Grantor Trusts – Even for the Beneficiary

Take-Away: The beneficiary of an irrevocable trust can be treated as the owner of that trust for income tax reporting purposes. This grantor trust classification for the beneficiary can produce some unique advantages.

Background: Grantor trusts are an important estate planning tool, but they can admittedly be confusing when applied in various settings. The benefit is that the grantor is taxed on the trust’s income, but the trust’s assets are not included in the grantor’s taxable estate at death. These complex grantor trust rules are found in IRC 671 through IRC 679.

Basic Grantor Trust (IDGT): Grantor trusts are most frequently encountered in what is called a sale to an intentionally defective grantor trust (IDGT) for estate tax minimization purposes. They can also found with GRATs and QPRTs and ILITs. With an IDGT-

The owner of an appreciating asset sells that asset to a IDGT that the grantor created. In exchange, the grantor receives a promissory note. The sale transaction is treated as if the grantor is dealing with himself, so that no capital gain is recognized on the grantor’s sale of the appreciated asset to the IDGT.
The estate planning benefit is that the grantor takes back a promissory note that does not appreciate in value. The sale to a IDGT is, in effect, an estate freeze technique designed to reduce the grantor’s estate exposure to federal estate taxes.
In addition, because the grantor must pay the income taxes on the IDGT’s income, the grantor’s payment of the IDGT’s income tax liability reduces the size of the grantor’s estate for future estate tax minimization purposes, which is the equivalent of a tax-free gift to the IDGT’s beneficiaries, usually the grantor’s family members. The grantor’s payment of the IDGT’s income tax liability is often called an estate burn. Thus, assets held in the IDGT are permitted to grow in a tax-free environment, as the grantor is paying the trust’s income tax bill each year.
The most common mechanism used to create an IDGT is for the grantor to retain the right in the trust instrument to exchange assets of equivalent value with the trust, although there are several other provisions in the Tax Code that can cause the grantor to be taxed on the trust’s income, e.g. the trust uses its income to pay premiums on a life insurance policy that insures the grantor-settlor’s life.

Beneficiary Grantor Trust (BDIT): While called grantor trusts when the trust’s settlor is taxed on the trust’s income, a grantor trust can cause an individual who is not the trust’s settlor to be taxed on the trust’s income.

IRC 671 provides that where it is specified in IRC 673 through 679 that the grantor, or another person, shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor, or the other person, those items of income, deductions, and credits against the tax of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account in computing taxable income or credits against the tax of an individual.
Specifically, IRC 678(a) provides that a person other than the grantor will be treated as the owner of any portion of a trust with respect to which: (i) such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself; or (ii) such person has previously partially released or otherwise modified such a power after the release or modification retains such control as would, within the principles of IRC 671 to 677, inclusive, subject a grantor of a trust to treatment as the owner of the trust.
This type of grantor trust is often referred to as a beneficiary defective inheritance trust, or BDIT.
A BDIT is thus an irrevocable trust that freezes the value of assets for gift and estate tax purposes when the assets are sold to the trust by the beneficiary-seller. The big difference between an IDGT and a BDIT, is that the beneficiary-seller is eligible to receive future discretionary distributions from the BDIT. In addition, the beneficiary-seller will enjoy asset protection with regard to the assets held in the BDIT, and may even leverage the value of the asset for gift and estate tax purposes, while having no impact on the beneficiary-seller’s available federal transfer tax exemption amount.
The creation of a BDIT is fairly straight-forward. A nominal grantor of the BDIT, usually a family member of the beneficiary-seller, contributes cash of $5,000 to the BDIT, but retains no powers or control over the BDIT that would cause the BDIT to be taxed to him/her. The BDIT is structured to not cause its assets to be included in the estate of the either the nominal grantor or the beneficiary-seller. Discretionary distributions are made by an independent trustee to the beneficiaries. The BDIT instrument provides the beneficiary-seller with a withdrawal right over the initially contributed funds for a limited period, like 60 to 90 days, which the beneficiary-seller permits to lapse without exercising their withdrawal right. That withdrawal right causes the trust to be classified as a BDIT for income tax reporting purposes.
Example: An 85 year old mother creates an irrevocable trust for the benefit of her 60 year old son who owns a successful and growing closely held business. Mother transfers $5,000 in assets to the trust. Her son is given the power to withdraw $5,000 in assets from the trust for a period of 60 days. Her son, after receiving notice of the transfer of the $5,000 to the trust, lets the withdrawal right lapse. Her son will be treated as the grantor of the trust for income tax reporting purposes. Her son sells his closely held business to the trust in exchange for a promissory note. Her son does not recognized any capital gain on the sale of the closely held business, as he is viewed as entering into a transaction with himself since the trust is a beneficiary grantor trust. Unlike a IDGT, her son remains a discretionary beneficiary of the BDIT with some rights in the trust that would not be available if the son had created his own IDGT.
IRC 678 provides that a beneficiary of a trust will be considered the owner, i.e. the grantor, for federal income tax purposes of any portion of the trust that such beneficiary can independently vest in himself or herself. Because the beneficiary-seller had the ability, albeit limited to a short period of time, to withdraw the entire corpus of the BDIT, the beneficiary-seller will continue to be considered the grantor of the entire trust for federal income tax purposes even after his/her withdrawal right has lapsed.
Once the BDIT is established the beneficiary-seller sells appreciating assets, e.g. interests in a closely held business to the BDIT. The sale is in exchange for a promissory note with interest equal to the applicable federal rate of interest (AFR) at the time of the sale. This has the effect of ‘freezing’ the value of the beneficiary-seller’s estate, as an appreciating asset is exchanged for a non-appreciating promissory note. Obviously, if a minority interest in the business is the subject of the sale, valuation discounts can be claimed, further freezing the value of the beneficiary-seller’s estate, as the promissory note given to the beneficiary-seller will have a smaller face amount.
The beneficiary-seller can serve as an investment advisor of the BDIT trustee or continue on in a managerial position if a closely-held business is sold to the BDIT, and thus maintain some degree of control over the asset sold to the trust.
As noted above, the beneficiary-seller remains a beneficiary of the BDIT, such that if there is a future change in financial circumstances of the beneficiary, the assets he/she sold to the BDIT will be available to the beneficiary-seller and his/her family. In contrast to an IDGT, the beneficiary-seller of a BDIT can even maintain the right to receive mandatory income distributions from the BDIT without adverse federal estate tax consequences.
A less obvious benefit derived from a BDIT is that assets are sold to the BDIT rather than gifted to the trust. Consequently, the BDIT would not be considered self-settled for federal bankruptcy purposes. Additionally, a BDIT will not normally be vulnerable to voidable transfer claims by the beneficiary-seller’s creditor since the transfer (exchange) is for fair consideration. If the BDIT has a spendthrift provision, the beneficiary-seller’s interest in the trust should be protected in a future divorce.

BDIT Risk: The risk associated with a BDIT is that the IRS could argue that the ‘sale’ is actually a gift. If the BDIT is initially funded with only a $5,000 cash gift, and the beneficiary then sells $10 million in a closely held business to the BDIT in exchange for a $10 million face value promissory note with interest at the very low AFR rate, like today’s rate, the IRS could assert that the BDIT is too thinly capitalized to secure the payments under the $10 million promissory note. The IRS would reason that no third-party seller would accept that promissory note without insisting on adequate collateral and/or significant guarantees, or demand a much higher interest rate on the promissory note.

Example of Grantor Trust – Revenue Ruling 85-13: An early example of how a grantor trust can arise under the complex Tax Code sections was in this Revenue Ruling. An irrevocable trust was created and funded with corporate shares of stock by its settlor as a gift. The settlor’s spouse was named as trustee. Neither the settlor, nor any other person, possessed an express power over, or an interest in, the trust that would cause the settlor to be treated as the owner of the trust. When the value of the shares of stock increased, the trustee (the settlor’s wife) transferred the shares of stock to the settlor. In exchange, the settlor gave the trustee an unsecured promissory note with a face value equal to the fair market value of the shares of stock, with a reasonable interest rate on the promissory note. The promissory note called for 10 annual installment payments, commencing three years after the exchange. Less than three years later the settlor sold the stock to an unrelated party. (The corporation made no distributions with respect to the shares to the settlor prior to the sale of the shares by the settlor.) The IRS held that the owner of a grantor trust is not merely taxed on a trust’s income, but is treated as the owner of the trust’s assets for federal income tax purposes. Consequently, although the settlor did not engage in direct borrowing of the corporate shares of stock, which is one of the grantor trust retained powers under the Trust Code, his acquisition of the trust’s corpus in exchange for his unsecured note was, in substance, the economic equivalent of borrowing the trust’s corpus. As a result, the settlor was treated as the owner of the trust (represented by the settlor’s promissory note) under IRC 675(3). Because the settlor’s promissory note was the only trust asset, the settlor was treated as the owner of the entire trust. Since the settlor was considered the owner of the promissory note held by the trust, the transfer of the corporate stock by the trustee to the settlor was not recognized as a sale for federal income tax reporting purposes because the settlor was both the ‘maker’ and the ‘owner’ of the promissory note.

Example of Beneficiary Grantor Trust- PLR 202022002 (February 25, 2020): Parents created an irrevocable trust for the benefit of their children and grandchildren. The parents transferred shares of stock to the trust. The trust was divided into separate trust shares of equal value for each of their children and grandchildren through that child. The trust instrument prohibited a distribution of the shares of stock, but it did allow for the distribution of the sales proceeds from the sale of the shares of stock. After the trust was funded, the shares of stock were transferred by the trustee to an LLC, which was classified as a partnership for income tax reporting purposes. The trust shares received, in exchange, LLC membership interests. The same restrictions on the distribution of the shares of stock also applied to the LLC membership interests held in each of the trust shares. The LLC interests (consisting of the shares of stock and cash) were then transferred to a subtrust for which there was one Beneficiary. The Beneficiary possessed the authority to withdraw all of the subtrust’s assets when she attains age 40, except for the LLC interests. The Beneficiary, over age 40, exercised her withdrawal right and withdrew all of the subtrust’s assets other than the LLC units. Later, the trustee of the subtrust agreed to sell the LLC units to another Trust for cash and a promissory note. The other Trust was a grantor Trust with respect to the Beneficiary. After the sale, the Beneficiary possessed the authority to withdraw the cash and the promissory note from the subtrust. The IRS held that because the Beneficiary has a power exercisable by herself to vest the proceeds from the sale of the subtrust’s LLC interests in herself, and that those proceeds are the subtrust’s only asset, the Beneficiary will be treated as the owner of the subtrust under IRC 678. Therefore, “the sale of the subtrust’s LLC interests to the Trust will not be recognized as a sale for federal income tax purposes because the Trust and the subtrust are both wholly owned by the Beneficiary “

Conclusion: While there is some complexity and risk in setting up a BDIT, the BDIT structure can present a big upside potential. A BDIT can provide a powerful estate freeze for a wealthy individual, much like an IDGT. However, a BDIT provides an element of control over the asset that was sold that is not available with an IDGT, not to mention continued access to the transferred asset since the beneficiary-seller remains a discretionary beneficiary of the BDIT. If we see the federal transfer tax exempt drop back to a much lower amount, e.g. $5.0 million in 2026, or $3.5 million if Joe Biden takes control of the White House, many wealthy individuals may find themselves with no available ‘unified credit’ to shelter future gifts. A BDIT would provide the opportunity to continue to shift wealth to other family members through the estate burn while continuing to enjoy the asset protection features of a third-party settled discretionary trust.