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

4-Feb-19

Administering a Non-Grantor Trust

Take-Away: There is a lot of talk these days about using non-grantor (irrevocable) trusts in response to the 2017 Tax Act, either to create multiple (trust) taxpayers that each can exploit the $10,000 annual SALT deduction, or to fragment and report business income which then enables each trust to claim the IRC 199A qualified business profit 20% income tax deduction. But just naming a trust as a non-grantor trust might not be enough if the trust is administered like a grantor trust.

Background: An irrevocable non-grantor trust is a separate taxpaying entity, with its own income tax rates and tax reporting obligations. [IRC 641(a).] A grantor trust is also an irrevocable trust, but its income, deductions and tax credits pass through, or back, to the settlor who created the irrevocable trust. [IRC 671.] The perceived benefits derived from using a grantor trust include: (i) the settlor can sell appreciated assets to the trust without having to recognize any taxable gain, as the grantor is treated as entering into a transaction with himself; (ii) the transferred asset to the trust, along with all future appreciation, escape estate taxation on the settlor’s death; and (iii) the income taxes that the settlor pays on the trust’s taxable income is not treated as a taxable gift by the settlor to the trust beneficiaries, which results in the trust assets growing something like a ‘tax-free’ environment. But with the recent increase in an individual’s transfer tax applicable exemption amount to $11.18 million, estate and gift taxes are far less of a concern than they once were, and now the focus is on saving income taxes, hence the second look many are giving to using non-grantor trusts as separate income tax-paying entities.

Administration: While a non-grantor trust may be created and intended to be taxed as such by its settlor, the non-grantor trust must also be administered by the trustee in a manner that conforms to non-grantor trust requirements. Failure to administer the non-grantor trust correctly however could quickly cause the trust to be classified by the IRS as a grantor trust, thus causing a far greater income tax liability for the settlor than was ever expected. This need to carefully administer the non-grantor trust correctly arises primarily from the multiple provisions under the Tax Code that can inadvertently trigger grantor trust income tax treatment. Examples of trust administration decisions that could inadvertently cause a non-grantor trust to be taxed as a grantor trust follow:

  • Sale: The trustee agrees to sell a trust asset to the settlor; that investment decision could cause the trust to be characterized as a grantor trust if, with hindsight, what the settlor gives to the trust is not of equivalent value to what the settlor received from the trust. [Treas. Reg.1.675-1(b)(2).]
  • Life Insurance: The trustee of the trust purchases a life insurance policy on the settlor’s life, or the settlor’s spouse, and pays a premium for that policy using trust assets; that trust investment decision could cause the trust to be characterized in whole or in part as a grantor trust; [Treas. Reg. 1.677(a)-1(b)(2)(iii).]
  • Loans: The trustee of the trust makes a loan to the settlor and the interest rate or security is viewed, of course with hindsight, as inadequate from a conventional business practice perspective; that trust investment decision could also cause the trust to be characterized as a grantor trust; [Treas. Reg. 1.675-1(b)(3).]
  • Distributions to Settlor’s Spouse: The trustee of the trust makes a distribution to the settlor’s spouse without the consent of an adverse party, or the trustee makes a distribution to the settlor’s spouse ignoring the need for such consent; that distribution decision could cause the trust to be characterized as a grantor trust; [Treas. Reg. 1.676(a)-1(b)(2)(i).] and
  • Implied Agreements: The trustee of the trust, or a trust protector, acts in a manner or follows a pattern of conduct that suggests an implied agreement by the trustee to benefit the settlor or which gives the settlor to control the beneficial enjoyment of the trust’s assets or income; that established pattern of behavior could cause the trust to be characterized as a grantor trust. [Treas. Reg.1.674(a)-1(a).]
  • Example: While the purchase of life insurance on the settlor’s life, a loan to the settlor, or a distribution from the trust to the settlor’s spouse all require an intent to act by the trustee, an implied agreement to cooperate with the settlor through a pattern of conduct could become an inadvertent trap. Consider the fairly recent case SEC v. Wyly, et. al, No. 1:2010cv05760- Document 622 (S.D.N.Y. 2015) which looked to a pattern of action to impute control over non-grantor trusts to their settlors. In that case 17 separate irrevocable non-grantor trusts were established. Each trust used a trust protector, none of whom were related or subordinate to the settlors as defined by IRC 672(c.) The trust protectors gave the trustees investment recommendations, after having solicited the investment opinions of the settlors, which included the trusts’ purchase of collectibles. The trustees, despite their presumed independence and freedom to exercise their discretion, inevitably followed the trust protectors’ (and indirectly the settlors’) investment recommendations. The Court imputed all actions of the trust protectors to the settlors based upon their pattern of action and conduct. What constitutes a pattern of conduct or action that permits a court (or the IRS) to ignore the language used in a trust is problematic at best, especially if a pattern of behavior in how a trust is administered by the trustee could lead to reclassifying the non-grantor trust as a grantor trust.

Conclusion: Needless to say there are several other grantor trust provisions of the Tax Code that could inadvertently cause a non-grantor trust to be reclassified as a grantor trust that might arise from how that trust is administered, e.g. the application of trust income to support the settlor’s dependent. [IRC 674(b)(1).] What is important is that how a non-grantor trust is administered by the trustee, along with many of the administrative decisions that the trustee makes, will need to be periodically reviewed but using a grantor trust perspective to determine if a violation of one of the Tax Code provisions occurred, or is about to occur. Probably the most dangerous is the optic of an implied agreement between the trustee and the settlor that arises from a pattern of conduct that attributes the trustee’s powers to the trust settlor, resulting in a conclusion that the trust should be taxed as a grantor trust.