Take-Away: Existing non-grantor irrevocable trusts can be converted to grantor trusts for income tax reporting purposes either through a trust modification proceeding or the exercise of a decanting power held by the trustee. Such a conversion would enable to settlor to substitute low basis assets held in the trust with high basis assets held by the settlor without any tax consequence. The result is to expose those low basis assets to  an income tax basis adjustment upon the settlor’s death.

Background Problem:  Suppose an irrevocable non-grantor trust was created several years ago, when the federal estate tax exemption was much lower, in order to shift a parent’s wealth for the benefit of children and grandchildren, and to avoid the parent’s exposure to federal estate taxes. Those trust assets have substantially increased in value over the years, thus exposing those assets to capital gain taxes when they are liquidated by the trustee. But now the settlor’s estate tax exemption is above $11 million. All of which causes, with hindsight, wishful thinking that this planning step could be revisited, in order to expose the appreciated trust assets to a step-up in income tax basis on the settlor’s death.

Solution: There is authority that a later conversion of a funded irrevocable non-grantor trust to a grantor trust should not cause adverse income, gift, estate, or generation skipping transfer tax results.

Background:  If the trust settlor retains the power to exchange or substitute assets with the trust for substantially equivalent value, the trust is a grantor trust for income tax reporting purposes. [IRC 675(4)(C).] If the trust is a grantor trust, the settlor is responsible to pay the income taxes incurred by the trust. The Service has held that the settlor’s payment of the income tax liability is not a taxable gift to the trust beneficiaries. [Revenue Ruling 2004-64.] In addition, if the settlor holds this power over the grantor trust the existence of this ‘swap power’ will not cause estate tax inclusion of the trust assets in the settlor’s estate. [Revenue Ruling 2008-22.]

Consequently, if the trust is classified as a grantor trust for income tax reporting purposes, the settlor can at any time substitute low tax basis assets held in the trust for high tax basis assets held by the settlor, such that upon the settlor’s subsequent death those low basis assets will be subjected to a basis adjustment (upward, hopefully) because those low basis assets will be included in the settlor’s taxable estate. [IRC 1014(a).] The settlor could also use a promissory note to be exchanged for the low basis assets held in the trust so long as the note carries fair market interest, and probably the note should be adequately collaterized as well, but the trustee will have to assure itself that the promissory note is, in fact, equivalent in value to the assets that are being transferred to the settlor.

If the trust is a non-grantor trust, this opportunity by the settlor to ‘swap’ assets of equivalent fair market value will be unavailable. Hence, the desire to convert the non-grantor trust to a grantor trust in order to move the low-basis assets out of the trust and back into the settlor’s taxable estate.

Converting a Non-Grantor Trust to Grantor Trust: There are two basic ways to convert a non-grantor trust to a grantor trust.

Modification: Under the Michigan Trust Code an irrevocable trust can be modified to add the power to substitute assets of equivalent value. But the settlor cannot be a party to the modification proceeding. The petition to modify the trust must be initiated either by the trust beneficiaries or the trustee. The Trust Code also permits a modification of the trust instrument even if the amendment results in a departure from the trust’s material purposes. [MCL 700.7411- consent by beneficiaries; MCL 700.7412 – unanticipated circumstances; or MCL 700.7416 – to further the trust’s tax planning objectives.]

The primary limitation if the trust instrument is modified to convert it to a grantor trust is that the substitution power that is added to the trust cannot be exercised in a manner to that shifts benefits among the trust beneficiaries. [Revenue Ruling 2008-22.]

Probate court approval of the modification of the trust should be obtained for a couple of reasons. First is that it will provide proof that the change is authorized by law. Second, it also provides the optic of permanence to the change to the trust.  In addition, it is possible that the probate court approval might (no guarantee) bind the IRS for some purposes, since the operative event for tax purposes, the settlor’s death with respect to estate tax inclusion of the substituted assets,  has not yet occurred. [Revenue Ruling 73-142.]

In sum, an irrevocable trust instrument can be modified to add provisions that will cause the trust to be converted to a grantor trust, which will enable the settlor to move appreciated assets back into the settlor’s taxable estate for purposes of an income tax basis adjustment on the settlor’s death.

Decanting: The trustee could also exercise its statutory decanting power under the Michigan Trust Code to add a provision to the trust instrument that grants the power of substitution to the settlor. [MCL 700.7820a(7.)] Arguably such an addition to the trust instrument would be in the nature of an administrative provision to the trust that would not impact the beneficial interests of the trust beneficiaries. While no court hearing is required if the trustee exercises its power to decant the assets to a ‘new’ trust created by the trustee, just a notice of 63 days to the trust beneficiaries, probably obtaining a probate court order approving the decanting to the ‘new’ trust with the power of substitution held by the settlor would be wise for the ‘optic’ reasons noted above. [See also BNA Tax Management Portfolio Trust Decanting No. 871-1st, Section D.3(b).]

Conclusion: Not every trust should be a grantor trust. But for those trusts that were created long ago which have successfully grown in value, some thought should be given to converting those non-grantor trusts to grantor trusts not only for the income tax reporting treatment, where the settlor’s payment of the trust’s income tax liability is not treated as a taxable gift to the trust beneficiaries, but also to substitute high basis assets for low basis assets held in the trust to expose those low basis assets to an income tax basis adjustment on the settlor’s death.