Take-Away: The benefit to lifetime gifts to a non-grantor irrevocable trust have been periodically covered in the past. Why they are covered again is the threat that grantor trusts might be subject to substantial tax law changes as Congress struggles to find revenues to pay for its pandemic relief programs, and to many, a grantor trust is perceived as a tax abuse. Career politicians understand that their failure to address unemployment, medical and foods crisis caused by the pandemic may lead to a Progressive wave in the 2022 mid-term elections, so that even Republicans might find themselves voting for some revenue generating tax law changes to retain their seats in Congress. Even if grantor trusts are greatly curtailed there remain several benefits to be derived from a non-grantor trust.

Background: With any change in Presidents there comes the fear of  dramatic changes in tax laws. Added to this normal anxiety as we approach the end of 2020 are: (i) a change in the political party that will occupy the White House; (ii) the perceived unfairness that the 2017 Tax Act benefited corporations and wealthy individuals more than the ‘middle-class’; (iii) the impact that the 2017 Tax Act had on the country’s growing financial deficit; and (iv) the $8+ trillion more in debt the country incurred in its fight to minimize the damage that the pandemic has caused individual and the economy. In the campaign leading up to Presidential election, one of the targeted tax abuses noted by a couple of progressive Presidential candidates were grantor trusts and their favorable tax treatment. As such, it may be time to reconsider the benefits of a non-grantor trust, and for existing grantor trusts to possibly release the powers that cause the trust’s income to be taxed to the grantor. Some of the reasons to consider a non-grantor trust follow.

Grantor Trusts Might Become Vulnerable to Estate Tax: During 2020’s Presidential campaign many tax proposals were floated, with a proposed wealth tax getting most of the  attention. One proposed change to the existing estate tax laws would be to include the value of assets held in a grantor trust in the grantor-settlor’s estate tax base. That proposal has created concern that a grantor trust might soon become a thing of the past. Such a tax law change proposal also begs the questions: (i) if such a change is made, when the change will become effective?; (ii) whether existing grantor trusts will be grandfathered? If existing grantor trusts are to be grandfathered with a legislative change, that might prompt some individuals to create a grantor trust before 2021, since most tax law changes that are made retroactive are retroactive to the first day of the calendar year in which the legislation is passed. Suggestion: Existing grantor trust instruments, or new grantor trust instruments that are executed before 2021, should be drafted with mechanisms that contemplate the grantor trust feature will be switched off, either by a decanting, a release of the retained power or right by the settlor, or its removal through trust amendment by a trust director.

Non-Grantor Trust Helps Creditor Protection Planning: While wealthy individuals regularly implement strategies in anticipation of the need for creditor protection, that is often not the case with a modestly wealthy individual, but who may with hindsight still need some form of creditor protection. The income tax benefits afforded by a non-grantor trust (identified below, e.g. preserving the SALT income tax deduction) might provide a very good reason under Michigan’s Uniform Voidable Transactions Act why the non-grantor trust was funded when a creditor later challenges the reasons why the settlor transferred assets to an irrevocable trust.

Non-Grantor Trust Can Differentiate SLATs: One of the big challenges to the creation and funding spousal lifetime access trusts (SLATs) is to differentiate the two trusts from each other to prevent the IRS from arguing the reciprocal trust doctrine applies, which otherwise brings the value of the SLAT’s assets back into the settlor’s taxable estate. One noticeable way to differentiate the two SLATs is for one trust to be a grantor trust for income tax reporting purposes, and the other SLAT is a non-grantor trust for income tax reporting purposes in order to exploit some of the income tax advantages (admittedly few) with the use of a non-grantor trust. The non-grantor SLAT (sometimes called a SLANT, a spousal lifetime access non-grantor trust) might be created to hold real estate to take advantage of the SALT income tax deduction available to that non-grantor trust.

Non-Grantor Trust Can Maximize Tax Deductions: Some income tax deductions that are no longer available due to the doubled standard deduction amount, or which might be eliminated in the future, e.g. President-elect Biden proposes to bring back the Pease income tax deduction limitations, might be preserved through the use of a non-grantor trust. A few examples include:

  • Charitable Deductions: If the non-grantor trust holds income producing assets, that trust could make charitable gifts and obtain a charitable income tax deduction, which deduction might not be available to the trust’s settlor who more than likely will claim the standard income tax deduction and be unable to claim the charitable income tax deduction.
  • SALT Deductions: If the individual settlor intends to itemize his or her income tax deductions, the deduction is  limited to the $10,000 for state and local taxes (SALT) paid in the calendar year. If real estate is owned by a separate non-grantor trust, the real property taxes paid by the non-grantor trust will be subject to that trust’s own $10,000 limit on the real property taxes that it pays.
  • Net Investment Income Tax: The net investment income tax (NIIT) can also be avoided if the non-grantor trust’s trustee is actively involved in a business held in the trust, when that would not be the case if the settlor of the grantor trust was no longer actively involved in the business held in the trust.
  • Defer State Income Taxes: State income taxes can sometimes be avoided when a non-grantor trust is used and it accumulates income, if there is no taxable nexus between the trust and the state. This was demonstrated in the Supreme Court’s 2019 Kaestner decision which prevented North Carolina from imposing its state income tax on a trust that had virtually no connection with North Carolina, other than one trust beneficiary living in that state. With a non-grantor trust,  the recognition of taxable income for state income tax reporting purposes might be deferred for a considerable period of time. This is the reasoning behind the attraction of DING-trusts, i.e. a Delaware Income Non-grantor Trust, or DING.

SLANTs: As noted, earlier, a SLANT combines the tax benefits of a non-grantor trust, e.g. claiming SALT deductions with the flexibility of a SLAT.  Intentionally structuring the SLAT to be a non-grantor trust however will be required.

  • SLATs Normally Grantor Trusts: The settlor of a SLAT is treated as the owner for income tax purposes of any portion of the trust the income from which, without the approval or consent of an adverse party, is or may be distributed to the settlor’s spouse or accumulated for future distribution to the settlor, or the settlor’s spouse, as determined in the discretion of the settlor or an adverse party, or both. [IRC 677(a).] If the goal is to use the settlor’s currently large federal gift tax exemption to fund the SLAT, the gift to the trust must be a completed gift. The gift is complete only if the settlor has “so parted with dominion or control as to leave him or her with no power to change the disposition.” [Treasury Regulation 25.2511-2(b).]
  • Non-Grantor SLAT: There are several ways a SLAT can be structured as a non-grantor trust, i.e. the SLAT becomes a SLANT.

Use an Adverse Party for Distributions: If an adverse party must approve distributions to the settlor’s spouse, the SLAT can both provide distributions to the settlor’s spouse and still not be taxed as a grantor trust. For example, an adverse party could be the eldest remainder beneficiary of the trust, e.g. the couple’s child, since their remainder interest in the SLAT would be adverse to the spouse’s lifetime interest in the same trust.

No Reversionary Interest: The settlor cannot retain a reversionary interest or right to re-vest title to the SLAT’s assets in the settlor. If the settlor’s retained power to re-vest title to the SLAT property, or to receive distributions from the SLAT, is exercisable only with the consent of an adverse party, the SLAT will generally not be taxed as a grantor trust.

No Retention of Rights by Settlor: The settlor must neither retain the right to direct the disposition of SLAT income or property, nor the right to receive trust income, nor the right to have the SLAT pay life insurance premiums on the settlor’s behalf. [IRC 677(a)(3).]

No Discharge of Debts:  No portion of the SLAT’s income or principal can be distributed to discharge the settlor’s legal obligations, or the legal obligations of the settlor’s spouse without the consent of an adverse party. Similarly, no portion of the SLAT be used to discharge debts of the settlor or to pay the settlor’s gift or estate taxes on the settlor’s death.

No Right to Substitute Assets:  If the goal is that the SLAT is to be taxed as a SLANT, then the settlor cannot hold any power to substitute assets of equivalent value. As a result, the SLAT should be funded with high basis assets if there will be no ability to remove those assets from the trust through a power of substitution. The inability to substitute assets may be one of the major drawbacks to using a SLANT.

No Power to Lend Assets Without Adequate Consideration: Similarly, one of the other popular powers to make a trust a grantor trust, is the settlor’s the power to borrow from the trust without adequate security. This provision will also be absent if the goal is to make the SLAT a SLANT.

Conclusion: Many married couples are adopting SLATs as 2020 comes to a close in anticipation of major tax law changes coming in 2021. The tax benefits of a non-grantor trust should not be overlooked, even when the motivation is to create and fund SLATs to utilize the spouses’ available  large federal gift and GST tax exemptions. There are both good and bad features to a SLAT that need to be considered, and in some situations, a SLANT might be a better choice, at least for one of the two spouses.