowing Power, and the Charity Power has been released with respect to a trust established under this agreement, then such trust for which these powers have been released shall not be treated as a grantor trust under subpart E of part 1 of subchapter J of chapter 1 of subtitle A of the Internal Revenue Code; provided that, thereafter, the Trustees shall appoint so many additional Independent Trustees such that at no time are more than half the Trustees related to or subordinate to the wishes of the Grantor within the meaning of Sections 672(c) and 674(c) of the Internal Revenue Code.

In addition to incorporating many of the ideas discussed previously in this article, these sample provisions highlight some other points. By putting the grantor trust provisions in one section of the trust agreement, the powers and authority for causing and terminating grantor trust status are easily identifiable and obviate the trust’s initial grantor trust status.

The sample provisions also suggest important practical ideas not discussed previously in this article. Section (A)(3) of the sample provisions requires that the grantor certify in writing to the trustee that the property being exchanged for the trust property is of equal value and allows for resolution should a dispute over the value of the exchanged properties arise. Section (A)(3) requires a writing to attempt to make the grantor accountable for ensuring that the exercise of the Substitution Power will satisfy the necessity that the exchanged properties are of equal value. Furthermore, if there is a dispute over the values of the exchanged properties, Section (A)(3) provides a manner to resolve the dispute.

Finally, the last sentence of Section (D)(3) allows the trustees of the trust for which grantor trust status is being terminated to appoint a sufficient number of Independent Trustees to ensure that they are not related or subordinate to the grantor. Grantor trust status may be caused if more than half of the trustees are related or subordinate to the grantor and have certain powers over distributions from a trust. See IRC § 674.

Conclusion

Although the Greenbook Proposal has not yet gained significant traction, tax planners should carefully consider emphasizing the termination of grantor trust status when drafting irrevocable trust agreements.

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