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:
- 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;
- 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;
- 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;
- 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
- 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.