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George F. Bearup, J.D. Senior Legal Trust Advisor

Incomplete Gifts – Part 2

Take-Away: An incomplete gift to a trust is often used as an intentional way to avoid paying a current gift tax. However, many different rules under the Tax Code are at play when a transfer is made, including the grantor trust rules, to reach this result. Various retained powers in the trust held by the settlor will cause the trust to be treated as owned by the its settlor, yet the gift to the irrevocable trust to be incomplete for gift tax purposes.

Background: Recently incomplete gifts were covered in an earlier missive that explained why they are sometimes used in estate planning. An incomplete gift can be used when the donor has no available applicable exemption amount remaining to shelter the gift from taxation, yet the goal is to ‘gift’ taxable income to others. An incomplete gift is thus used when the donor’s goal is to shift taxable income from the donor to an irrevocable non-grantor trust, such as a DING, in part to keep the settlor’s own income in a lower marginal income tax bracket. A settlor- donor’s goal may also be to expose the trust assets to a complete step-up in income tax basis on the donor-settlor’s death (while shifting reportable income away from the donor during the donor’s lifetime.) Incomplete gifts are formally described in the Tax Code when it comes to a settlor-donor’s retained interests in statutorily authorized trusts like QPRTs and GRATs. [IRC 2702(a)(3), the zero ($0.00) valuation rule for a retained interest by a trust settlor- “This subsection shall not apply to any transfer- (i) if such transfer is an incomplete gift… For purposes of subparagraph A, the term ‘incomplete gift’ means any transfer which would not be treated as a gift whether or not consideration was received for such transfer.”  The intentional creation of an incomplete gift often involves the interplay of both the gift tax rules and the grantor trust rules of the Tax Code.

Incomplete Gift Rules: What follows are the basic rules behind when an incomplete gift is made by a donor, or a settlor who funds an irrevocable trust.

  1. The federal gift tax applies whether the transfer is made  in trust or otherwise, whether the gift is direct or indirect, and whether the property is real, personal, tangible or intangible. [IRC 2511(a).] So we start with the premise than most transfers are taxable gifts.
  2. A gift is complete as to any transferred property, or part of such transferred property or interest in such property, of which the donor (or settlor) has so irrevocably ‘parted with dominion and control’ as to leave the donor (or settlor) with no power to change its disposition, whether for the donor’s (or settlor’s) own benefit or the benefit of another. [Regulation 25.2511-2(b).]
  3. However, if upon the transfer of property, whether in trust or otherwise, the donor (or settlor) reserves any power over its disposition, the gift may be wholly incomplete or partially complete and partially incomplete. This determination will depend on the facts and circumstances of the specific situation. Therefore, the donor’s (or settlor’s) transfer of a property that is subject to a reserved power will result in the examination of the donor’s (settlor’s) retained power and the scope of the power. This case-by-case analysis  often then leads in large lifetime transfers to a request for an IRS Private Letter Ruling.
  4. A gift is incomplete when the donor (or settlor) reserves the power to re-vest the beneficial title in himself. A settlor’s gift to a trust is also incomplete if, and to the extent that, a reserved power gives the settlor the power to either name new trust beneficiaries or to change the interests of the trust beneficiaries as between themselves, unless that reserved power is held as a fiduciary power that is limited by a fixed or ascertainable standard. [Regulation 25.2511-2(c).] A settlor’s retention of the power to change the beneficial interests in the trust will cause the gift to be incomplete for gift tax purposes, even though the settlor’s retained power may be defeated by the actions of third parties. Goldstein v. Commissioner, 37 Tax Court 897 (1962).
  5. A donor (or settlor)  is considered to hold a retained power if it is exercisable by the donor (or settlor) in conjunction with any person who does not have a substantial adverse interest in the disposition of the transferred property, or the income from such property. A trustee is not considered to be a person who possesses an adverse interest in the disposition of the trust property or the trust’s income. [Regulation 25.2511-2(e).] However, this Regulation does not formally define what is a substantial adverse interest.
  6. If the settlor retains a power of appointment over property that is transferred to a trust, and the trustee is directed to pay the trust income to the settlor or to accumulate the trust income in the trustee’s discretion, and the settlor retains a testamentary power to appoint the trust’s remainder interest to the settlor’s descendants, no portion of that transfer is a completed gift. If, however, the settlor had not retained a testamentary power of appointment over the trust assets, but instead provided that the remainder interest automatically goes to the settlor’s heirs, the entire transfer by the settlor would be a completed gift. [Regulation 25.2511-2(b).]
  7. The taker-in-default of an unexercised power of appointment over a trust corpus is considered to hold an interest in the trust that is adverse to the exercise of the power of appointment held by the settlor. [Regulation 25.2511-3(b)(2.)]
  8. Similarly, if an individual is a co-holder of a power of appointment over trust assets with the settlor, he/she is considered to hold an adverse interest where the co-holder may possess the power of appointment after the settlor-appointer’s death and may exercise it at that time as a general power of appointment, i.e. in favor of himself/herself, his/her creditors, his/her estate creditors, or the creditors of his/her estate. [Regulation 25.2514-3(b)(2).]
  9. If the settlor relinquishes or terminates the power to change the beneficiaries of the trust (or the transferred property) that occurs prior to the settlor’s death, that relinquishment or termination will be treated as an event when the gift is completed, thus triggering gift taxes and the obligation to report the gift by the settlor. [Regulation 25.2511-2(f).]

Grantor Trust Rules:  The role played by the grantor trust rules in funding an irrevocable trust is best described by a private letter ruling. [Private Letter Ruling 201507008 (released February 13, 2015).]

Facts: The settlor created an irrevocable trust for her benefit and her issue’s benefit. A distribution advisor under the trust instrument was given the sole discretion to direct an independent trustee (a trust company) to distribute income and principal to the settlor. The distribution advisor also possessed the sole discretion to direct the trustee to distribute income and principal to the settlor’s issue. The settlor held under the trust instrument a ‘consent power.’ With the written consent of the trust protector the settlor could appoint during her lifetime, or under her Will    a testamentary limited power of appointment) any part of the accumulated net income or principal of the trust to a private foundation and to any issue of her father. However, the settlor could not exercise the power of appointment to appoint the accumulated net income or principal to herself, her creditors, her estate or the creditors of her estate. On the settlor’s death the accumulated and unappointed net income would then be divided into equal shares for the settlor’s living children or their issue if a child did not survive. If the settlor did not have any living issue at her death, an ‘alternative mechanism’ then kicked- in, where equal shares would be created for the benefit of the living children of the settlor’s father. If there were no living issue of the settlor’s father, then the trust’s income and principal would be distributed to a private foundation. The settlor also retained the right to borrow part of the accumulated net income and trust principal, with the trustee determining the interest rate for such loan, which rate could not be less than reasonable market rates at the time the loan was made. None of the distribution advisor, the independent trustee or the trust protector were related or subordinate to the settlor, per IRC 672(c), nor could any of the successor fiduciaries be either related to or subordinate to the settlor.

Trust Ownership: To determine if a settlor is the owner of the trust’s property, the IRS will look at IRC 673 through 678 which describe various situations where the settlor, or another person, is treated as the owner of a specific portion of the irrevocable trust. A settlor is treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income is subject to a power of disposition, exercisable by the settlor or a non-adverse party, without the approval or consent of any adverse party. [IRC 674(a).]

Borrowing Power: A settlor will be treated as the owner of any portion of a trust in respect of which a power exercisable by the settlor or a non-adverse party enables the settlor to borrow the corpus or income, directly or indirectly, without adequate interest or without adequate security except where a trustee (other than the settlor) is authorized a general lending power. [IRC 675(2).]

Distributions to the Settlor: A settlor is treated as the owner of any portion of a trust if the income, without the approval or consent of an adverse party is, or, in the discretion of the settlor or a non- adverse party, may be (i) distributed to the settlor or the settlor’s spouse; or (ii) held or accumulated for future distribution to the settlor or the settlor’s spouse. [IRC 677.]

IRS Holdings: With the above provisions, it is clear that the trust created and funded by the settlor was to be taxed as a grantor trust. The IRS then reached the following conclusions.

  1. The settlor’s retained consent power over the trust income and principal as to their distribution was treated as her holding a power, exercisable by her in junction with the distribution advisor, to change the beneficial interests of the trust. The distribution advisor had no substantial adverse interest in the disposition of trust property; rather he was merely a coholder of the settlor’s consent power. “As such, the settlor’s retention of the consent power caused the transfer of property to the trust to be wholly incomplete for federal gift tax purposes.” [Regulation 25.2511-2(e).]
  2. The settlor also retained a lifetime limited power of appointment to appoint income and principal to the issue of her father or a foundation. She could only exercise the lifetime limited power of appointment in conjunction with the trust protector. However, like the distribution advisor, the trust protector was merely a coholder of the power of appointment, and as such, he had no substantial adverse interest in disposing the assets transferred by the settlor to the trust. Hence, this retained power of appointment gave the settlor the reserved power to change the interests of the trust beneficiaries. “This reserved power causes a gift to be incomplete. The retention of the lifetime limited power of appointment therefore caused the transferred property to the trust to be wholly incomplete for federal gift tax purposes.” [Regulation 25.2511-2(c).]
  3. The settlor’s testamentary limited power of appointment to appoint trust property to her father’s issue or to a foundation is also considered a retention of dominion and control over the remainder of the trust. ”The retention of this power causes the transfer to be similarly incomplete regarding the trust remainder for federal gift tax purposes.” [Regulation 25.1511-2(b).]
  4. The settlor retained dominion and control over the trust’s income and principal until the distribution advisor or the independent trustee exercised its distribution power. Consequently, the settlor’s power over the income and principal was presently exercisable and not subject to a condition precedent. “Therefore, even if either of the actions of third parties (that is, the distribution advisor or the independent trustee) could defeat the settlor’s ability to change beneficial interests, her transfer of assets to the trust was wholly incomplete for gift tax purposes.” In short, the settlor’s contribution of property to the trust was not a completed gift subject to federal gift tax purposed, even if the distribution advisor or the trustee did not go along with her distribution consent. Moreover,  any distribution from the trust to the settlor was “merely a return of the trustor’s property.”
  5. However, when there was a distribution of income or principal by the distribution advisor to any trust beneficiary other than the settlor, that was a completed gift by the settlor at the time of the distribution, as would the settlor’s lifetime exercise of her limited power of appointment in favor of a person other than herself- a completed gift of the appointed property at that time. These ‘gifts’ made from the trust would have to be reported by the settlor on her own Form 709 Federal Gift Tax Return.
  6. Finally, on the settlor’s death, the fair market value of the property still held in the trust would be includible in her taxable estate for federal estate tax purposes, since those assets were considered to remain under her dominion and control until her death. [IRC 2036, 2038.]

Conclusion: Incomplete gifts to grantor trusts are not often encountered since the goal when funding an irrevocable trust is to permanently remove assets (and future appreciation) from the settlor’s taxable estate. There are occasions, though, when an incomplete gift to a trust may make sense, either to shift income or to avoid paying to pay a 40% federal gift tax. Most often used is the settlor’s retention of a limited power of appointment to cause the transfer to the trust to be incomplete. A mistake often made in drafting a trust is to couple the settlor’s power with the consent of another, believing that the present of the ‘other’ will cause the gift to be complete. It is only in the event that the ‘other’ possesses an adverse interest in the trust will their consent to the settlor’s power be deemed sufficient for the transfer to the trust be a completed gift, if that is the intent. In the situation where the settlor has fully used his/her applicable exemption amount but does not wish to make a taxable gift, it may be better to avoid estate inclusion if the donor has exhausted his/her applicable exemption amount to simply enter into a net-gift arrangement with the donee, where the donee agrees to pay the federal gift tax due on the transfer, or if the donor is in poor health, to enter into a net-net-gift agreement where the donee agrees to pay both the federal gift tax and any potential federal estate tax (if the donor dies within three years of the gift) instead of the donor.