Take-Away: As previously covered, there are several estate planning strategies that can be exploited using the historically low applicable federal rates (AFRs) of interest. One strategy that should be avoided with regard to the low AFR interest rates, however, is using a promissory note with a low AFR rate of interest as a ‘swapped’ asset with a grantor trust.

Background: In the past we have covered (too extensively, some would say) the benefits of using a grantor trust. As a practical matter, any transaction between the trust’s grantor/settlor and the grantor trust are ignored for federal income tax purposes. [Revenue Ruling 85-13.] Thus, a sale to a grantor trust by the grantor will not cause any gain to be recognized, and the grantor will be required to pay the income taxes on the grantor trust’s income. The assets held in the grantor trust are not included in the grantor’s taxable estate. Prior to death, the grantor can exercise the right to substitute assets of equivalent value with the assets held in the grantor trust. The reacquired assets, if they have a low income tax basis, will then be included in the grantor’s taxable estate, but they will receive an income tax basis adjustment to the assets’ fair market value as of the date of the grantor’s death, effectively washing out any capital gain tax exposure.

Swap Power: There are many technical ways for a trust to be classified as a grantor trust. One common practice is for the grantor to retain the power to substitute assets of equivalent value with the trust’s assets. That retained power of substitution, or swap power, makes the trust a grantor trust for income tax reporting purposes. [IRC 675(4)(C).] The power of substitution must be exercised in a non-fiduciary capacity. Consequently, if the goal is to cause an irrevocable trust to be classified as a grantor trust, the power to substitute assets of equivalent value will be included in the trust instrument. The power of substitution does not have to actually be exercised for the trust to be classified as a grantor trust; its mere presence in the trust instrument is sufficient to classify the trust as a grantor trust.

  • Exercised in a Non-Fiduciary Capacity: With most grantor trusts the grantor does not act in a fiduciary capacity. However, other factors could suggest the existence of a fiduciary relationship. For example, the grantor may have transferred a minority interest of stock in a corporation to the grantor The grantor retained the majority interest in the corporate stock. Now the grantor wants to substitute assets of equivalent value with the trust for the minority stock previously transferred to the trust. The grantor may be viewed as acting in a fiduciary capacity due to the grantor’s controlling position in the corporation. In that case, it is possible that the  asset substitution will result in taxable gain recognized by both the grantor and the trust.
  • Cannot Shift Benefits: A power of substitution cannot be exercised in a manner that may shift benefits or interests in the trust among trust beneficiaries. [Revenue Ruling 2008-22.]

Exercise of Swap Power: The concern arises if the grantor actually wishes to exercise his or her retained right to substitute assets of equivalent value with the trustee. Specifically, what if the grantor proposes to transfer to the trustee a promissory note carrying a currently low AFR rate? Will that promissory note be viewed as substantially equivalent value?

  • Example: The grantor has just been diagnosed as terminally ill. Previously the grantor created and funded a grantor trust with leased commercial real estate with a low income tax basis, but which pays a strong and steady stream of rental income that is, in turn, distributed to the trust beneficiaries. The grantor exercises his right of substitution and proposes to transfer to the trust an interest- only promissory note of 20 years carrying this month’s AFR of 1.14% in exchange for the commercial real estate, which presumably will receive a step-up in its income tax basis on the grantor’s death. The trustee is not convinced that receiving a 20-year interest only promissory note paying 1.14% a year is of equivalent value, nor will the interest received equate to the rental income the trustee receives and distributes which the trust beneficiaries currently enjoy.
  • Revenue Ruling 2008-22: According to this Revenue Ruling, a trustee of a grantor trust has an affirmative duty (especially if the ‘swap power’ expressly references the Revenue Ruling) under applicable state law to take steps to protect the trust, in particular, the duty to satisfy itself if the proposed assets to be swapped with the trust’s assets are worth less than the assets that are to be swapped out of the trust, i.e. the fiduciary duty to prevent waste of trust assets.

Promissory Notes Offered in Substitution: There are just a few reported cases that have held that using a promissory note as a substituted asset for the trust’s ‘hard’ asset is permissible. [Benson v Rosenthal, 2016 Westlaw 1046126 (E.D. La. 2016). Eden v Schinazi, 2015 Westlaw 10394360, (Ga. App. 2015).]  Yet, there are other cases where the proffered promissory note to the trustee was not deemed to be of equivalent value.

  • AFR: In In re Condiotti, 2013 Westlaw 4126987 (Colo. App. 2013)  the grantor tried to substitute an unsecured promissory note of $9.5 million with an AFR interest rate of 1.27%, which paid interest only for 9 years before the promissory note ballooned and was to be paid in full at that time. The court found that the proposed note using the AFR rate was not equivalent in value to the assets held in the trust.
  • Fair Value: Another question for which there are no good answers is what is meant by substantially equivalent value. Does it mean fair market value using the willing buyer-willing seller standard used in the Tax Code, fair value, or something else? In In re Rigoni, 2015 Westlaw 4255417 (Mich. App. 2013) the trustee hired an appraiser to appraise the value of the promissory note that the grantor was offering in substitution for trust assets. The trustee’s appraiser concluded that the trustee was not a willing seller, since the settlor possessed the unilateral right to substitute assets, and therefore the proper standard to measure the value of the grantor’s proffered promissory note was fair value. The Michigan Court of Appeals agreed that ‘fair market value’ was not the proper standard to measure the value of the proposed promissory note because the trustee-seller was not a willing seller. If fair value is the standard to be used to value the proposed promissory note offered in exchange for the trust’s assets, then some valuation discounts may not be available.

Trustee’s Duty: The grantor’s exercise of his or her retained right to substitute assets of equivalent value is when friction often arises. The grantor selected the trustee of the grantor trust and expects that selected trustee to cooperate when the grantor exercises its rights of substitution. As the creator of the grantor trust, the grantor will consider that he or she possesses the unilateral and unchecked power to swap assets with the trust. In contrast to the grantor’s expectations, the trustee has a fiduciary duty only to the trust’s beneficiaries, and not to the grantor. If the trustee believes that the proposed asset to be substituted with the trust is not of equivalent value to what is to be removed from the trust, then the trustee has a fiduciary duty to defend the trust. This dynamic thus brings into question the standard to be applied as to what is equivalent value, if a promissory note is offered in exchange for trust assets, and how the trustee goes about implementing its responsibilities under the trust to the beneficiaries and also acts in compliance with Revenue Ruling 2008-22’s affirmative duty.

Trustee’s Checklist: If Greenleaf Trust is asked to serve as the trustee of a grantor trust, it should review the trust instrument with the expectation that someday in the future the grantor may actually exercise the grantor’s retained right to substitute assets of equivalent value. In that event, the trust instrument should anticipate and address many of the questions raised above. Some guardrail provisions that Greenleaf might insist upon in the trust instrument before it  agrees to serve as trustee of a grantor trust with a ‘swap’ power include the following:

  • Address when and how a swap power is exercisable, e.g. by an agent acting under a durable power of attorney? Does the grantor tender the asset with a qualified appraisal before the trustee must respond?
  • Address if swap power is exercisable in a non-fiduciary capacity without the consent or permission of another person who is in a fiduciary position.
  • Address what constitutes equivalent value: Is it fair market value, fair value, fair market valuation without any discounts, or some other standard?
  • Address if the exchange of assets is to occur before or after value is determined.
  • Address how disputes over equivalent value between the grantor and the trustee are to be resolved, e.g. binding arbitration.
  • Address the repercussions if the swap power is released, or expires with the passage of time or upon a specified event. Does the promissory note immediately come due if the trust ceases to be classified as a grantor trust?
  • Address if promissory notes should even be considered or treated as a substituted asset of equivalent value.
  • Address if a promissory note must require some installment principal payments.
  • Address if a promissory note offered in exchange must be secured or collateralized in some fashion.
  • Address if AFR interest rates used with the promissory note will be will be representative of equivalent value.
  • Address if a swap power is assignable by the grantor. (If the swap power comes under the control of the grantor’s creditors, must the trustee defend the trust from the creditor’s exercise of the swap power?
  • Identify if a swap power previously released by the grantor can be later restored to or ‘toggled’ back on (i.e. appointed or added by a trust director).
  • Identify if a certification process is envisioned for the trustee to follow to ascertain if what is offered by the grantor in exchange is of equivalent value.
  • Require some minimum period of time, e.g. 90 days, before the proposed swap by the grantor is effective, in order to give the trustee time to obtain an appraisal of the asset, or promissory note, that is offered in exchange for trust’s asset, as well as the appraisal of the trust’s asset that is to be exchanged.
  • Authorize the trustee to incur appraisal costs, at the trust’s expense, to evaluate the value of the assets, including promissory notes, that are offered by the grantor in exchange for trust assets.
  • Confirm that the trustee possesses the power to reinvest the trust corpus and a duty of impartiality with respect to trust beneficiaries at all times the swap power is in effect.
  • Confirm that the swap power carves out powers over life insurance on the grantor’s life and voting stock in closely held corporations [within the meaning of IRC 2036(b)] which would otherwise cause estate tax problems for the grantor.
  • Authorize the trustee to incur legal costs, at the trustee’s expense, if it concludes that what is being offered by the grantor is not an asset of equivalent value, or what is offered is contrary to the terms of the trust. These costs might include the express authority given to the trustee to petition the probate court for a determination of equivalent value, or to defend the trust if the grantor initiates litigation to compel the trustee to accept the grantor’s proffered asset or promissory note, or trust beneficiaries sue the trustee for breach of trust which they claim occurred when the trustee accepted  assets of lesser value from the grantor.

Conclusion: The currently low AFR rates of interest are extremely beneficial in many estate planning strategies these days, including sales to intentionally defective grantor trusts. However, those same low AFR rates should not necessarily be used if the grantor of a grantor trust wishes to substitute a promissory note in exchange for trust assets of equivalent value. The trustee of such a trust will be expected to defend the trust if the grantor fails to meet his or her burden of showing that what is offered is of equivalent value. While many estate planning attorneys draft trusts intended to be grantor trusts by including the power to substitute assets of equivalent value, they seldom expect that the grantor will actually exercise that retained power of substitution. In contrast, the trustee of the grantor trust has to assume that at some point in the future the grantor will actually exercise the right of substitution, and the trustee needs to be prepared for the multitude of questions and concerns that arise with the exchange of assets with the trust, and in particular if the grantor wishes to exchange assets for a low-interest promissory note.