Grantor Trusts: Trustee Responsibilities

Take-Away: Grantor trusts are popular estate planning devices these days. The trust’s income is taxed to the grantor, but the payment of the trust’s income tax liability by the grantor is not treated as a taxable gift. Similarly, since the trust is treated as the grantor’s alter ego, the sale of appreciated assets from the grantor to the grantor trust does not cause a capital gain to be recognized. In short, the grantor is considered as the owner of the trust for income tax purposes. A grantor trust is most often created by the grantor/settlor retaining the right to substitute assets of equivalent value with the trustee. Often overlooked, however, is the trustee’s ongoing duty to administer the trust for the benefit of trust beneficiaries, notwithstanding the grantor’s retained right to substitute assets.

Background: Several different ways exist in which to create a grantor trust for income tax reporting purposes. This occurs when the trust instrument is drafted so that the grantor, or in some cases a non-adverse party, derives benefits from the income, holds the power to revoke the trust or to withdraw trust property, holds a power to control the beneficial enjoyment of the trust, holds a power to exercise some administrative powers over the trust, or retains a reversionary interest in either the trust’s income or principal. But the most popular way in which to create a grantor trust is through the use of a retained substitution power.

Substitution Power: The most widely used method to create grantor trust status is to include a power, exercisable in a non-fiduciary capacity by the grantor or any person without the approval or consent of any person in a fiduciary capacity, to reacquire the trust corpus by substituting property of an equivalent value, often called a substitution power. [IRC 675(4)(C).] The mere existence of this substitution power will cause the trust to be treated as a grantor trust for income tax reporting purposes, but it will not cause the value of the trust’s assets to be included in the grantor’s taxable estate for federal estate tax purposes. [Revenue Ruling 2008-22 and Revenue Ruling 2011-28.]
A surprise to the grantor, recently reported in an earlier missive, was when the grantor sought to be reimbursed for the income tax burden that the settlor had due to his previously created grantor trusts over 30 years old. The trustee refused the grantor’s request for a reimbursement, claiming insufficient liquidity in the trust to make the income tax reimbursement to the grantor. The grantor then filed a motion with the court to compel the trustee to make an ‘equitable reimbursement’ for the income taxes the grantor had to pay on the trusts’ income for several years. The court dismissed the grantor’s petition, finding that only a trustee or the trust beneficiaries could file a motion to modify the trust to achieve the grantor’s tax objectives. In short, the grantor did not have legal standing to seek the modification of the trust to obtain a reimbursement of $1,261,068 in income taxes previously paid. Millstein v Millstein, 2018 Ohio App. LEXIS 2493 (June 14, 2018).
Note that with currently drafted grantor trusts this may not be that big a problem since most grantor trusts give the trustee the discretion to reimburse the grantor for income taxes for which the grantor is legally liable, as authorized in Revenue Ruling 2004-64. The Millstein grantor trusts had been created long before the 2004 Revenue Ruling which authorized trustee discretion to reimburse the grantor from the trust.

Trustee Duties : What are the trustee’s duties if, in fact, the grantor actually exercises his/her substitution power? Recall that this is an irrevocable trust and the trustee’s fiduciary duties extend to the trust beneficiaries, not to the grantor/settlor. A substitution power used to create a grantor trust is not a tax gimmick. The trustee has no discretion to oppose or interfere with the grantor’s exercise of the substitution power, even if the trustee has reservations about the nature of the property that the grantor proposes to substitute for the trust’s assets. Yet the trustee does have the duty to perform all reasonable and necessary due diligence to ensure that the property to be substituted by the grantor is equivalent in value to the trust property that is to be received by the grantor.

Equivalent Value: In one unreported Michigan case the trustee refused to comply with the grantor’s exercise of his retained substitution power. That refusal by the trustee was sustained by the court because the court agreed with the trustee that the value of the property being tendered by the grantor was not equivalent to the value of the property that the grantor sought to remove from the trust. In re Dino Rigoni Intentional Grantor Trust for Benefit of Rajzer, 2015 Mich. App. LEXIS 1369 (July 14, 2015.
Unsecured Note: In another case, the trustee’s refusal to participate in the exchange of assets was sustained because the grantor only offered as the substitute asset an unsecured promissory note. In re Mark Vance Condiotti Irrevocable GST Trust, No 14CA0969 (Col. App. (July 9, 2015.)

Example: Yet an interesting example of the limits of the trustee’s refusal to cooperate with a grantor’s retained substitution power is Benson v. Rosenthal, Civ. Action No.15-782, 2016 WL 2855456 (E.D. La. 2016).

Facts: The grantor created several grantor trusts over a 5 year period for the benefit of his daughter and grandchildren. The trust instruments contained a substitution power. The trust instruments also authorized the trustee to “loan to the grantor up to 100% of the trust assets.. upon the terms and conditions as deemed appropriate by the trustee.” The grantor exercised his substitution power and indicated his intent to give the trustee an unsecured promissory note in exchange for the trust’s assets of ‘equivalent value.’ Each proposed promissory note also contained a valuation adjustment clause that provided that the face amount of the note would adjust automatically to correspond with a later determined appraised value of the trust assets received by the grantor.
Trustee Position: The trustee refused to complete the substitution of assets citing several grounds: (i) the substitution power required a simultaneous transfer of property between the trustee and the grantor; (ii) an unsecured promissory note was not an appropriate investment for the trusts; (iii) the trustee needed to independently verify the equivalence of assets to be exchanged with the grantor; and (iv) the attempted substitution was in essence a request for a loan which, under the trust instrument, the trustee possessed the discretion to deny.
Court: The court made several holdings in connection with these grantor trusts. First, the substitution power is a unilateral right to be exercised by the grantor; the exercise of that right cannot be rejected or impeded by the trustee. Second, the trustee’s only duty is to ensure an exchange of property of equivalent value, implying a simultaneous transfer is not required. Third, the trustee did not possess any discretion to delay the substitution of property during the period in which the verification of asset values was undertaken, i.e. the delay while the appraisals were obtained. Fourth, the grantor only had to certify to the trustee the equivalence in values of the trust property and the tendered unsecured promissory notes; all that was required of the grantor was that he tender the promissory notes in fulfillment of his obligation. Consequently, the grantor’s certification ensured the exchange was of equivalent value. No mention was made by the court if the unsecured promissory notes were appropriate investments for the trustee to hold, but apparently the court thought so since it ordered that the trustee exchange trust assets for grantor’s unsecured notes.

Conclusion: We can expect to see more grantor trusts used to shift wealth to younger generation family members since the grantor’s payment of the trust’s income tax liability is not treated as a taxable gift to the family members. In addition, grantor trusts can be effectively used to avoid recognizing capital gains on the grantor’s sale of appreciated assets to an intentionally defective grantor trust. But it is important to keep in mind the limits imposed on the trustee who objects when only an unsecured promissory note is offered by the grantor in exchange for trust assets. A certifications of value equivalence is apparently all that the trustee can expect from the grantor, and while holding an unsecured note may not be an appropriate investment for the trustee to hold is apparently an insufficient reason, standing alone, to oppose the proposed substitution. All that is expected of the trustee is that due diligence be performed to assure asset value equivalence. Less clear, while remaining unanswered, is how a trustee meets the income needs of the trust beneficiaries if all the trustee holds is an unsecured, interest-bearing, promissory note.