The Grantor Trust Rules and their Implications

May 19, 2009

Presented by:

Philip A. Di Giorgio, Esq.& Louis W. Pierro, Esq.

Introduction

While all men (and women) may indeed be While all men (and women) may indeed be created equal, all trusts are not created created equal, all trusts are not created equal, at least for tax purposesequal, at least for tax purposes

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Introduction to Grantor Trusts

The income, deductions and credits of some trusts are attributable to grantors

These trusts are known as “Grantor Trusts”

(IRC § 671)

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Motivations for Grantor Trusts

Disparity between tax rates for trusts and individuals– Example: 2009 the top tax rate of 35% is applicable to

married couples filing jointly with taxable income of $372,950 or more whereas, in 2009 the top income tax rate of 35% kicks in for trusts with taxable income of $11,150 or more!

Permit the assets of a trust to grow tax free for the benefit of the beneficiaries with the income tax instead being borne by the grantorDesire to avoid the recognition of taxable gains in transactions between the grantor and a grantor trust

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Income Tax Filing Requirements

Any taxable income; or

Gross income of $600 or more

In general, the trustee of a grantor trust must obtain an EIN for the trust and file an I.R.S. Form 1041 for a trust if the trust has either of the following:

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Income Tax Filing Requirements

In some cases the trustee of a grantor trust may not need to obtain an EIN number or file a tax return

(See Treas. Reg. 1.671-4 for a description of optional filing methods for grantor trusts.)

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7 Statutory Triggers for Grantor Status

1. Reversionary Interest in Excess of 5%2. Power to Control Beneficial Enjoyment3. Certain Administrative Powers4. Power to Revoke5. Income for Benefit of Grantor6. Person other than Grantor Treated as

Substantial Owner7. Foreign Trusts Having One or More U.S.

Beneficiaries

(IRC § 673 thru 679)7

Basic Categories of Grantor Trusts

Revocable Living Trusts (RLT’s)

Irrevocable Trusts Included in the Grantor’s Estate for Estate Tax Purposes

Intentionally Defective Grantor Trusts (IDGTs) Excluded from the Gross Estate

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Revocable Trusts (RLTs)

Having a Revocable Trust is like having an alter ego

RLT

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Revocable Trusts (RLTs)

All revocable trusts are classified as grantor trusts

The income, deductions and credits of a grantor trust are attributable to the grantor

Sale of residence by RLT will require grantor to report a capital gain, but grantor will be entitled to claim IRC § 121 exclusion from capital gain

Decedent’s estate may elect to have RLT treated as part of the estate for a limited period of time following decedent’s death

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Irrevocable Trusts

Common factors which will cause a Trust to be included in a Grantor’s estate for estate tax purposes- Grantor retains the right to possess or enjoy

transferred property for life - Grantor retains right to income from

transferred property for life- Grantor retains the right to designate who will

possess or enjoy the transferred property- Grantor retains the right to alter, revoke or

amend the trust

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Irrevocable Trusts

– Grantor retains a reversionary interest in excess of 5% of the value of the transferred property as of the date of death

– Grantor deemed to have general power of appointment over trust assets

– Grantor has retained an incident of ownership over an insurance policy transferred to a trust

– Grantor transfers or otherwise relinquishes any of the aforementioned powers within three years of death

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Examples of Irrevocable Trusts Included in Gross Estate

Grantor Retained Annuity Trusts (GRAT’s)

Qualified Personal Residence Trusts (QPRT’s)

Charitable Lead Annuity Trusts (CLATS)

Irrevocable Medicaid Trusts with Retained Income Trusts

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Treatment of GRATs

GRAT treated as a grantor trust as to income because GRAT payments must be made from trust income

GRAT treated as a grantor trust as to principal if grantor retains testamentary power to appoint accumulated capital gains

Retention by grantor of reversionary interest having value in excess of 5% of GRAT at time of transfer makes trust a grantor trust as to principal

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Treatment of GRATs

If GRAT is treated as grantor trust, then there will be no recognition of gain in regard to transfers between the grantor and the GRAT

If grantor does not survive trust term, the assets of the GRAT will be included in the grantor’s estate

The method of calculating the portion of the GRAT included in grantor’s estate is set forth under Treas. Reg. 20.2036-1(c)(2)

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Treatment of QPRTs

All income of a QPRT must be paid to the grantor All QPRTs are grantor trusts as to incomeQPRT in which the grantor has retained a testamentary power of appointment over principal or a reversionary interest in excess of 5% of QPRT, will be a grantor trust as to principal In the event that the grantor does not survive the trust term, the assets of the QPRT will be included in the grantor’s estate

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Treatment of CLATs

Grantor of CLAT may only claim income tax deduction for assets transferred to CLAT if trust is a grantor trustIf CLAT is a grantor trust; income of CLAT is attributed to grantor CLAT may be included in grantor’s estate if grantor does not survive trust term and transfer is deemed not to be a completed gift, or if grantor retains too much control over charitable beneficiary

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Treatment of Medicaid Trust

Trust with retained income in grantor is grantor trust as to income Medicaid trusts can become grantor trusts as to principal by giving grantor a testamentary special power of appointment (SPOA) over corpusRetained SPOA has convenient side effect of making transfers to such trusts incomplete gifts for gift tax purposes Such a trust is included in grantor’s estate

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Intentionally Defective Grantor Trusts

Grantor Trusts Excluded from the Gross Estate - commonly known as IDGTs

Trusts designed as IDGTs include:– Irrevocable Life Insurance Trusts (ILIT’s)– Dynasty or Generation Skipping Transfer Tax

(GST) Trusts

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IDGT No Recognition of Asset Gain

In general, assets transferred to a grantor trust retain the character and tax basis for income tax purposes, as they had in the hands of the grantor just prior to the transfer

A notable exception to this rule is the case of Rothstein v. United States, 735 F. 2d 704 (2d Cir. 1984)

However, the IRS indicated it will not follow Rothstein in Rev. Rule. 85-13, 1985-1 CB

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What does this mean for taxpayers?

Taxpayers may generally rely on Revenue Rulings published in the Internal Revenue Bulletin

In addition some commentators have indicated that IRS decision not to follow the Rothstein case in IRS Rev. Rul. 85-13 will be applied by the IRS even in the second circuit where the Rothstein case was decided

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Irrevocable Life Insurance Trusts

ILITs are one of the most common Intentionally Defective Grantor Trusts in use

Transfer existing life insurance policy to ILIT or gifting cash to enable the trustee to pay premiums on new policy

Goal - assets excluded from grantor’s estate

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ILIT as Grantor Trust

Retention by grantor of a power to substitute property of equivalent value for trust property may trigger grantor trust statusPower to substitute held by grantor in a fiduciary capacity will not cause estate tax inclusion but will not trigger grantor trust statusIn a recent ruling IRS held power to substitute retained by grantor in a non-fiduciary capacity, would not cause inclusion in grantor’s estate Withdrawal power would ordinarily make beneficiary a grantor, as to the portion of the trust over which power is heldBeneficiary will not be treated as grantor, if trust is already being treated as grantor trust as to grantor

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Exchanging or Transferring a Policy

If the goal is simply to retire an insurance policy which has outlived its usefulness in exchange for a policy of similar value which is more in tune with the current needs of the trust an IRC § 1035 exchange may be appropriateIf insurance policy has accumulated significant cash value, the trustee must seriously consider the transfer for value rule which could require recognition of income by the grantor upon the sale of the policyIn order to avoid transfer for value rule, consider sale of policy to a grantor trust

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Dynasty Trusts (GST)

Commonly used for generation skipping transfer tax planning

Transfers of assets by gift or sale to a GST trust are like transfers to a GRAT in that both techniques are referred to as an “Estate Freeze”

Success of GRAT tied to ability of GRAT assets to out perform IRC § 7520 rate

Success of sale to GST trust depends on ability of trust assets to out perform the applicable federal rate in effect at the time of transfer

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Dynasty Trusts (GST)

As is the case with GRATs, if a GST trust, is designed as a “grantor trust” for income tax purposes, a sale by the grantor to that trust will not be recognized for tax purposesUnlike the GRAT a transfer to a GST trust designed as an IDGT can be used as an effective generation skipping transfer tax planning toolIn contrast to GRAT, if grantor dies during term of note issued by GST trust, only the balance of note & any accrued interest will be included in grantor’s estateUnlike the GRAT or the QPRT, it is hoped the GST trust will last for generations

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Tax Basis of Transferred Assets

Assets transferred gratuitously to a grantor trust have the same tax basis in the hands of the trustee immediately after the transfer as they did in the hands of the grantor immediately before the transfer.

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Relieving Income Tax Burden

Release of grantor trust power by the grantor can cause adverse tax consequences when the trust holds assets subject to debt in excess of basis A disinterested party, such as a trust protector, can be granted the power to toggle off the grantor trust provisions without triggering adverse tax consequencesOne safe (though expensive) way to toggle grantor trust provisions back on once they have been toggled off, or add them where they previously did not exist, would be through a trust reformationA disinterested trustee could be given the discretion to reimburse the grantor from trust assets for the amount of income tax attributable to the grantor from the trust

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Tax Consequences of Termination

Release of Grantor Trust Powers During the Grantor’s Lifetime:

Grantor will be required to recognize gain to the extent that the balance of any debt deemed to be assumed by the trust exceeds the grantor’s adjusted basis in the trust at the time the trust ceased to be a grantor trust

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Termination Due to Death

Grantor trust ceases to be a grantor trust upon the death of the grantor

The tax consequences of the death of the grantor while a note issued by a GST trust or other IDGT is still outstanding are less universally agreed upon

Some commentators believe that the basis of the trust assets upon the death of the grantor will be the same as the trust’s adjusted basis in the assets just prior to the death of the grantor

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Termination Due to Death

Other commentators believe that trust assets should acquire a step up in basis upon the death of the grantor

Given the uncertainty of the potential capital gains which may be triggered by the grantor’s death, the best approach may be to make every effort to ensure that the note is paid off prior to the date of death

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Conclusion

The grantor trust is a powerful

estate planning tool which offers

practical and beneficial

solutions to a wide variety of

planning objectives

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Questions?

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www.PierroLaw.com