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Intentionally Defective (?)

Grantor Trusts

Givner & Kaye, A Professional [email protected]

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A Professional [email protected]

What We Will Cover [Part 1]:1. How Did The Grantor Trust Rules Originate? P. 32. Common Examples of Grantor Trusts. P. 43. What Do We Usually Mean When We Say “Grantor Trust”? P. 54. Common Techniques Involving Grantor Trusts. P. 65. What Are The Ways In Which A Trust Can Be Taxed? P. 76. Benefit Of Techniques Involving Grantor Trusts. P. 87. Why Are Grantor Trusts Called (By Some) “Defective”? P. 98. Example (Diagram). P. 119. Gift Tax Issue. P. 1210. Calculations. P. 1311. What Powers/Interests Make A Trust Taxed To The Grantor? P. 1612. What Powers/Interests Make Someone Else The Owner? P. 1813. Foreign Trusts Have One Or More U.S. Beneficiaries. P. 1914. What Powers Make A Grantor Trust That Is Excluded From The Estate? P. 2015. Overlooked Consequences of Grantor Trust Status. P. 2116. Turning Grantor Trust Status On And Off. P. 2217. Proactive Use Of “Swap” Power. P. 2318. Grantor Trust Tax Return Obligation. P. 2519. Installment Sales With Grantor Trusts. P. 26

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How Did The Grantor Trust Rules Originate?Income tax rates used to be as high as 91%, so taxpayers wanted to shift income from

high bracket taxpayers to a lower bracket taxpayer while retaining controls over the trust. Theinitial tool was a revocable trust. Congress eliminated that with the earliest version of Section676, entitled “Power To Revoke.”

Then Congress added the earliest version of Section 677(b), entitled “Obligations ofsupport,” taxing the grantor to the extent that trust income is actually used to discharge a supportobligation.

The most important development was Helvering v. Clifford (1934), in which Mr. Cliffordfunded an irrevocable trust for the benefit of his wife; was the trustee; had the power to makediscretionary distributions; and received the assets back at the end of 5 years. That resulted inthe so-called Clifford regulations (1946), under which the grantor was taxed if the assets wouldrevert within 10 years or less or the grantor had any of a series of broad administrative powers.In 1954, the first modern Code adopted Sections 671 – 678.

The TRA 1976 added Section 679, taxing a U.S. grantor if a trust is a foreign trust andhas any U.S. beneficiaries. All foreign trusts were treated as grantor trusts starting in 1996.

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Common Examples Of Grantor Trusts“Living” Trusts (A.K.A. “Family” Trusts; “Revocable” Trusts; “Inter Vivos” Trusts).

Crummey Trusts.

Life insurance trusts (ILITs).

Grantor Retained Annuity Trust (GRAT) and Grantor Retained Unitrust (GRUT).

Children’s Trust (not always).

Dynasty Trust (not always).

Qualified Personal Residence Trust (QPRT).

Charitable Lead Trust (not always).

What about a Qualified Subchapter S Trust (QSST)? It’s a Section 678 trust (taxed to someone other than the grantor).

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What Do We Usually Mean When We Say “Grantor Trust”?

We are usually referring to a trust that isboth owned by the grantor for income taxpurposes and not owned by the grantor fortransfer tax purposes.

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Common Techniques Involving Grantor TrustsThe basic transaction is a transfer of an asset to a children’s trust, in

which the children’s trust is a grantor trust. Instead of, or in addition to, a children’strust there might be a (i) grandchildren’s trust; (ii) dynasty trust; and (iii) completedgift asset protection trust.

What are the assets being transferred? Real estate. Tenancy incommon interests in real estate. Limited partnership interests in family limitedpartnerships which own mostly real estate. Membership interests in LLCs whichown mostly real estate. Stock in closely held, usually “S”, corporations.

How are the assets transferred? QPRTs for principal and vacationresidences. Outright gifts. installment sales. Part-gift, part-sales. Self-CancellingInstallment Notes (SCINs). Grantor Retained Annuity Trusts (GRATs – seldomGRUTs). SCIN-GRATs. Private Annuities. Part-gifts, part-PAs/GRATs/SCINs.

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What Are The Ways In Which A Trust Can Be Taxed?

1. Simple Trust (all income must be distributed to thebeneficiary).

2. Complex Trust (trustee has discretion whether or notto distribute to the beneficiary).

3. Grantor Trust (taxed to the grantor).

4. Person other than grantor taxed (IRC Section 678).

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Benefit Of Techniques Involving Grantor TrustsEstate freeze transactions, e.g., GRATs, gifts, sales, rely on three

factors to transfer wealth to children: (i) valuation discounts; (ii)investment return in excess of the AFR or Section 7520 rate; and (iii)grantor’s payment of the income tax on the children’s trust income.

Financial projections of an estate freeze technique demonstratethat in the long run, i.e., over the life expectancy of the parent, the leastimportant of the three factors is the size of the valuation discount. Now,with the taxpayer victories in Christensen (11/13/09 8th Cir.), Petter (8/4/11 8th

Cir.), Hendrix (Tax Court 6/15/11) and Wandry (Tax Court 3/15/12), definedvalue gifts eliminate much of the concern about gift tax audit when usingdiscounts.

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Why Are Grantor Trusts Called (By Some) “Defective”? [part one]

Grantor trusts were originally used to shift taxable income tolower bracket taxpayers. The grantor trust rules were designed toprevent taxpayers from taking advantage of graduated income tax ratesby creating multiple trusts that would function as separate taxpayers,while reserving interests in or powers over the trusts inconsistent withtheir tax independence. Income tax planning was designed to avoid theimpact of those rules.

Modern estate planners use grantor trusts to shift futureappreciation in assets from the parents’ estate while forcing the parentsto pay the income taxes. So the active use of rules that were previouslyavoided has been interpreted as, somehow, being “defective”: positivelyelecting into rules that make a trust taxed to the grantor.

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Why Are Grantor Trusts Called (By Some) “Defective”? [part two]

There is one other reason why people view Grantor Trusts as, somehowdefective. This relates to the fact that the income tax laws and the transfer tax (gift, estateand generation skipping taxes) are completely different laws. As such, the concept of“ownership” is different for the two laws. Therefore, we have a trust – a grantortrust – which can be “owned” by the grantor under one law – the income tax law – and yetnot owned by the grantor under the other group of laws – the transfer tax laws. Mostlawyers and CPAs are used to situations where trusts are treated the same way for bothsets of laws.

For example, a “living” trust – while the parents are alive – is owned by theparents for both income tax and estate tax purposes. Similarly, before “modern” estate taxplanning began in roughly 1982, most irrevocable trusts were both not owned by theparents for income tax and estate tax purposes. Now, most irrevocable trusts drafted bysophisticated estate tax planners are taxed to the parents for income tax purposes and notowned by them for transfer tax purposes.

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Example

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Parents Children’s Trust

IndependentTrusteeUncle Sam

Income Producing Property

Step 1: Create Trust

Step 2:Transfer Property

Step 3: PropertyGenerates Cash flow and taxable Income

Step 4: K-1 Issued to ParentsStep 5: Parents pay income tax

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Gift Tax IssueThe IRS originally considered the parents’ payment of the income taxes on

the income of a grantor trust to be a gift to the children (the trust’s beneficiaries).PLRs 9352004, 9444033 and 9504021.

The IRS ultimately realized the error of its position, Rev. Rul. 2004-64,because the grantor, not the trust, is liable for the tax. The result is the samewhether or not there is a reimbursement provision in the trust instrument or underlocal law and, if the trustee reimburses the grantor, it is not a gift from the childrento the parents. For estate tax purposes, a reimbursement provision will not causeestate tax inclusion even if exercised unless there is an understanding between thegrantor and the trustee or other facts, e.g., the grantor’s power to remove thetrustee and name the grantor as the trustee. If there is an express or impliedunderstanding, then there will be inclusion under Section 2036(a)(1).

Having a discretionary tax reimbursement clause is still a good safety valve.

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Calculations [part 1]MarriedIndividualsFiling TrustsJoint AndReturns Estates

Taxable Income $125,000 $125,000Federal Tax* $ 37,764 $ 48,655

$ 10,891 more

*not counting exemptions

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Calculations [part 2]Starting 5% Cash and 40% InitialTrust Corpus Taxable Income Income Tax Parents’ Estate$1,000,000 $10,000,000$1,000,000 $50,000 $20,000 $ 9,980,000$1,050,000 $53,500 $21,000 $ 9,959,000$1,103,500 $55,175 $22,070 $ 9,936,930$1,158,675 $57,934 $23,174 $ 9,913,756$1,216,609 $60,830 $24,332 $ 9,889,424$1,277,439 $63,872 $25,549 $ 9,863,875$1,341,311 $67,066 $26,826 $ 9,837,049$1,408,377 $70,419 $28,168 $ 9,808,881$1,478,796 $73,940 $29,576 $ 9,779,305$1,552,736 $77,637 $31,055 $ 9,748,250

+552,736 (10 years) $630,373 (11 years) ($251,750) ( $251,750)

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Calculations [part 3]Starting 5% Cash and 40% InitialTrust Corpus Taxable Income Income Tax Parents’ Estate$1,630,373 $ 81,519 $32,607 $ 9,715,643$1,711,892 $ 85,946 $34,238 $ 9,681,405$1,786,838 $ 89,432 $35,737 $ 9,645,668$1,876,270 $ 93,814 $37,525 $ 9,608,143$1,970,084 $ 98,504 $39,402 $ 9,568,741$2,068,588 $103,429 $41,372 $ 9,527,369$2,172,017 $108,601 $43,440 $ 9,483,929$2,280,618 $114,031 $45,612 $ 9,438,317$2,394,649 $119,732 $47,893 $ 9,390,524$2,514,381 $125,719 $50,288 $ 9,340,236+1,514,381 (20 years) $1,640,100 (21 years) ($659,864) ( $659,764)

Do the parents want to now turn grantor trust status off???

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What Powers Or Interests Make A Trust Taxed To The Grantor? [part 1]

Section 673(a) reversion worth more than 5%

Section 674(a) power of disposition of income or principal exercisable bygrantor/nonadverse party without approval of an adverse party

Section 675(1) grantor/nonadverse party without approval of an adverse party to deal withor dispose of trust income or assets for less than adequate consideration

Section 675(2) grantor/nonadverse party borrow without adequate interest or securityexcept independent trustee pursuant to general lending power

Section 675(3) grantor borrows and has not repaid without adequate interest/security

Section 675(4)(A) power to vote securities in which trust’s votes are significant

Section 675(4)(B) power to control or veto trust investments when assets are stock in whichtrust’s votes are significant

Section 675(4)(C) power to reacquire trust corpus by substituting assets of equivalent value

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What Powers Or Interests Make A Trust Taxed To The Grantor? [part 2]

Section 676 grantor or nonadverse party can give assets back to grantor

Section 677(a)(1) income without approval of an adverse party may be distributedto grantor or grantor’s spouse

Section 677(a)(2) income without approval of an adverse party may be held oraccumulated for future distribution to grantor or grantor’sspouse

Section 677(a)(3) income without approval of an adverse party may be used to paypremiums on life of grantor or spouse if the trust is silent or only allowsprincipal to be used, it is not a grantor trust.

Section 677(b) income is actually applied to discharge grantor’s supportobligation

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What Powers Or Interests Make Someone Other Than The Grantor The Owner?

Section 678(a)(1) power exercisable solely by himself to vestincome or principal in himself

Example: Crummey withdrawal power. Rev. Rul. 81-6. Reg. Section 1.671-3(a)(3) suggests a fractional approach. Grantor transfers $130,000 to Trustin 2011; Child has right to withdraw $13,000 for 30 days in 2011; and thetrust earns $12,000 in 2011. Amount subject to withdrawal divided by FMVof trust X trust income = Child’s share of income: $13,000 divided by$130,000 X $12,000 = $1,000 taxable to child.

Section 678(a)(2) previously released or modified such a power andafter the release retains a Section 671-677 power

Section 678(b) Exception: doesn’t apply if the grantor is taxableComfort: PLRs 200729005 – 200729016 provide some comfort that having

Crummey powers in grantor trusts will not prevent the trustfrom being a wholly grantor trust.

Section 678(c) Only applies to extent income is actually appliedto discharge person’s support obligation

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Foreign Trusts Having One Or More U.S. BeneficiariesSection 679(a)(1) U.S. person who transfers property to a foreign trust is treated as

the owner for his taxable year of the portion of the trust attributable to theproperty if for the year there is a U.S. beneficiary of any portion of the trust.

Exceptions: Transfers by reason of transferor’s death.Transfers for fair market value.

Traps: Applies if NRA grantor becomes resident within 5 years of transfer to trust.Applies if trust later becomes a foreign trust.If someone has discretion to appoint beneficiaries, it has a U.S. beneficiary.

Presumption: U.S. beneficiary unless no income or principal may be paid or accumulatedto a U.S. person (i) during the year and (ii) on termination.

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What Powers Make A Trust Taxed To The Grantor But Keep The Trust Outside The Grantor’s Taxable Estate?

Section 674(a) Grantor/nonadverse party’s power to add a charitable beneficiary.

Section 675(2) Grantor/nonadverse party has power to allow grantor to borrowwithout paying adequate interest or security. (But requireadequate interest to avoid gift tax problem. Section 7872.)

Section 675(4)(C) Power to reacquire trust corpus by substituting assets ofequivalent value (sometimes called the “swap power”).

Section 677(a)(3) Power to use trust income to pay premiums on the life of thegrantor or spouse.

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Overlooked Consequences Of Grantor Trust Status1. Increases the phase outs of the grantor’s medical expense and itemized

deductions because they are based on AGI.

2. Grantor’s additional income can cause AMT exposure.

3. Grantor trust status can continue after technique has expired and continue toreduce grantor’s estate, necessitating a “flip switch.”

4. Grantor can be taxed on large capital gain when children’s trust sells assetsacquired by means of gift, SCIN, GRAT, private annuity, etc.

5. Children’s Trust has grantor’s basis (versus DOD FMV had asset been includedin grantor’s estate).

6. Life insurance trusts: avoid transfer for value rule of Section 101(a)(2) because agrantor trust is treated the same as the grantor.

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Turning Grantor Trust Status On and OffPLR 9304017: the IRS ruled that the trusts were grantor trusts where the

trustee had the power to add one or more beneficiaries. The trusts allowed thetrustee to renounce this power irrevocably if done so in writing, which wouldeliminate the power of control over beneficial enjoyment of trust property, whichwould “turn off” grantor trust status.

CCA 200923024 in which conversion of nongrantor trust to grantor truststatus was approved.

Mild Caveat: Notice 2007-73 – Transaction of Interest – in which options insecurities are used to manipulate taxable income.

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Proactive Use Of “Swap” Power [part 1]1. Near Death Swap To Use Section 1014 Step-Up To DOD FMV.

Mom and Dad sold Building worth $1,000,000, with basis of$100,000, to children’s trust. Dad is near death when building isworth $1,500,000. Mom and Dad exercise power under the trust andSection 675(4)(c) to exchange $1,500,000 of cash for the building.Dad dies while Mom and Dad own the Building. As a result, theBuilding now has a basis of $1,500,000. The children’s trust cannow buy the building from Mom for $1,500,000 and, of course (i)Mom recognizes no gain or loss on the sale; and (ii) the children’strust’s basis is $1,500,000.

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Proactive Use Of “Swap” Power [part 2]2. Near Death Swaps To Preserve Loss.

Mom and Dad own stock worth $1,000,000 with a basis of $2,000,000.Dad is near death. Mom and Dad exercise power under the children’s trustand Section 675(4)(C) to exchange the stock for $1,000,000 of cash held bythe children’s trust. On Dad’s death, Mom and Dad do not own the stock,so it does not “step-down” in basis to the DOD FMV.

3. Swaps Due To 3 Year Rule For Life Insurance.

Dad owns insurance policy with a face amount of $3,000,000 and a FMVof $100,000. He exchanges it for $100,000 held by his children’s trust. Thisway if Dad dies within 3 years, despite IRC Section 2035, the policy will notbe included in his taxable estate. IRC Section 2035(d).

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Grantor Trust Tax Return ObligationCertain grantor trusts may take advantage of exceptions to the fiduciary return

filing and trust TIN requirements. A TIN need not be obtained for a trust that is taxable to asingle individual as a grantor trust under §§671-679 if the Regs. §1.671-4(b)(2)(i)(A)alternative reporting method is used. Regs. §301.6109-1(a)(2). The trustee must furnishthe TIN of the person taxable as the trust owner to the payors and the trust owner mustreport the income on his individual return; no 1041 is filed. If the grantor is a trustee or co-trustee, the trustee has no further obligation. If the grantor is not a trustee or co-trustee,the trustee must furnish the grantor with a statement that: (1) shows all items of trustincome, deduction, and credit for the taxable year; (2) identifies the payor of each incomeitem; (3) provides the grantor with the information necessary to take the items into accountin preparing his return; and (4) informs the grantor that the items shown on the statementmust be included in computing the grantor's taxable income on his return. If a revocabletrust is taxable to H and W who file a joint return, the spouses may use this method. Regs.§1.671-4(b)(8). A TIN must be obtained for the trust for the first taxable year in which it isnot treated as taxable to a single individual (or spouses filing jointly) or the trustee choosesnot to report under the Regs. §1.671-4(b)(2)(i)(A) method. Regs. §301.6109-1(a)(2).”

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Installment Sales With Grantor TrustsIf the client survives to the repayment of the note, all is good.

However, if the client dies before the note is repaid, there are a great manyuncertainties. Most commentators believe that because payments from thetrust are not IRD, there is no basis for reporting the gain on a Form 1041(grantor’s death should not cause recognition of the gain from the sale).

What is the trust’s basis in the assets it purchased from the nowdeceased grantor? Section 1012 provides that it is the purchase price.Others argue for a stepped-up basis under Section 1014. Others argueSection 1015 (gift basis).

Are post-death payments on the note IRD and, therefore, taxable tothe beneficiaries when they receive the payments? Most say “no” becausethe payments would not be income to the grantor under Rev. Rul. 85-13and, therefore, could not be IRD.

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Questions and Answers

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