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The Tax Lawyer

The Tax Lawyer: Spring 2023

The Incapacitated Grantor and the Revocable Trust: Unnecessary Tax Complexity and a Reform Proposal

Sergio Evan Pareja

Summary

  • Revocable trusts are common will substitutes that also provide a mechanism for managing a person’s assets in the event of mental incapacity. Generally speaking, these trusts are grantor trusts for federal income tax purposes.
  • When a grantor is afflicted with mental incapacity a serious question is raised about the income tax status of the trust. Specifically, absent a specific state law or trust provision to the contrary, the trust arguably ceases to be a grantor trust. This has numerous potential adverse tax consequences.
  • This Article proposes a straightforward solution: the law should be changed to create a default rule that grantor trust status for a revocable trust will continue until an incapacitated grantor’s death.
The Incapacitated Grantor and the Revocable Trust: Unnecessary Tax Complexity and a Reform Proposal
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Abstract

Revocable trusts are common will substitutes that also provide a mechanism for managing a person’s assets in the event of mental incapacity. Generally speaking, these trusts are grantor trusts for federal income tax purposes, which means that the person who created the trust, the grantor, will continue to report the income and deductions from trust assets as if the trust did not exist. When a grantor is afflicted with mental incapacity, say as a result of dementia or a stroke, a serious question is raised about the income tax status of the trust. Specifically, absent a specific state law or trust provision to the contrary, the trust arguably ceases to be a grantor trust. This has numerous potential adverse tax consequences, including increased taxes due to a compression of income tax rates, the potential loss of the exclusion of gain on the sale of a primary residence, and the potential loss of S corporation status if the trust owns S corporation stock. This Article proposes a straightforward solution: the law should be changed to create a default rule that grantor trust status for a revocable trust will continue until an incapacitated grantor’s death.

I. Introduction

I shall begin with a hypothetical example that is meant to illustrate the problem that this Article seeks to redress. Ana is an 80-year-old widow with one adult child, Marcos, and two granddaughters, Maria and Carmen. Marcos is relatively well-off, and Ana’s estate plan contemplates that her property will mainly pass to her granddaughters at her death. Ana values privacy and her autonomy greatly. She is not wealthy, but she has enough assets to comfortably provide for her for the rest of her life and to leave some small gifts to Marcos as well as other gifts to charities and close friends at her death. The rest of her property will go to her granddaughters. Her assets include some publicly-traded stock, shares of an S corporation, and her home. Marcos has agreed to serve as a fiduciary if Ana is unable to manage her own affairs.

When working on her estate plan, Ana considered two possible broad ways to arrange her affairs. Under Option 1, she would merely execute a standard will and a “springing” durable power of attorney, among other documents, naming Marcos as her personal representative under the will and as her agent under the power of attorney. Because it would be a springing power of attorney, it would take effect upon Ana’s incapacity, and, because it is durable, it would last throughout her incapacity until her death. She would not utilize a trust to own any of her assets. Ana would continue to prepare her own individual income tax return, as she has done every year for the past 60 years. Should she be determined to be mentally incapacitated, the power of attorney grants Marcos the power to prepare her individual income tax returns, which he would readily do on her behalf.

Under Option 2, Ana would execute a revocable trust, a pour-over will, and a limited power of attorney that merely gives her agent the power to transfer property to her trustee to be administered in accordance with the terms of the trust. She would name Marcos as her co-trustee of the revocable trust as well as her personal representative under the will and her agent under the power of attorney. She would not give Marcos the power to revoke the trust because she wants to maintain control over the ultimate disposition of her assets. The basic idea is that she would transfer all of her assets to the trust during her lifetime. This approach would allow her assets to pass outside probate at her death, providing a relatively high level of privacy that has always been important to Ana. In addition, Marcos could continue managing her assets without missing a beat if she becomes incompetent. Because he’s a co-trustee, there would be no need to formally have her declared “incapacitated,” and trust terms would provide him with more detailed guidance regarding how she would like her assets administered in the event of her incapacity. Under this approach, Marcos and Ana could simply have a friendly understanding that he will step up and take over when it seems like she is unable to do it.

After weighing the pros and cons, Ana decided to go forward with Option 2. A key reason for her decision was that she was concerned about incapacity planning, and she had heard that financial institutions do not always honor powers of attorney as reliably as trusts due to the concern that the agent may be acting beyond the scope of his or her authority. She also did not particularly like the idea of having to officially be declared incapacitated to transfer authority to Marcos.

Ana was a diligent client, and she was careful to retitle all of her major assets in the name of the revocable trust. Under the Internal Revenue Code, the fact that the trust is revocable means that, for federal income tax purposes, it is a “grantor trust.” This, in effect, means that, for federal income tax purposes, the trust does not exist. As a result, Ana continues to report all income and deductions on her individual income tax return even though the assets are all titled in the trust’s name.

Now suppose that a few years after setting up her estate plan, Ana has a stroke that leaves her mentally (and perhaps also physically) incapacitated. While the trust may technically still be revocable, she certainly lacks the legal ability to revoke the trust while mentally incapacitated. In addition, suppose that under the trust agreement and the laws of the state where Ana lives, nobody else has the automatic power to revoke the trust on Ana’s behalf during this time period. Because neither Ana nor somebody on her behalf can revoke the trust, it arguably ceases to be a grantor trust, at least during Ana’s incapacity, for federal income tax purposes. While tax law on this issue is not entirely clear, I believe that this is the more likely outcome.

It is helpful to assume that the trust is not a grantor trust during any period of Ana’s incapacity to analyze what might happen. In this case, Marcos will have a duty to file a separate income tax return for the trust each year in addition to the individual income tax return for Ana. There are numerous potentially adverse consequences to having the trust be a separate taxpayer, which are described below. While many of these consequences can be avoided, they add unnecessary complexity to the administration of the trust and potentially create a trap for the unwary. While the reality is that a trustee in Marcos’s situation may, and commonly does, hide his knowledge of Ana’s incapacity and continue filing individual income tax returns on her behalf, there are ethical considerations at play as well if Marcos believes that Ana has lost her power to revoke due to her incapacity and that, as a result, the trust is no longer a grantor trust. A key point of this Article is that Marcos should not be put in the position of having to decide whether his knowledge of Ana’s incapacity means that he needs to treat the trust as irrevocable for tax purposes.

Part I of this Article discusses the general applicability of the grantor trust rules.

Part II of this Article addresses potential adverse tax consequences related to the termination of grantor trust status.

Part III of this Article discusses current ways to avoid problems associated with the termination of grantor trust status. It also accepts the reality that some trustees will just hide their knowledge of the grantor’s incapacity and continue to treat the trust as a grantor trust. Part III concludes by homing in on the ethical concerns that apply to this approach and by discussing broader duties and potential for liability by the trustee as well as by any attorneys or accountants that the trustee may hire.

Part IV of this Article analyzes the current way that revocable trusts are taxed when the grantor becomes incapacitated under the principles of administrative efficiency, equity, and neutrality. This analysis ultimately leads to the conclusion that the current system is administratively inefficient, inequitable, and not neutral when it comes to incentivizing certain behaviors.

Part V of this Article presents and analyzes my proposal. The core proposal is quite simple: Congress should amend the Code to create a default rule that grantor trust status shall continue until the grantor’s death if the trust was fully revocable until the grantor became incapacitated. This default rule could be changed by the grantor through an express provision to the contrary in the trust agreement or by individual state laws providing a contrary rule.

II. The Grantor Trust Rules

A. In General

Broadly speaking, all trusts are taxed as (1) simple trusts, (2) complex trusts, or (3) grantor trusts. While, for federal income tax purposes, simple trusts and complex trusts are separate taxpayers, grantor trusts are effectively treated as if they do not exist, and all income, deductions, and credits are generally reported on the individual income tax returns of the grantor. In certain limited cases, they may be reported on a third party’s individual returns instead of on the grantor’s returns.

There are potential disadvantages to having a trust taxed separately from the grantor, including a compression of tax rates, limitations on owning S corporation stock, and loss of the exclusion of gain on the sale of a primary residence, among other things. These disadvantages, which are a focus of this Article, are discussed in greater detail below.

B. Ways in Which a Trust is a Grantor Trust

For federal income tax purposes, a trust is a grantor trust in any one of these five general situations:

  1. The grantor has a reversionary interest in the income or principal of the trust, and the value of that reversionary interest exceeded five percent of the trust’s total value at the time of transfer to the trust;
  2. The beneficial enjoyment of trust’s income or principal is subject to a power of disposition that is held by the grantor or a nonadverse party (or both) without the approval or consent of an adverse party;
  3. The grantor or a nonadverse party has the power to deal with the trust for less than full and adequate consideration or may borrow from the trust without adequate interest or security;
  4. The power to re-vest in the grantor title to any portion of the trust is exercisable by the grantor or by a nonadverse party; or
  5. Income is, or (in the discretion of the grantor or a nonadverse party) may be, distributed to the grantor or the grantor’s spouse, or held or accumulated for future distribution to the grantor or the grantor’s spouse, without the approval or consent of an adverse party.

Apart from the above five ways in which the grantor may be treated as the owner of the trust’s assets, a person other than the grantor (i.e., a third party) is, alternately, treated as the owner of any portion of a trust with respect to which that person has a power (exercisable alone) to vest the corpus or the income from the corpus in himself or herself.

By definition, a revocable trust is one in which somebody, typically the grantor, has retained the power to revoke the trust and re-vest title of the trust assets in the grantor. This power to revoke generally will cause the revocable trust to be a grantor trust under section 676. As explained in the accompanying Treasury Regulations, that section provides as follows:

If a power to revest in the grantor title to any portion of a trust is exercisable by the grantor or a nonadverse party, or both, without the approval or consent of an adverse party, the grantor is treated as the owner of that portion, except as provided in section 676(b) (relating to powers affecting beneficial enjoyment of income only after the expiration of certain periods of time). If the title to a portion of the trust will revest in the grantor upon the exercise of a power by the grantor or a nonadverse party, or both, the grantor is treated as the owner of that portion regardless of whether the power is a power to revoke, to terminate, to alter or amend, or to appoint. See section 671 and §§ 1.671-2 and 1.671-3 for rules for treatment of items of income, deduction, and credit when a person is treated as the owner of all or only a portion of a trust.

Simply stated, this means that, if the grantor or a person who is not a beneficiary of the trust (i.e., a nonadverse party) can revoke the trust, then the trust will be a grantor trust.

C. Effect of Incapacity of Grantor on Grantor Trust Status

Suppose an unmarried grantor, like Ana in our hypothetical, retains the sole power to revoke her trust and does not explicitly give that power to revoke to any other person. What happens if Ana, due to a stroke or other adverse event, becomes mentally incapacitated and, therefore, is unable to revoke the trust? If none of the other provisions making the trust a grantor trust apply, this means that the sole basis for grantor trust status under the Code was the fact that the trust was revocable. If that revocability effectively disappears, or at least is suspended, during the grantor’s incapacity, then the trust arguably ceases to qualify as a grantor trust during that incapacity. If this happens, the trust immediately becomes a separate taxpayer from Ana, and the tax impact is potentially very significant.

Assuming that grantor trust status terminates, the next question concerns the type of trust that then exists. Generally speaking, as mentioned above, the trust will then either be a simple trust or a complex trust. Because the trustee is not required under the trust agreement to distribute all of its income to its beneficiaries currently, nor is it prohibited from making charitable contributions or distributions from the corpus, it is not a simple trust. Therefore, it would almost certainly be taxed as a complex trust.

Suppose that the trustee is desperate to avoid classification of the trust as a complex trust rather than a grantor trust. Could the trustee unilaterally re-vest the trust property in Ana, or could one at least argue that the trustee has the power to re-vest the trust property in Ana and that, therefore, the trust should continue to be a grantor trust? To determine whether that is permissible, it is necessary to consider the state law applicable at the trust’s situs. Might a court-appointed conservator or guardian or, perhaps, an agent under a power of attorney be able to do that? Commonly under state laws, the guardian or the grantor’s agent may only revoke the trust if it is expressly authorized in the trust instrument. It’s also worth mentioning that the trustee typically has a duty to resist an attempted revocation by the grantor if the trustee knows of the grantor’s incapacity. In addition, if the grantor attempts to revoke and the trustee knows of the grantor’s incapacity, the trustee has a duty to inquire regarding the circumstances surrounding the attempted revocation.

The need to look to state law, which may further require looking to the power of attorney as well as to the terms of the trust agreement, creates unnecessary confusion and complexity, with potentially severe tax consequences, at a time when the grantor has just become mentally incapacitated. The timing for this uncertainty could hardly be worse. In addition, this assumes that it is a simple matter to know that the grantor has become incapacitated. While that may be fairly easy when the grantor has a stroke and a medical diagnosis, the situation becomes far more complicated if the trustee firmly believes that the grantor is incapacitated, but there is no formal medical diagnosis. This might occur, for example, when there is a gradual mental decline due to dementia. The myriad issues were recently noted in an article by James Hammil, CPA, Ph.D:

What if an 88-year-old Mom starts to lose her mental capacity and names Daughter as co-trustee? No tax issue if Mom is ‘starting’ to lose capacity. By inference, she still has capacity.

Let’s say that (now) 90-year-old Mom has lost capacity. Daughter handles all aspects of the trust. Is a trust return required?. . . Yes. Mom cannot revoke or change the terms of the trust. . . . A trust is no longer a grantor trust when the grantor is incapacitated.

Tax preparers don’t judge capacity. Who does?. . . Capacity to execute legal decisions is a legal judgment. . . . Don’t call a doctor. Call a lawyer. But, until that happens, and it may not, the tax return preparer keeps reporting a grantor trust. I doubt there’s anyone to stop him.

This situation is unnecessarily chaotic and uncertain. Trustees are bound by fiduciary duties and high ethical standards, discussed below, yet there is no clarity as to how they should proceed. It seems more likely than not, in my opinion, that incapacity of the grantor, absent an express trust provision or a state law that would permit a non-adverse party to revoke the trust, would cause the trust to cease to be a grantor trust. Although the Code and the Treasury Regulations provide no explicit guidance on this topic, it is consistent with the spirit of the United States Treasury Department’s comments when it issued final regulations under section 645, which relates to an election for a revocable trust to be taxed as part of a decedent’s estate:

Clarification has been requested as to whether a trust qualifies as a QRT [“qualified revocable trust”] if the grantor’s power to revoke the trust lapses prior to the grantor’s death as a result of the grantor’s incapacity. Some trust documents for revocable trusts provide that the trustee is to disregard the instructions of the grantor to revoke the trust if the grantor is incapacitated. The IRS and the Treasury Department believe that, if an agent or legal representative of the grantor can revoke the trust under state law during the grantor’s incapacity, the trust will qualify as a QRT, even if the grantor is incapacitated on the date of the grantor’s death.

Similarly, the American Bar Association (“ABA”) notes on its website that “One of the benefits of a revocable living trust is that there is no obligation to file a separate tax return for the trust while the trustor is alive and has capacity; because a revocable living trust is a grantor trust, all the trust’s income is taxed as income of the trustor (I.R.C. § 671).” Implicit in both the cited Treasury Department comment as well as the ABA’s website is the notion that a grantor’s loss of mental capacity may cause an otherwise revocable trust to become irrevocable for federal income tax purposes, at least if somebody else does not have the power to revoke the trust on the grantor’s behalf. Despite this seemingly clear outcome under federal tax law, the matter becomes less clear when we consider non-tax implications to the loss of capacity by the grantor.

Outside the tax context, Professor Grayson M.P. McCouch of the University of Florida has noted that, “A revocable trust does not become irrevocable merely because the settlor becomes incompetent. Such a result would be nonsensical as a practical matter, given the difficulty of determining capacity, the problems of notifying the trustee and the beneficiaries, and the possibility (however slim) that the settlor might recover capacity in the future.” In making this argument, Professor McCouch also notes that, “Of course, the settlor’s power of revocation might automatically terminate upon loss of capacity if the trust so provides.” In effect, Professor McCouch is saying that the presumption is the reverse of that which appears to exist in the tax context; specifically, it seems that a revocable trust may be presumed to become irrevocable upon the grantor’s incapacity for tax purpose but not for trust law purposes. Both presumptions could be reversed with express language to the contrary in the trust agreement.

While I agree as a general matter with Professor McCouch’s belief that there are significant problems with treating a revocable trust as irrevocable due to the grantor’s incapacity, and I think that is a fine conclusion for non-tax reasons, I do not reach this same conclusion when I consider the tax impact of the grantor’s incapacity. Here, I think that incapacity, absent state law or a trust provision to the contrary, causes grantor trust status to terminate for the tax year in question. I will admit, however, that the law in this area is not completely clear. It is this lack of clarity that leads me to the conclusion that a change to the law is necessary.

It is also important to think about mental incapacity broadly. We generally use the term “incapacity” loosely in the legal context and have not crafted our trust or tax laws in ways that reflect the complexity of the situation. In reality, the entire concept of “incapacity” is quite nuanced. If we consider whether a grantor has retained a realistic ability to revoke a trust, for example, it seems that there is a distinction between different types of incapacity. A grantor, for example, may have a relatively minor stroke that renders the person temporarily incapacitated, although it is apparent that he or she is on the road to recovery. In that case, loss of an actual ability to revoke is clearly a temporary matter. That seems very different from the case of a severe stroke that puts the person in a persistent vegetative state after which it is absolutely clear that the person will never recover. Somewhere in between, we have cases in which cognitive decline may be gradual, albeit permanent, and which may demonstrate certain periods with heightened cognition and others with severe impairment. While the law in this area is not nearly developed enough (or nuanced enough) to deal with these extremely difficult situations, that would be an admirable goal, which is far beyond the scope of this Article. In the meantime, I merely would propose that we create some clarity from a tax perspective with respect to the specific situation of grantor trusts.

In sum, while the outcome depends on a variety of factors, including state law, the trust agreement, and powers of attorney, the incapacity of the grantor may cause a revocable trust to convert from a grantor trust to a complex trust for income tax purposes. In addition, the actual determination of when a grantor becomes incapacitated can be very nuanced and fact-sensitive. Because of the general lack of clarity in this area, it also may be fairly easy for the trustee to act as if the incapacity does not exist so as to keep treating the trust as a grantor trust for tax purposes. This has practical and ethical implications that are discussed in greater detail below. The relatively modest proposal of this article is an attempt to address this limited issue in a fairly straightforward fashion so as to provide trustees, as well as their legal and tax advisors, with some clarity.

III. Tax Effect of Terminating Grantor Trust Status

A. In General

If a revocable trust ceases to be a grantor trust due to the incapacity of the grantor, it almost certainly will be a complex trust rather than a simple trust. This is because a simple trust by its terms must distribute all of its income to its beneficiaries currently and must not make charitable contributions or any distribution from the corpus of the trust. Accordingly, this Article focuses on the vastly more likely situation in which the loss of grantor trust status will result in the revocable trust being classified as a complex trust.

During the time period when a trust is definitely a grantor trust because the grantor can revoke it (that is to say, prior to the grantor becoming incapacitated), there are a variety of ways in which income may be reported to the Service. That said, the focus of this Article is on the typical revocable living trust that is commonly used as a will substitute. In that case, the trust normally would have one individual as a grantor, and the tax treatment, explained below, is quite clear and simple. It is worth noting that the tax treatment of a joint revocable trust created by a married couple is generally going to be the same as that of a single grantor trust because, in the case of a married couple who files jointly, they are treated as a single grantor for income tax purposes.

Prior to the grantor’s incapacity, a typical revocable living trust with a single grantor may use one of two optional methods for income tax reporting. The instructions to Internal Revenue Service Form 1041 refer to the first method as “Optional Method 1.” Under this method, the trustee furnishes the name and social security number of the grantor, as well as the address of the trust, to each payor of income to the trust during the taxable year. Note that a grantor is commonly also the trustee of a revocable living trust. If the grantor happens to not also be the trustee or a co-trustee of the trust, the trustee also must give the grantor a statement showing the income, deductions, and credits of the trust for the taxable year. This statement also must identify each payor, providing enough information for the grantor to compute his or her taxable income for the year. The statement also must inform the grantor that the items need to be included when the grantor prepares his or her own individual income tax return. With Optional Method 1, the trustee does not need to obtain a separate taxpayer identification number or employer identification number (“EIN”) for the trust. Also, the trustee does not actually need to file anything with the Service on behalf of the trust. This is clearly meant to be a convenient and simple approach.

As one might guess, the instructions to Form 1041 refer to the second method of income tax reporting for a single-grantor grantor trust as “Optional Method 2.” Under this method, the trust actually utilizes an EIN, which means that the trustee needs to apply for one. This may be done by completing and filing Form SS-4, “Application for Employer Identification Number” with the Service. The trustee then will need to provide the trust’s name, EIN, and address to all payors of income to the trust during the year. In addition, under this method, the trustee also must then file with the Service the appropriate Form 1099 reporting the income or gross proceeds paid to the trust during the taxable year. In practical effect, then, this method treats the trust as receiving the payments and then immediately turning around and transferring them to the grantor, even though no such transfer needs to occur because it is a grantor trust. Each Form 1099 that the trustee prepares must reflect the grantor as the payee or recipient of the payment and the trust as the payor. As with Optional Method 1, unless the grantor is the trustee or a co-trustee of the trust, the trustee also must provide the grantor with a statement each year showing the income, deductions, and credits of the trust. As with Optional Method 1, the statement must identify each payor, providing sufficient information for the grantor to compute his or her taxable income. In addition, it must inform the grantor that the items need to be included when the grantor prepares his or her own individual tax return.

Assuming that the simpler Optional Method 1 is used, the trust does not have an EIN prior to the grantor’s incapacity. Accordingly, when grantor trust status terminates due to the incapacity of the grantor, the trustee will then be required to obtain an EIN for the trust. If, on the other hand, Optional Method 2 was used, the trust will already have an EIN when the grantor becomes incapacitated. In this case, the trustee may continue to use the same EIN as before for the rest of the grantor’s life (that is to say, while the trust is a non-grantor trust but only until the grantor’s death).

After termination of grantor trust status due to the incapacity of the grantor, the trustee is required to start filing a Form 1041 to report the items of income, deductions, and credits applicable to the period after the termination. At this point, the general rules of income taxation of trusts will apply. As mentioned, the trust almost certainly will be a complex trust at that point, and, accordingly, this Article is focused entirely on the rules governing complex trusts during this time period. Generally speaking, a change from grantor trust status to complex trust status can result in higher tax rates applying due to a compression of the trust income tax rate schedule and adverse tax consequences when certain assets are owned by the trust.

B. Trust Tax Rates

The general principle of the rules applicable to complex trusts is that, except to the extent that specific differences are identified in the Code, the taxable income of a trust is computed in the same way as for an individual. These differences are found in Part I of Subchapter J of the Code.

While the detailed rules in Subchapter J are quite intricate and nuanced, the general principle behind the taxation of complex trusts is relatively simple. Upon termination of grantor trust status, the complex trust will be subject to what is commonly referred to as a form of “conduit” taxation. What this means in this context is that a complex trust will be taxed each year only to the extent it receives and retains taxable income. If the trust makes, or is required to make under the trust terms, a distribution to a beneficiary, then a deduction is granted to the trust to the extent of the distribution. The income is then allocated and taxed directly to the beneficiary who receives the distribution.

As mentioned, the basic idea in Subchapter J is simple enough: income flows through to the beneficiary to the extent that distributions must be made, or are in fact made, to that beneficiary. This provides an opportunity for a trustee to avoid a compressed trust rate schedule, discussed below, by distributing income to the grantor. Of course, the necessity of computing and distributing income out of the trust is an unnecessary step with added complexity. Perhaps more importantly, a distribution is particularly problematic if the grantor does not need the income and would have preferred that it remain in the trust. Said differently, if it makes sense for non-tax reasons to keep the money in the trust, but the distribution is being made solely for tax reasons, we have a clear case of the tax tail wagging the trust dog.

Assuming that the trustee does not distribute all trust income to the grantor, either intentionally or perhaps even as an oversight in the case where a trustee may make distributions in the trustee’s discretion, the amount of income that remains in the trust will be taxed at the trust level rather than to the beneficiary. Those trust-level taxes are imposed based on the trust income tax brackets.

Trust income tax brackets are almost the same as the income tax brackets for individuals; however, as mentioned, they are much more compressed than the brackets for individuals. In addition, trust brackets do not include 12 percent, 22 percent, or 32 percent tax rates, but they do share the same highest rate as the highest rate for individuals (currently 37 percent). This compression is extremely significant, and it makes it much more likely that taxes will be higher for a complex trust that retains its income than for a grantor trust that retains its income. For example, in 2023, trusts hit the highest federal income tax bracket for federal income tax purposes at $14,450 of income, while married persons filing jointly reach it at $693,750 of income, and single individuals reach it at $578,125 of income.

In addition to the difference in the compression of the aforementioned rate brackets, the Code imposes a “Net Investment Income Tax,” which is also known as a “Medicare Tax,” on the “unearned income” of individuals, estates, and trusts. For individuals, the Net Investment Income Tax is equal to 3.8 percent of the lesser of (i) the individual’s net investment income for the year, or (ii) the individual’s modified adjusted gross income for that taxable year in excess of a threshold amount. That threshold amount is $200,000 for single individuals and $250,000 for married couples filing jointly.

For complex trusts, the Net Investment Income Tax is equal to 3.8 percent multiplied by the lesser of (i) the trust’s undistributed net investment income, or (ii) the trust’s adjusted gross income for that taxable year in excess of the dollar amount at which the highest income tax bracket begins ($14,450 for 2023). Note that the threshold amount for the Net Investment Income Tax is not indexed for individuals, but it is indexed for trusts because it is expressly tied to the highest income tax bracket for trusts, which changes each year.

Because a grantor trust is not a separate income taxpayer from the grantor, the Net Investment Income Tax is not directly imposed on grantor trusts. Instead, each item of income (and each deduction) is treated as if it had been received (or as if it had been paid directly) by the grantor. This means that the determination of whether the Net Investment Income Tax applies is handled at the grantor level, and that is where one must calculate the amount of Net Investment Income Tax that is owed.

C. Trust Situs

When evaluating the consequences of terminating grantor trust status, it is also necessary to consider state income tax implications. While an analysis of the income tax laws of all of the nation’s states and territories is far beyond the scope of this Article, it is important to have a general understanding of the issues with respect to state taxation in order to understand how termination of grantor trust status, coupled with a trust situs that is different from that of the grantor, can have significant adverse tax consequences.

Broadly speaking, a state may tax the worldwide income of a resident of the state, but the state may only tax non-resident income if that state is the source of the income. This principle is rooted in limitations found in the United States Constitution; specifically, the Due Process Clause “requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.” When a state statute attempts to tax something outside of it jurisdiction, it is a violation of the Due Process Clause of the Fourteenth Amendment to the United States Constitution. As the United States Supreme Court explained in the 2019 case of North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust:

[W]hen assessing a state tax premised on the in-state residency of a constituent of a trust – whether beneficiary, settlor, or trustee – the Due Process Clause demands attention to the particular relationship between the resident and the trust assets that the State seeks to tax. Because each individual fulfills different functions in the creation and continuation of the trust, the specific features of that relationship sufficient to sustain a tax may vary depending on whether the resident is a settlor, beneficiary, or trustee.

In addition to the Due Process limitations on a state’s power to tax, there are also Commerce Clause limitations. The standard, which was set by the United States Supreme Court in Complete Auto Transit, Inc. v. Brady, is whether “the tax is applied to an activity with a substantial nexus with the taxing State, is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the State.” The concept of “substantial nexus” is in addition to the “minimum contacts” requirement of the Due Process Clause. According to the Court, the “substantial nexus” test requires that, in order for the state to have the power to tax, the taxpayer must have “avail[ed] itself of the substantial privilege of carrying on business in that jurisdiction.”

What this all means is that, provided that a state’s law does not violate the broad “minimum contacts” and “substantial nexus” limitations of the United States Constitution, and provided that the state tax law in question is permitted under that state’s constitution, the state may tax the trust. Because states have broadly divergent views on taxation, of course, the basis upon which a state will attempt to tax a trust varies from state to state. In some states, for example, residency of a trust for tax purposes is based on the domicile of a grantor at the time when an irrevocable trust is created. Other states look to the domicile of the trustee as the situs of the trust for tax purposes. Others look to the place where the beneficiaries reside to determine if the state can tax the trust. Still others determine that residency by the principal place of administration of the trust. As you might imagine, some states utilize a combination of the foregoing factors to determine whether to tax the trust, which means that we really have a smorgasbord approach to the state taxation of trusts.

Because a grantor trust is generally treated as non-existent for federal income tax purposes, it also is usually ignored as a separate taxpayer for state tax purposes as well, which makes taxation of the trust’s income relatively simple. Simply stated, for grantor trusts, states most commonly look to the grantor’s state of residence to determine residency for state income tax purposes. The issue is that a grantor trust very well may be taxed differently (that is to say, in a different state) when grantor trust status terminates due to the grantor’s incapacity. For example, assume that the grantor, Ana in our example, lives in a state with no income tax, such as Texas, but her co-trustee, her son Marcos in our example, lives in a high-income tax state such as California. Assume for simplicity that all trust assets are publicly-traded stock. While the trust is a grantor trust, it almost certainly will not be subject to any state income taxes because there are none in Texas. Upon Ana’s incapacity, however, it is quite possible that the trust’s situs for state income tax purposes will shift to California under California’s trust situs rules. If that happens, there will be a large increase in the overall amount of taxes owed due to the sudden imposition of a California income tax on the trust.

Numerous states impose state income taxes on trusts based on the residence of the grantor or trustees. In the late 1800s and early 1900s, many state courts considered the issue of tax jurisdiction due to the residence of trustees, and, in most cases, the courts determined that a trust could be taxed in the state of the trustee’s residence. The U.S. Supreme Court “has never denied the constitutional power of the trustee’s domicile to subject them to property taxation.”

One potential for tax abuse is the use of trust taxation rules to attempt to defer taxes by a year. “States typically impose tax on a beneficiary in the year in which the beneficiary receives the income from the trust,” and this could open the door to deferral. That said, the United States Supreme Court has made it clear that this effort at deferral can be dealt with by imposing “throwback taxes.” For example, California and New York both levy a throwback tax on distributions of prior year’s accumulated income to a resident beneficiary. The idea behind a throwback rule is to allow states to target trusts that have utilized jurisdictional rules to avoid state income taxes by effectively letting the state recoup lost taxes once the state obtains jurisdiction to tax the trust.

D. S Corporation Status

If the grantor of a revocable trust, Ana in our example, owns S corporation stock in her revocable trust, then there could be a significant problem if the trust ceases to be a grantor trust due to the grantor’s incapacity because only certain trusts are permitted to be S corporation shareholders. As mentioned, when the trust is a grantor trust, it is as if the trust does not exist for federal income tax purposes. This means that an individual, the grantor, rather than a trust is the S corporation shareholder for federal income tax purposes. In this context, this is generally desirable because an individual who is a U.S. citizen or permanent resident generally is a permissible S corporation shareholder. If, however, due to the grantor’s incapacity, the shareholder subsequently becomes the trust rather than the grantor, then the corporation’s S election will automatically terminate, immediately and involuntarily, for federal income tax purposes unless the trust is a particular kind of trust that is an eligible S corporation shareholder. When S termination happens, the corporation is suddenly deemed to be a C corporation, which is subject to a second, corporate-level of taxation. Forced and unexpected S termination is a surefire way to anger the other shareholders of the S corporation.

Interestingly, the Code provides that a revocable trust, whether funded at death through the grantor’s will or during the grantor’s lifetime, remains an eligible S corporation shareholder for a full two years after the grantor’s death. If, however, grantor trust treatment ceases due to the grantor’s incapacity, the two-year grace period does not apply. This appears to be an arbitrary distinction with significant adverse tax consequences for the uninformed.

Upon termination of grantor trust status due to the grantor’s disability, the corporation’s S status generally will immediately terminate unless the trust is an Electing Small Business Trust or, alternatively, a Qualified Subchapter S Trust. One issue worth noting, with details outside the scope of this Article, is how items of income and expense will be allocated between the grantor trust and the non-grantor trust in the year when grantor trust status is terminated. Very broadly speaking, income and expenses that year are divided by the number of days in the S corporations’ taxable year. This calculation produces a per diem amount that is allocable to the shareholders on a daily basis. I note this mainly to illustrate the added complexity, in addition to the cost, that can result from an inadvertent termination of S corporation status.

1. Electing Small Business Trust (“ESBT”)

The Code requires that, to qualify as an ESBT, all beneficiaries must be eligible individuals, estates, or charities. Also, no interest in the ESBT can be acquired by purchase. The trustee makes the ESBT election by providing certain information and by submitting a letter to the pertinent Internal Revenue Service Center. Because termination of S corporation status happens immediately upon failure to meet the S corporation requirements, it makes sense for the trustee to make the ESBT election in anticipation of an expected incapacity of the grantor, assuming that the grantor’s mental decline is gradual. This is obviously not possible when the incapacity is sudden and unexpected.

Upon making the ESBT election, the ESBT becomes the taxpayer and it is taxed at the highest federal tax rate (currently 37 percent) with respect to the stock of the S corporation regardless of whether any trust income is actually distributed to the beneficiaries. This is potentially a serious adverse income tax effect that would have the greatest impact in situations in which the recipients, individually, are in lower income tax brackets than the trust. If a revocable living trust is acting as a substitute for a will, the beneficiary typically will be the grantor, which means that ESBTs are likely to have the greatest adverse effect from a tax perspective on grantors who are in income tax brackets that are lower than the highest income tax bracket. That said, there may be additional income beneficiaries as well.

2. Qualified Subchapter S Trust (“QSST”)

Unlike an ESBT, which may have multiple beneficiaries, a QSST can only have one income beneficiary. With a QSST, no corpus of the trust may be distributed to anyone apart from that one beneficiary. If a revocable living trust is acting as a substitute for a will, that one beneficiary is likely to be the grantor. The beneficiary’s income interest must terminate upon the earlier of the death of the beneficiary or the termination of the trust, and if the trust terminates before that beneficiary’s death, all assets of the trust must pass to that beneficiary. The income beneficiary of the trust (again, most commonly the grantor if it is a revocable living trust) must make a QSST election, and as part of making the election must agree to be directly taxed on the QSST’s share of the income of the S corporation.

Because we are dealing with a situation involving the incapacity of the grantor and an immediate termination of S corporation status as a result of a loss of the power to revoke due to the incapacity, the election ideally would be made by the grantor in anticipation of that person’s expected incapacity, assuming that the grantor’s mental decline is gradual. It also presumably could be made by the grantor’s agent under a power of attorney if the impending incapacity is gradual. As with an ESBT, this is obviously not possible when the incapacity is sudden and unexpected. The QSST election is made by filing a statement with the Service that contains certain required information. The normal result of the QSST election is that all S corporation income from the QSST is taxed directly to the beneficiary.

A significant issue with a QSST is the requirement that each year all income must be distributed to the beneficiary. Assuming that the sole income beneficiary is the grantor, that may force a distribution to the grantor when she doesn’t need or want the distribution. In addition, the limitation to having only one beneficiary is a serious limitation that may work against broader estate planning goals, such as a desire to make transfers to other beneficiaries during the lifetime of the grantor.

E. Life Insurance

It is worth identifying a special situation that would apply if the revocable trust happens to own a life insurance policy on the life of the grantor or the grantor’s spouse. The Treasury Regulations and the Code expressly indicate that grantor trust status results if the trust income may be applied to pay premiums of life insurance on the grantor’s life. This would appear to mean that, despite the grantor’s loss of a power to revoke due to incapacity, the fact that a trust owns life insurance on the grantor’s life can act as a kind of “saving device” that would allow the trust to continue to be taxed as a grantor trust. The rules are not exactly clear, and there is also the possibility that, even if the trust does not own the policy, if the trust merely has the express power to purchase a policy and to pay premiums on the policy, it may cause the trust to be taxed as a grantor trust despite the grantor’s incapacity. On the other hand, there is some support for the notion that grantor is only taxed as the owner to the extent that income actually is used to pay life insurance premiums.

F. Sale of Principal Residence

Under current law, a person who sells his or her principal residence may exclude up to $250,000 of gain from that sale from income if, for at least two of the five years preceding the sale, the seller (1) owned the property and (2) used the property as his or her principal residence. This rule applies to exchanges of property in addition to sales. The amount of gain that may be excluded from the sale is double (i.e., $500,000) for sellers who are married filing jointly.

Now suppose Ana in our example had been living in her house for 20 years, and the home had appreciated in value by $200,000 during that 20-year time period. Also suppose that many years ago, as part of her estate plan, she transferred title to the home to her revocable living trust. If, shortly before her incapacity, she decides to sell her home, none of the gain will be taxable. This is because, for federal income tax purposes, the trust essentially does not exist. Simply stated, a grantor is treated as owning a residence owned by the grantor’s grantor trust for purposes of satisfying the two-year ownership requirement. This means that the residence is treated as if it were owned by Ana for purposes of the sale, despite being legally owned by her revocable trust. This definitely is the result if Ana is not incapacitated and holds a power to revoke.

Now suppose that, instead, Ana became incapacitated over three years before the sale as a result of a stroke. After three years of hoping that she will recover, her son Marcos, the trustee, has the trust sell her residence. Assuming that Ana’s incapacity means that she cannot revoke the trust, it ceased to be a grantor trust over three years ago. Non-grantor trusts that own real estate are not independently eligible for the gain exclusion that can apply to sales by individuals (including grantor trusts owned by those individuals for tax purposes). As a result, even though Ana has lived in the residence longer than the past five years, the gain on the sale will be fully taxable to the trust because she has not owned it at least two of the past five years. The non-grantor trust has owned it for over three of those years. 200,000 dollars of gain comfortably puts the trust into the top capital gain income tax bracket, which means that the $200,000 will be taxed at the top federal capital gain rate of 20%. That results in federal taxes of $40,000, assuming that the proceeds are not distributed out of the trust in a way so as to qualify for the distribution deduction. As mentioned, the fact that the rate is 20% is due to the compressed nature of trust income tax brackets. It is worth mentioning that, apart from the federal tax, the trust may owe state capital gains taxes as well, depending on state law. Had the exclusion of gain not been applicable and had the gain been taxable to the grantor trust because it was sold before Ana’s incapacity, then the gain likely would have qualified to be excluded from income entirely as the sale of Ana’s principal residence.

The result of this situation is that a great deal of the $200,000 of gain ($40,000 or more) will unnecessarily be lost to taxes due to the fact that Ana became incapacitated before the sale. Now, this tax can be avoided, as discussed below, by transferring the home to Ana from the trust before making the sale. This, however, is a cumbersome additional step that could scare away potential buyers in a competitive market. It is also a completely unnecessary trap for the unwary that is likely to have its greatest impact on those who cannot afford legal and tax advice.

IV. Current Ways to Avoid the Problem of Termination of Grantor Trust Status

A. In General

Given the foregoing increased taxes that will be imposed as a result of the termination of trust’s status as a grantor trust, a competent attorney will want to advise the trustee regarding ways to avoid those taxes. It can be done in nearly every case; however, doing so results in added complexity and legal fees for Ana’s family. In addition, it may result in the transfer of assets in a way that does not make sense other than for the tax benefits. I will address the ways to eliminate the additional taxes, as well as the potential problems, below.

The first increased taxes resulted from the compressed trust rate structure at the federal level. As mentioned, the way to avoid these additional taxes is to distribute that income from the trust to Ana. That will provide the trust with a full deduction of the distributable net income (DNI) from the trust. The end result is that Ana will pay taxes at her individual rate, and the trust will not pay taxes. A fundamental problem with this strategy is that, aside from the income tax benefits, it may make no sense whatsoever to distribute the income to Ana. She might have no need for the income, and it goes against her broader goal of keeping all of her assets in the revocable trust, where it will pass outside of probate at her death. The necessity of computing DNI each year, as well as filing separate trust income tax returns, is an additional step, with obvious costs, that was created solely by virtue of the fact that the trust became a non-grantor trust upon Ana’s incapacity.

Let’s turn now to changes to the trust’s situs and state taxation. While the trust is a grantor trust, its situs for state tax purposes will likely be Ana’s state of residence. Assuming that she lives in a low- or no-tax state, a challenge arises if the trust ceases to be a grantor trust and, as a result, the trust becomes subject to taxation in a high-tax state, possibly due to the fact that the trust administration or trustee’s domicile is in that other state. As with the compressed federal trust tax rates, the best approach here from a tax perspective likely will be to distribute income to the grantor/beneficiary from the trust. This may not ultimately prevent the trust income from being taxed in the state where the trustee resides, especially if the grantor lives in a state with no state income taxes, but it is the best option to try to minimize state taxes.

As to the loss of S corporation status due to the trust ceasing to be a grantor trust, the planning options are limited. If the grantor’s incapacity is coming about slowly, say as a result of a gradual onset of Alzheimer’s disease, the simplest option is to transfer the S corporation stock out of the trust prior to her incapacity. She would then own it individually, and her agent under her power of attorney could make decisions with respect to the stock during her incapacity. The downside with this approach is that income that she actually receives from the S corporation will not be in the trust unless it is transferred to the trust by the grantor shortly after the grantor receives the money. An alternate approach is to make the trust an ESBT or QSST just before the grantor’s incapacity, with the trustee or grantor making the appropriate ESBT or QSST election just before the grantor’s incapacity to ensure that there will be no point in time when the trust is not a qualified S corporation shareholder.

If the grantor’s incapacity is sudden and unexpected, the termination of S corporation status will also be sudden and unexpected. In this case, the S corporation should attach a notification to its income tax return showing that a termination has occurred and also showing the date of that termination. If this happens, it is possible for the Service to grant relief to allow the corporation to preserve its S corporation status. A key element in obtaining such relief is that the corporation must demonstrate that the termination was inadvertent. If this is demonstrated, the Service has the power to waive the termination and retroactively restore S status. To leave open that possibility, the following five elements must be met:

  1. The corporation must have previously made an S election that has terminated;
  2. An inadvertent act terminated that S election status;
  3. The Service must determine that the termination happened inadvertently;
  4. Steps must be taken within a reasonable time period to correct the terminating condition; and
  5. The corporation and its shareholders during the termination time period must agree to make any tax adjustments required by the Service consistent with S corporation status.

As mentioned, the Service determines whether a termination was inadvertent. The burden is on the S corporation to establish that, under the relevant facts and circumstances, the Service should find that the termination happened inadvertently. If the terminating event was not under the corporation’s control and was not part of a plan to terminate the election, as would seem to be the case with the sudden and unexpected incapacity of the grantor, it would tend to establish that the termination was inadvertent.

The payment of life insurance premiums by a trust creates a unique situation. The reason for mentioning life insurance is because it provides an opportunity for the informed to ensure that the trust will remain a grantor trust throughout the grantor’s life. Should the grantor want to ensure that grantor trust status continues throughout the grantor’s incapacity, the grantor could have her revocable living trust own a policy on her life. The problem with this is that the grantor may not be interested in having a life insurance policy, and there certainly are costs associated with owning life insurance.

The final issue I’ve addressed with respect to the loss of grantor trust status is the exclusion of gain on the sale of the grantor’s principal residence. The easiest way to avoid losing this valuable tax benefit is to transfer the residence to the grantor prior to the sale. There are some timing issues with this tactic, however. As mentioned, the home must be the seller’s principal residence during at least two of the last five years prior to the sale. Assuming that the grantor, either individually or through a grantor trust, had owned the residence for many years prior to termination of grantor trust status, we can easily compute how long the residence must be owned by the grantor outside the trust after termination of grantor trust status and prior to the sale. If the non-grantor trust owned the residence for three years or less, it is possible to transfer the home out of the trust to the grantor with an immediate sale by the grantor. In that case, the grantor will have owned the residence for at least two of the last five years at the time of sale. If, on the other hand, the non-grantor trust has owned the residence for more than three years, that means that for every day over three years that the non-grantor trust has owned the residence, the grantor will need to own it in her own name after distribution to her and prior to the sale to ensure that she will have owned it a minimum of two out of the last five years at the time of sale. She also may need to occupy it as her principal residence during some portion of that time period to ensure that she meets the two-year occupancy rule. This means that if the non-grantor trust has owned the residence for five years or more, then the grantor will need to own it in her own name for at least two years after it is distributed to her. She also will need to live in it for at least two years if she was not living in it while it was owned by the non-grantor trust.

The planning lesson here is that, assuming that a revocable trust that owns the grantor’s principal residence becomes irrevocable due to the grantor’s incapacity, and assuming further that there is a chance that the grantor may want to sell the residence before death, it would be wise for the trustee to transfer to residence to the grantor from the trust as quickly as possible after termination. That would provide the grantor with the most flexible path to excluding gain.

Assuming that it is impossible to exclude the gain because of an urgent need to sell the property, the planning question here is how to reduce the adverse tax consequences. In this case, the best plan is to have the trust distribute all proceeds to the grantor during the tax year of the sale. That will have the benefit of allowing the trust to deduct the amount distributed from its income. The gain will still be taxable, but it will likely be taxable at a lower rate due to the fact that trust rates are compressed as compared to individual rates.

The sad reality is that the most common way to avoid tax issues related to termination of grantor trust status is with the method suggested by Dr. Hamill: “Call a lawyer. But, until that happens, and it may not, the tax return preparer keeps reporting a grantor trust. I doubt there’s anyone to stop him.” Given that lack of capacity is not always obvious, and given that there are many potential negative tax consequences to termination of grantor trust status, I believe that Dr. Hamill is correct. Many return preparers are likely to simply ignore the issue and prepare the grantor’s tax returns as if she is not incapacitated and as if the trust remains a grantor trust. The problem is that the attorneys and accountants who regularly advise trustees have ethical duties to not knowingly further what may be viewed (at least to some) as bordering on tax fraud, assuming that the trustee knows that the grantor no longer has the mental capacity to revoke the trust. In addition, trustees have fiduciary duties, and they could be held personally liable if they knowingly file false income tax returns. In this case, they would be filing a return showing that the trust is a grantor trust when they know that its grantor trust status has terminated as a result of the grantor’s incapacity and inability to revoke the trust. This is discussed in greater detail below.

B. Ethical Issues

1. Trustee Liability

A trustee is a fiduciary who has ethical responsibilities and duties and who is potentially subject to personal liability for breaching those duties. According to the Restatement (Third) of Trusts, “A trust . . . is a fiduciary relationship with respect to property, arising from a manifestation of intention to create that relationship and subjecting the person who holds title to the property to duties to deal with it for the benefit of charity or for one or more persons, at least one of whom is not the sole trustee.” This fiduciary relationship “demands of [the trustee] an unusually high standard of ethical or moral conduct” and has been characterized as “one of highest duties of care and loyalty known in the law.”

According to the Uniform Trust Code (UTC), the trustee has a duty “to act in good faith and in accordance with the terms and purposes of the trust and the interests of the beneficiaries.” Typically, as part of the trustee’s duties, he or she is responsible for preparing and filing fiduciary income tax returns each year for a non-grantor trust. The return is due on the 15th day of the fourth month following the end of the trust’s tax year, which is April 15 for calendar year trusts.

In his thought-provoking piece, Revocable Trusts and Fiduciary Accountability, Professor McCouch correctly notes that “[t]he trustee of a revocable trust is generally protected from fiduciary liability for actions taken at the settlor’s direction or with the settlor’s approval. That protection may be vitiated, however, if the settlor lacks capacity to authorize the trustee’s actions.”

Section 601 of the UTC provides that “[t]he capacity required to create, amend, revoke, or add property to a revocable trust, or to direct the actions of the trustee of a revocable trust, is the same as that required to make a will.” The UTC also notes that “[a] settlor’s powers with respect to revocation, amendment, or distribution of trust property may be exercised by an agent under a power of attorney only to the extent expressly authorized by the terms of the trust or the power . . . . A [conservator] of the settlor or, if no [conservator] has been appointed, a [guardian] of the settlor may exercise a settlor’s powers with respect to revocation, amendment, or distribution of trust property only with the approval of the court supervising the [conservatorship] or [guardianship].” The comments to section 602 of the UTC provide further that “[a] settlor’s power to revoke is not terminated by the settlor’s incapacity. The power to revoke may instead be exercised by an agent under a power of attorney . . . , by a conservator or guardian . . . , or by the settlor personally if the settlor regains capacity.” These comments may provide some degree of comfort to a trustee who believes that, for tax purposes, an incapacitated grantor continues to hold a power to revoke. But the comments are in no way binding on the Service and should not provide much comfort to a trustee regarding the preparation of tax returns in a case when the grantor is clearly incapacitated and has no agent, guardian, or conservator. Stated differently, just because a trust may be revocable, in the sense that someday either the grantor may regain capacity or somebody may revoke it on the grantor’s behalf, that does not necessarily make it revocable for tax purposes in a particular tax year if, during that entire year, nobody has been appointed or named who actually has the power to revoke. The mere possibility that somebody might have been appointed who could have revoked the trust would appear to be insufficient to make the trust a grantor trust under section 676.

As mentioned previously, there are various degrees of incapacity, and the law should provide clearer distinctions between, on the one hand, permanent, severe incapacity, and on the other hand temporary incapacity from which the grantor is likely to recover. As has been well-stated by Professor McCouch, “Determining whether a settlor has capacity with respect to a particular transaction often raises difficult legal and factual issues, and the resulting uncertainty creates a dilemma for the trustee who must decide whether to comply with instructions given by a settlor of doubtful capacity.”

As one might imagine, the fiduciary duties of a trustee are particularly challenging if the trustee is forced to make determinations about the grantor’s capacity, especially determinations that have direct federal tax implications. The trustee of a revocable trust has ethical obligations to the grantor and, potentially, to the trust beneficiaries, which may make it very difficult for the trustee to decide to move forward with a proposed transaction. As noted by Professor McCouch,

If the trustee complies and it later turns out that the settlor lacked the requisite capacity, the trustee may be liable to the beneficiaries for a breach of trust (if the transaction was not otherwise authorized under the terms of the trust). On the other hand, if the trustee refuses to comply and it turns out that the settlor was in fact competent, the trustee may be liable to the settlor for disobeying valid instructions.

Professor McCouch also notes that, “[i]n the absence of reason for a contrary belief, the trustee is entitled to assume that the settlor has the requisite capacity.”

In their thought-provoking article, Professors David Feder and Robert Sitkoff note that, while revocable trusts are regularly used as will substitutes, the UTC ignores the fact that they “are also commonly used for incapacity planning as a substitute for a court-appointed conservator (or guardian).” This has significant implications and contrasts with the very likely intent of the grantor to avoid court involvement. Their article focuses on standing to enforce a trust in the event that a settlor becomes incapacitated.

[U]nless the settlor has named an agent under a durable power of attorney, a court-appointed conservator will be required. But because this solution requires court involvement, which a funded revocable trust is typically meant to avoid, there is reason to doubt the aptness of the will substitute model upon the incapacity of the settlor.

They argue that the beneficiaries should be given the power to enforce the trust whenever the grantor is incapacitated.

Professors Feder and Sitkoff argue that giving the beneficiaries of revocable trusts presumptive power when the settlor is incapacitated is more likely to comport with the grantor’s intent because there will be no need to go to court to give somebody standing. They also note that this is the approach that the Restatement (Third) of Trusts prescribes. According to Professors Feder and Sitkoff:

Distilled to its essence, our argument is that the settlor of a funded revocable trust typically intends more than just a will substitute. She also intends, actually or impliedly, for the trust to substitute for conservatorship. . . . To be sure, a settlor could provide expressly that the other beneficiaries would not have standing to enforce the trust during a period of the settlor’s incapacity.

In the Indiana case of Fulp v. Gilliland, the court correctly noted that “[r]evocable trusts are popular substitutes for wills, intended to provide non-probate distribution of people’s estates after their deaths, allowing them to retain control and use of their assets during their lifetimes.” The issue in that case was whether beneficiaries of a revocable trust could sue to enforce the trust during the grantor’s lifetime, while the grantor was not incapacitated. The grantor still had the full power to revoke the trust. The court correctly found that “[h]olding that trustees also owe a duty to remainder beneficiaries would create conflicting rights and duties for trustees and essentially render revocable trusts irrevocable.”

The basic idea is that a transfer to a revocable trust is treated as a lifetime inter vivos transfer, which avoids the applicability of the formalities of the statute of wills, but the transfer is subject to divestment through the grantor’s revocation. Because the trust may be revoked, the beneficiaries lack standing to sue, and the trust property is effectively treated as if the settlor owned it directly. Professors Feder and Sitkoff correctly note that an added benefit of treating the property as if still owned directly by the grantor is that it prevents “the settlor from defeating public policy limits on freedom of disposition.” Specifically, treating the trust as fully revocable and the trust assets as if they are effectively owned by the settlor prevents settlors from using revocable trusts to avoid creditors or the spousal forced share at death.

Professors Feder and Sitkoff argue quite persuasively that a revocable trust should be viewed as a conservatorship substitute in addition to a will substitute. One of the main reasons people utilize revocable trusts as will substitutes is to avoid the court-administered process of probate. The same rationale should apply to conservatorships, which are court-administered processes that apply during incapacity and that require the filing of a petition and a court determination of incapacity of the settlor. Rather than defaulting to a conservatorship as the way to enforce a trust, Professors Feder and Sitkoff argue that the default should be for the beneficiaries to have the trust enforcement power upon the settlor’s incapacity. This would merely be a presumption that could be reversed by the express trust terms. Rather than going to court to prove the settlor’s incapacity, the grantor could establish a simple method in the trust agreement to establish incapacity, such as the opinion of the settlor’s physician and, perhaps, some additional people. Professors Feder and Sitkoff readily acknowledge that their view is not the prevailing one:

All told, as of this writing twenty-six states deny beneficiary standing during the settlor’s incapacity, whereas only fourteen states recognize such standing. Four states have various idiosyncratic rules, and seven appear not yet to have addressed the issue. It would be fair to say, therefore, that the majority position codified by prevailing American law is that in the event of the settlor’s incapacity, enforcement of a revocable trust will require a conservatorship proceeding if there is no agent already authorized by a durable power of attorney . . . . The main reason for denying beneficiary standing to enforce a revocable trust upon the settlor’s incapacity is inconsistency with the nature of a revocable trust as a will substitute.

Filtering it down to their core argument, it appears that Professors Feder and Sitkoff believe that the intent of the settlor should control, and most settlors of revocable trusts would prefer to avoid court involvement during their incapacity. That could most easily be done with a default rule that would give the beneficiaries standing during the settlor’s incapacity. The majority view, however, treats a revocable trust solely as a will substitute. Because beneficiaries of wills do not have standing to enforce a will prior to a grantor’s death, beneficiaries of revocable trusts shouldn’t either. As a result, the majority view is that beneficiaries do not have such standing. An added benefit of this majority view is that it protects the rights of creditors and spouses by creating the fiction that the trust is fully revocable during the settlor’s incapacity. I say “fiction” because the only way for a settlor to revoke, assuming that the settlor has not expressly delegated the power to revoke to an agent under a power of attorney, is to ask a court to appoint a conservator and to give that conservator the power to revoke.

While the fiction of the power to revoke during incapacity may work for trust law and creditor purposes, there is no evidence that it would work for federal tax law purposes. Because income tax status is generally assessed on an annual basis as income tax returns are filed, there is nothing to prevent a trust from being a fully revocable grantor trust in year one, an irrevocable non-grantor trust in year two owing to the grantor’s incapacity, and a revocable grantor trust in year three due to the grantor’s regained capacity. That seems like the likely outcome, especially if the only grounds for claiming that the grantor has a power to revoke in year two is by asking a court to appoint a conservator and giving that person a power to revoke. If that doesn’t happen in year two, then nobody has a power to revoke that year other than at a purely theoretical level. Because of that, it seems more likely than not that the trust will lose its grantor trust status in year two. This possibility is certainly something that the trustee needs to consider.

The possibility of the trust becoming a non-grantor trust in year two creates some challenging ethical dilemmas for the trustee. Suppose that the trustee knows that the grantor is gradually becoming severely mentally incompetent. Knowing that, should the trustee take actions, such as distributing income and setting up an ESBT for example, that may not be the most desirable courses of action except for the potential tax issue? Alternatively, should the trustee hide the fact that she knows that the grantor is incapacitated, especially given the “unusually high standard of ethical or moral conduct” that applies to trustees? Does it matter if the trustee hopes that the incapacity is temporary and that the grantor will gradually regain her capacity? What if, rather than an incapacity that is likely to be temporary, it is clear that the grantor is going to be incapacitated for the remainder of her life, as was the case for Terri Schiavo? At that point, it seems particularly problematic for the trustee to hide his knowledge of the grantor’s incapacity and her inability to revoke the trust for the rest of her life.

2. Attorney’s Duties

While the trustee has the primary fiduciary duty to the trust beneficiaries, a trustee generally may choose to hire professionals, such as attorneys and accountants, to provide legal and tax advice and for assistance with preparing tax returns. An attorney hired for this purpose may be asked by the trustee to provide an opinion about the legal capacity of a grantor to amend or revoke a trust. If the attorney clearly determines that the grantor lacks the capacity to revoke, this may have broader tax implications, expanding the level of advice that the attorney will need to convey to the trustee. What duty does the attorney have in this context?

The American Bar Association’s Model Rules of Professional Conduct (MRPC) provide that “[i]n representing a client, a lawyer shall exercise independent professional judgment and render candid advice. In rendering advice, a lawyer may refer not only to law but to other considerations such as moral, economic, social and political factors, that may be relevant to the client’s situation.” Furthermore, the comments to the MRPC provide,

Matters that go beyond strictly legal questions may also be in the domain of another profession. Family matters can involve problems within the professional competence of psychiatry, clinical psychology or social work; business matters can involve problems within the competence of the accounting profession or of financial specialists. Where consultation with a professional in another field is itself something a competent lawyer would recommend, the lawyer should make such a recommendation. At the same time, a lawyer’s advice at its best often consists of recommending a course of action in the face of conflicting recommendations of experts.

A fair reading of this rule and the comments would indicate that an attorney will likely need to advise a trustee client that there is a legitimate possibility that the trust is a non-grantor trust for federal income tax purposes during any period of the grantor’s inability to revoke due to incapacity. As to whether the grantor is incapacitated or not, it is likely to be necessary to seek the opinion of other professionals, such as medical experts.

3. Accountant’s Duties

In most cases, a fiduciary will likely hire one or more tax professionals to give tax advice and to assist with the preparation of trust income tax returns, if necessary, and tax returns for an incapacitated grantor. While a detailed analysis of the ethical rules applicable to accountants is beyond the scope of this Article, it is worth noting that three prominent promulgations potentially impact tax professionals, as well as their clients, from an ethical standpoint: (1) the Association of International Certified Professional Accountants’ (AICPA’s) Statements on Standards for Tax Services (the Standards), (2) the Service’s Circular 230, and (3) relevant penalty provisions in the Code. The Standards apply only to AICPA members, while Circular 230 applies to anybody who practices before the Service.

The Standards provide the following statement regarding the preparation of tax returns by AICPA members:

5. If the applicable taxing authority has no written standards with respect to recommending a tax return position or preparing or signing a tax return, or if its standards are lower than the standards set forth in this paragraph, the following standards will apply:

(a) A member should not recommend a tax return position or prepare or sign a tax return taking a position unless the member has a good-faith belief that the position has at least a realistic possibility of being sustained administratively or judicially on its merits if challenged.

(b) Notwithstanding paragraph 5(a), a member may recommend a tax return position if the member (i) concludes that there is a reasonable basis for the position and (ii) advises the taxpayer to appropriately disclose that position. Notwithstanding paragraph 5(a), a member may prepare or sign a tax return that reflects a position if (i) the member concludes there is a reasonable basis for the position and (ii) the position is appropriately disclosed.

In essence, this means that an AICPA member must believe in good faith that his or her position regarding grantor trust status has a “realistic possibility” of being sustained by the Service in an audit. This seems unlikely if the member is taking a position that would require an obviously incapacitated grantor to be able to revoke the trust. Alternatively, the member can take the position provided that he or she has a “reasonable basis” for taking that position and discloses that the position is being taken on the tax return. Either option would appear to require some deeper level of inquiry into the legal capacity of the grantor. This would presumably involve an inquiry with an attorney who, in turn, would likely consult with a medical professional.

Circular 230 provides, inter alia, “A practitioner must exercise due diligence — (1) In preparing or assisting in the preparation of, approving, and filing tax returns, documents, affidavits, and other papers relating to Internal Revenue Service matters; (2) [i]n determining the correctness of oral or written representations made by the practitioner to the Department of the Treasury; and (3) [i]n determining the correctness of oral or written representations made by the practitioner to clients with reference to any matter administered by the Internal Revenue Service.” It also notes that “a practitioner will be presumed to have exercised due diligence for purposes of this section if the practitioner relies on the work product of another person and the practitioner used reasonable care in engaging, supervising, training, and evaluating the person, taking proper account of the nature of the relationship between the practitioner and the person.” This section, which applies to anybody who practices before the Service, also would appear to require the return preparer to make a further level of inquiry with respect to the grantor’s legal capacity.

Section 6694 refers to the term “tax return preparer.” Broadly speaking, there are two types of tax return preparers: (1) those who are licensed to practice under state law as well as before the Service (these are referred to as “enrolled” tax return preparers) and (2) those who are not licensed to do so ( “unenrolled” tax return preparers). In general, “enrolled” tax return preparers include, among others, certified public accounts, attorneys who prepare tax returns, enrolled agents, appraisers, and enrolled actuaries. “Unenrolled” tax return preparers, on the other hand, are permitted to prepare returns, but they may not practice before the Service.

The Code defines a “preparer” as “any person who prepares for compensation, or who employs one or more persons to prepare for compensation, any return of tax imposed . . . or any claim for refund . . . .” Notably, the term does not include somebody who prepares a return for no compensation. Section 6694 imposes a penalty:

If a tax return preparer — (A) prepares any return or claim of refund with respect to which any part of an understatement of liability is due to a position described in paragraph (2), and (B) knew (or reasonably should have known) of the position, such tax return preparer shall pay a penalty with respect to each such return or claim in an amount equal to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim.

The penalty can be avoided if either (1) there is or was “substantial authority” for the position, or (2) the position was disclosed (and is not a tax shelter or reportable position) and there is a “reasonable basis” for the position. This, once again, would appear to require the return preparer to make a further level of inquiry with respect to the legal capacity of the grantor.

V. An Analysis of the Current Law

A. General Approach

It helps to analyze the current law, under which a revocable trust’s grantor trust status may terminate as a result of the grantor’s incapacity, under principles of equity, administrative efficiency, and neutrality.

1. Equity

“Horizontal equity” simply means that similarly-situated taxpayers should bear similar tax burdens. “Vertical equity” focuses on taxpayers who are not similarly situated and asserts that these taxpayers should bear tax burdens relative to their ability to pay.

For purposes of this analysis, let us assume that incapacity of the grantor terminates, at least for any tax years during the grantor’s incapacity, the grantor trust status of that grantor’s revocable trust. The potential for terminating grantor trust status when this happens compromises horizontal and vertical equity. I will address each in turn.

As to horizontal equity, let’s take two similarly-situated taxpayers (Similar Grantors), one of whom (Taxpayer A) puts nearly all of her assets in a revocable living trust and the other one of whom (Taxpayer B) does not have a revocable trust but utilizes a durable power of attorney. Both are unmarried, and each has one son, who will serve as her fiduciary. Also, assume that they have approximately the same net worth of $500,000, which consists of a primary residence and stock in an S corporation, a small business located in the Similar Grantors’ state of residence, as well as some publicly-traded stock. Taxpayer A’s assets are held as assets of the trust, and Taxpayer B’s assets are held in her own name. For simplicity, assume that the publicly-traded stock provides them with $20,000 of ordinary dividend income each year, and the S corporation provides them with additional ordinary income of $10,000, all of which is distributed currently by the S corporation. They both live in a state with no state income taxes (say, Texas), and their sons live in a place with a relatively high level of income taxes (say, Chicago) that taxes non-grantor trusts based on the domicile of the trustee. Simply put, these are similarly-situated taxpayers.

Now let’s assume that the Similar Grantors both become mentally incapacitated as a result of a severe stroke. Not wanting to disrupt their lives and hoping that they will recover, their sons keep them in their homes and personally hire nurses to care for them. For simplicity and ease of comparison, assume that the sons pay for everything and none of the Similar Grantors’ income is spent or distributed from the trust. After a bit more than three years, the sons move the Similar Grantors out of their respective homes and into the sons’ homes. The Similar Grantors’ homes are sold at a gain of $200,000 during the fourth year after their incapacity began.

Under the current system, Taxpayer A, the taxpayer who used the revocable trust, will likely see her income taxes increase significantly as a result of her incapacity, due to the compression of trust income tax rates. Assuming, as I have done for simplicity, that she has $30,000 of annual taxable income, the total federal income tax on that amount would be $9,245. She also will see state income tax amounts increase significantly if the trust situs for state income tax purposes changes from Texas, with no state income tax, to Illinois, with a flat tax of 6.45%. With $30,000 of ordinary income, that works out to an additional state income tax of $1,935. In addition, she likely will see the S corporation lose its S corporation status, subjecting the corporation to a higher level of taxation. Finally, there will be significant tax implications from the sale of her home. At the time of sale, she will have owned the home for less than two of the past five years for federal income tax purposes. As a result, the $200,000 of gain from the sale of the residence will be subject to income taxes. The rate for over $14,650 of capital gain income, as is the case here, is 20%, resulting in a total federal tax of $40,000. As mentioned, this assumes that no distributions are made from the trust. When the dust settles, the total taxes owed on Taxpayer A’s relatively modest income that year is $51,180.

Taxpayer B, on the other hand, will be taxed at individual rates, resulting in significantly lower taxes overall, even though she is also incapacitated. Her $30,000 in ordinary income will result in a federal tax in the amount of $3,380. There will be no state income taxes, because all income will remain in Texas. In addition, the S corporation will maintain its status as an S corporation. Very significantly, she will be entitled to exclude all of the $200,000 of gain from the sale of her primary residence because she will have owned and lived in the residence for more than two of the five years preceding the sale. In short, Taxpayer A’s assets will produce a tax liability of $51,180 that year, while Taxpayer B’s same assets will produce a tax liability of $3,380. While this could be ameliorated by Taxpayer A’s trustee making a distribution from the trust, tax issues should not force a distribution if it is otherwise preferable to keep the money in trust. In sum, Taxpayer A and Taxpayer B are treated very differently from each other for federal income tax purposes. This is a gross violation of the principal of horizontal equity.

In addition to the horizontal equity issues described above, there are vertical equity implications to the current tax treatment of incapacitated taxpayers who own assets in a revocable trust. To illustrate this, let us alter our facts and assume that another person, Taxpayer C, utilizes a revocable trust and is like Taxpayer A in every way except that she makes an additional $600,000 a year in ordinary dividend income from other publicly-traded stock that she owns (i.e., she is much richer than Taxpayer A). To keep things simple, let us assume that some of that stock is already owned by the trust, producing $20,000 per year in the trust, with the remaining stock, producing $580,000 per year, outside the trust.

Apart from the above numbers, everything is like the original example with Taxpayers A and B. Taxpayer C, just like Taxpayers A and B, has other stock that produces $30,000 in annual income ($20,000 from publicly-traded stock and $10,000 from S corporation stock), and, just like Taxpayer A, she transfers that stock to the trust. The point of these numbers is to establish that Taxpayer C is already in the top income tax bracket of 37% individually and with respect to the trust before she transfers the stock that produces $30,000 a year of ordinary income to the trust. This means that there is no added tax cost to Taxpayer C, from a tax perspective, of transferring the stock producing an additional $30,000 a year to the trust. Whether she keeps that stock in her name or holds it in trust, it will be taxed at a rate of 37%.

To see the disparity between the treatment of Taxpayer C, on the one hand, and Taxpayer A, on the other hand, it is easiest to simply reflect on the difference between Taxpayer A and Taxpayer B. As mentioned, the primary distinction between trust income taxation and individual income taxation is the compression of the trust income tax rate brackets. Specifically, trusts reach the top income tax bracket of 37% at only $14,450 of income, whereas individuals hit the top bracket at $578,125 of income. In the last hypothetical example, comparing Taxpayer A and Taxpayer B for horizontal equity purposes, we saw that Taxpayer A, who held her assets in trust, had a federal income tax of $9,245 on her $30,000 of ordinary income, while Taxpayer B, who held her assets outside of a trust, had a federal income tax of $3,380 on her $30,000 of ordinary income. This difference is primarily because most of the ordinary trust income for Taxpayer A is taxed at a federal rate of 37% due to the compression of the rates while most of Taxpayer B’s ordinary income is taxed at a federal rate of 12%. In effect, what this tells us is that the annual cost, solely with respect to the $30,000 in ordinary income, for Taxpayer A to move assets that produce $30,000 per year into trust is $5,865. Remember, it will cost Taxpayer C nothing to move similar assets producing $30,000 a year to her trust.

The point of looking at vertical equity is to observe that the impact of our current law is felt much more acutely by people who make relatively little money each year, like Taxpayer A, as compared to people who are well-off, like Taxpayer C. For Taxpayer A, who does not have much money, the decision to move stock producing $30,000 a year of ordinary income will cost her $5,865 in additional federal income taxes. For Taxpayer C, on the other hand, it will not cost anything in additional taxes to move identical assets to her trust. This distinction violates the principal of vertical equity.

2. Efficiency

“Efficiency” usually focuses on the following two types of costs: (1) indirect costs (these are expenses that taxpayers incur when they attempt to comply with the law) and (2) direct costs (these are expenses that the government incurs when it administers the tax law). Termination of grantor trust status as a result of the grantor’s incapacity has the greatest impact on indirect costs. With respect to direct costs, the primary cost inefficiency from the government’s perspective is that the taxpayer will need to file a separate income tax return for the trust that generally would not be necessary if the trust were a grantor trust, which means that there will be an additional return for the government to deal with. The primary indirect costs, on the other hand, are transaction costs that the taxpayer will incur as she, or her trustee, works to minimize the additional taxes that otherwise would be owed with respect to termination of grantor trust status. These likely would include such things as hiring attorneys and accountants to explain the implications of leaving assets in trust and to provide her with tax and legal advice regarding ways to minimize those taxes as well as the cost to transfer assets, such as the taxpayer’s principal residence and S corporation stock, out of the trust. Transfers of real estate involve legal fees for matters such as preparing deeds as well as recording fees. There may also be property tax implications. Transfers of stock involve similar costs for legal work. In addition, if income is to be distributed out of the trust each year, an attorney or accountant will need to compute the amount each year.

3. Neutrality

Tax “neutrality” suggests that the Code generally should not motivate people to alter their behavior primarily for tax reasons absent a public policy reason for doing so. Our current law regarding termination of grantor trust status due to the grantor’s incapacity fails at this. At its most basic level, the ways that can be used to mitigate or eliminate taxes, such as distributing trust income each year, as well as transferring the principal residence and S corporation stock out of the revocable trust, conflict with the grantor’s entire purpose in setting up the trust. She valued privacy and wanted to keep assets out of probate. Once the assets are distributed to her, they will lose those benefits. Even worse, because it is not completely clear under the current law if or when a grantor trust might be treated as irrevocable for federal income tax purposes and, therefore, become a non-grantor trust from a tax standpoint, the taxpayer will feel pressured to take actions to mitigate taxes when those actions may or may not be necessary.

VI. My Proposal

A. In General

For ease of reference, the current version of section 676 is pasted in its entirety below:

Section 676. Power to revoke.

(a) General rule. The grantor shall be treated as the owner of any portion of a trust, whether or not he is treated as such owner under any other provision of this part [i.e., section 641 et seq.], where at any time the power to revest in the grantor title to such portion is exercisable by the grantor or a non-adverse party, or both.

(b) Power affecting beneficial enjoyment only after occurrence of event. Subsection (a) shall not apply to a power the exercise of which can only affect the beneficial enjoyment of the income for a period commencing after the occurrence of an event such that a grantor would not be treated as the owner under section 673 if the power were a reversionary interest. But the grantor may be treated as the owner after the occurrence of such event unless the power is relinquished.

My core proposal is relatively simple. I propose that Congress amend the Code to adopt a new section 676(c) that would read as follows:

(c) Grantor’s incapacity. Absent express language in state law or in the trust agreement to the contrary, if (1) the grantor or a non-adverse party, or both, should have the power to revest in the grantor title to any portion of a trust and (2) the grantor or a nonadverse party, or both, should become mentally incapacitated and, as a result of that incapacity, should lose that power to revest in the grantor title to any portion of a trust, then the grantor shall be continue to be treated as the owner of that portion of the trust during such incapacity under Subsection (a).

Of course, I also would propose that the President should support this statutory change to enshrine it as law. Assuming that this change is made to the Code, it would also be necessary for the Treasury to enact regulations in support of this change.

If there are the political obstacles making it impossible to change the Code as I have proposed, I would urge the Treasury to enact regulations “clarifying” the current state of the law to effectively confirm what I have proposed. The current Regulations related to section 676(a) are pasted below for ease of reference:

§ 1.676(a)-1 Power To Revest Title To Portion Of Trust Property In Grantor; General Rule. If a power to revest in the grantor title to any portion of a trust is exercisable by the grantor or a nonadverse party, or both, without the approval or consent of an adverse party, the grantor is treated as the owner of that portion, except as provided in section 676(b) (relating to powers affecting beneficial enjoyment of income only after the expiration of certain periods of time). If the title to a portion of the trust will revest in the grantor upon the exercise of a power by the grantor or a nonadverse party, or both, the grantor is treated as the owner of that portion regardless of whether the power is a power to revoke, to terminate, to alter or amend, or to appoint. See section 671 and §§ 1.671-2 and 1.671-3 for rules for treatment of items of income, deduction, and credit when a person is treated as the owner of all or only a portion of a trust.

Specifically, the Treasury should add the following clarifying language to the end of the above regulation:

If, absent express language in state law or in the trust agreement to the contrary, (1) the grantor or a nonadverse party, or both, has the power to revest in the grantor title to any portion of a trust and if (2) solely as a result of the subsequent mental incapacity of the grantor or the nonadverse party, or both, the power to revest title arguably has terminated temporarily or permanently, the grantor shall continue to be treated as the owner of that portion, except as provided in section 676(b), throughout such incapacity. In effect, the trust, or such portion, shall continue to be treated as revocable if the sole basis for a change in the tax status of the trust is the incapacity of the grantor or the nonadverse party, or both. This provision is meant to clarify and confirm the principle that, absent express language in the trust agreement or state law to the contrary, a revocable trust shall continue to be a revocable trust throughout any period of the grantor’s incapacity.

B. The Benefits of my Proposal

The primary problem with the status quo is the uncertainty of the income tax effect of the incapacity of the grantor on a revocable trust. When this uncertainty is combined with a fiduciary duty on the part of the trustee that “demands of [the trustee] an unusually high standard of ethical or moral conduct” and that has been appropriately characterized as “one of highest duties of care and loyalty known in the law,” it puts trustees in an untenable position. The trustee must either hide knowledge of a grantor’s obvious mental incapacity, despite the potential for adverse income tax consequences, or make distributions solely for tax reasons, even if the trustee knows that the grantor would not want the distributions to be made. My proposal aims to free the trustee from this unnecessarily challenging situation.

The primary goal of my proposal is to provide some clarity in an area where the law is less than clear. The proposal also seeks to do this in a way that does what most grantors would have wanted when establishing the trust. This proposal allows trusts to be used to provide grantors with certainty throughout their incapacity without the need to go to court to establish that they are incapacitated. It lets the trustee administer the trust exactly as the grantor may have wanted prior to the incapacity. The trustee would not need to establish that the grantor is incapacitated, and the trustee could continue to administer the trust exactly the same as before—as a grantor trust. This provides grantors and trustees with much-needed clarity and simplicity.

This proposal defers to expressly-stated grantor intent and state law. This means that the proposal merely creates a presumption or, better said, a default rule. Should the grantor actually want the trust to convert to a non-grantor trust in the event of the grantor’s incapacity, the grantor could simply state it in the trust agreement. Similarly, should state legislators want that outcome in a particular state, they can do so by enacting a clear law that would cause that to happen to trusts located in that state.

C. The Problems with my Proposal

One obvious problem with my proposal is that default rules may be changed by individual grantors and state legislators. This can have the effect of differing outcomes in different cases and in different states, depending on where the trust is located. That said, I think it is more important that we adhere to well-established principles of trust law, such as deferring to expressly-stated grantor intent and state law, than it is to provide consistency throughout the United States.

Another problem is political in nature. While I think the best way to change the law in the area of federal income tax is to amend the Code, I recognize the difficulty of Congress passing any law in today’s challenging political climate. Because of that, it is quite possible that a proposal of this nature will never become a reality through the congressional process. It is primarily for that reason that I have offered up the possibility of having the Treasury make changes to the Regulations to effectuate the desired change. While not ideal, and while creating some risk of a successful judicial challenge, I believe it is a worthwhile and feasible back-up plan.

VII. Conclusion

This article aims to address a very specific issue that is not discussed with great frequency. The issue, however, is a real one. The law is simply not clear enough, and the outcome is potentially severe enough, that some attention is needed. My proposed change is relatively simple and, I would hope, non-controversial. Because extremely wealthy people are already in the highest income tax bracket under current law, and because the advice of legal and tax counsel is readily available to them, the proposed change will have a relatively small effect on people in that demographic. This is a problem that will more likely be faced by people of relatively moderate means. My proposed solution makes planning their final years much simpler and less stressful. It reduces overall costs and provides them with much needed certainty.

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