Take-Away: In the past the income and estate tax benefits of a grantor trust have been covered. Also previously covered is the fact that most spousal lifetime access trusts (SLATs) are grantor trusts. It is possible to structure a SLAT to not be a grantor trust, but that classification can be toggled on-and-off in how the trust is administered and taxed.

Background: Grantor trusts are popular estate planning tools for a variety of reasons. The settlor of the trust is taxed the trust’s income, but the value of the trust’s assets are not included in the settlor’s taxable estate at death. The settlor’s payment of the trust’s income tax liability is essentially a tax-free gift to the trust beneficiaries. [Revenue Ruling 2004-64.] In addition, any transaction between the settlor and the grantor trust is pretty much ignored for tax purposes, which means that the settlor could sell an appreciated asset to the grantor trust and not recognize any capital gain on that sale. If the sale to the grantor trust was in exchange for an installment promissory note, the interest paid by the grantor trust to the settlor is not taxable income. While those are popular advantages to the use of a grantor trust, there can also come a time when the grantor trust classification ceases to be a benefit, and instead it creates a burden on the settlor who must pay the income tax.  Accordingly, trusts need to be flexible to address the settlor’s income tax reduction or avoidance, deal with the compressed income tax brackets of an irrevocable trust and the net investment income tax imposed on trust income, and pursue the goal of maximizing itemized income tax deductions.

Grantor Trust Rules: The settlor of an irrevocable trust will be taxed on the trust’s income, called a grantor trust, under IRC 671 through 677. A common form of grantor trust is when the settlor retains the power to exchange assets with the trust, for equivalent value. [IRC 675(4)(C).] If the trust holds policies of life insurance on the lives of the settlor or the settlor’s spouse, the trust will be classified as a grantor trust for as long as the trust owns the life insurance policy and any portion of the trust’s income may be applied for the payment of the life insurance premiums. [IRC 677(a)(3).] Yet another power that causes the settlor to be taxed on the trust’s income is when a loan at below market interest rates is made by the trust to the settlor, if a non-adverse party, like the settlor’s spouse, acts as the trustee of the trust. [IRC 675(2).] In this case, the settlor is taxable as the owner of any trust or portion of a trust over which the settlor, or any non-adverse person, possesses the power to lend trust income or principal, directly or indirectly, to the settlor without both adequate interest or adequate security. The mere existence of this ‘prohibited’ power held by the settlor, or the settlor’s spouse, to borrow trust income or trust principal without either adequate interest or adequate security is sufficient to cause the trust to be classified as a grantor trust whether or not the power is actually exercised.

SLATs: A spousal lifetime access trust, or SLAT, is normally taxed as a grantor trust because the trust income and principal may be distributed to the settlor’s spouse, or accumulated for future distribution to the settlor’s spouse in the discretion of the trustees. [IRC 677(a).] The scope of IRC 677(a) is extremely broad and almost any trust in which the settlor’s spouse is or could be a future trust beneficiary is likely to be classified as a grantor trust.

Toggling Grantor Trust Status: When a trust instrument is created with grantor trust powers, such as the power of substitution of assets of equivalent value, or the settlor’s power to borrow from the trust at less than adequate security, grantor trust status can be toggled on and off.

  • Renunciation of the Retained Power: The easiest way to toggle grantor trust status off is by the settlor’s renunciation of the retained ‘triggering’ powers .A trust director could be given the power to amend the trust to confer on the settlor the power to substitute assets of equivalent value, or give the non-adverse trustee the authority to make below-market rate loans to the settlor, effectively toggling on-and-off the trust’s classification as a grantor trust.
  • Non-adverse Party Consent: By toggling grantor trust status on or off, the settlor will be treated as the ‘owner’ of either or both of the income and principal of the trust for income tax purposes and will be taxed directly on the trust’s income to the extent that the settlors holds a particular power over the trust. While the settlor may wish to retain the grantor trust power to substitute assets of equivalent value in order to retain flexibility to obtain an income tax basis step-up of appreciated substituted assets on the settlor’s death [IRC 1014(a)], the settlor may nonetheless no longer want the trust to be classified as a grantor trust where the settlor pays the trust’s income tax liability. These dual goals might be achieved by requiring the settlor’s exercise of the power to substitute assets of equivalent value to be subject to the consent of an adverse party. That required consent of an adverse party would prevent the settlor’s substitution power from triggering grantor trust status, while it would still provide the settlor income tax basis planning flexibility. [Treasury Regulation 1.672(a)-1(a).]

Adverse Party: As noted a grantor trust pursuant to IRC 677 may be avoided if distributions to the settlor’s spouse in a SLAT may be made only with the consent of an adverse party. A person is considered to be adverse if such a person possesses a “substantial beneficial interest” in the trust that would be adversely affected by their exercise, or non-exercise of a power. [IRC 672(a).] The challenge is in identifying an individual who may hold an adverse interest, as the determination of “substantiality” is fact-based relative to the size of such individual’s interest in the trust relative to the size of the trust’s corpus. [Treasury Regulation 1.672(a)-1(a).]

Distribution Committee: Instead of relying on a single person to provide the consent needed to make the trust a non-grantor trust, the trust instrument might rely upon the appointment of a distribution committee comprised of a class of discretionary trust beneficiaries who have the discretion to distribute income and/or principal between or among themselves. [See Private Letter Ruling 201310002 in the context of a trust for the settlor’s spouse.] The members of this committee will not be treated as holding a general power of appointment over the trust corpus if their exercise of the power is in conjunction with another member of the committee who has a substantial adverse interest to the exercise of the power of the holder (or his or her creditors or their estate.) In addition, because none of the other distribution committee members possess a power exercisable alone to vest trust income or principal in himself or herself, none of them are deemed to be the owner of the trust for income tax purposes. [IRC 678(a).]

  • Actual Borrowing of Trust Assets by Settlor:  A lesser known rule that causes grantor trust classification is if the settlor borrows trust corpus or income and has not entirely repaid the loan, including interest, before the beginning of the next tax year. If that is the case, then the trust is classified as a grantor trust for that tax year. [IRC 675(3).] Grantor trust treatment will not arise if the loan provides for adequate interest and security, and if the loan is made by a trustee other than the settlor, the settlor’s spouse, or a trustee who is related or subordinate or subservient to the settlor. If the borrower is the settlor’s spouse, the same rule applies. [IRC 672(e).] Thus, there may be no retained power to compel a loan from the trust by the settlor or the settlor’s spouse, yet depending upon the terms of the loan and its status at the close of the year, the trust might fall within the classification as a grantor trust.

IRC 675(3)’s language provides that grantor trust status depends upon a loan being outstanding at the beginning of a taxable year and not repaid in full before the end of the year; “The grantor has….borrowed… and has not completely repaid…before the beginning of the taxable year.” Thus, if borrowing occurs during a tax year and the loan is repaid by the end of the year, grantor trust status would not seem to exist for that year. However, the courts and IRS interpret IRC 675(3) to create grantor trust status if the loan to the settlor is outstanding at any time during the year. [Revenue Ruling 86-82.] Consequently, it is possible for the trustee to make a loan to the settlor on December 30 of a year, and the trust will be classified as a grantor trust for that entire year. Accordingly, this strategy could be used in year-end planning to create a grantor trust retroactively for the entire year.

Example:  Rob and Laura are financially very well off. They have fully utilized their lifetime transfer tax exemptions funding an irrevocable, non-grantor, trust for the benefit of their son Richie. Rob is the settlor of the trust for Richie. Richie’s trust uses a bank as trustee. Rob and Laura are currently in a low income tax bracket for this year. In contrast, the Richie’s trust sold some appreciated asset and has substantial taxable gain income for the year to report. Rob buys back all of the assets from Richie’s trust in exchange for a promissory note. Rob’s promissory note given to the trustee is unsecured, but it carries commercial interest rate. Grantor trust treatment for Richie’s trust will occur for the year of the sale to Rob for his note. The result is that Rob and Laura pay the income tax on Richie’s trust’s income for the year of the sale.

Scope of Grantor Trust Treatment?: Unclear is whether grantor trust classification under IRC 675(3) applies only to the amount actually borrowed and not repaid before the end of the taxable year, or whether it applies to all income or corpus that could have been borrowed if some borrowing occurs. In one court decision, where the settlor borrowed less than all of the trust’s income, the settlor was taxed only on the portion of the current year’s income that the principal of the loan at the beginning of the year bore to the total trust income from the trust’s inception. Bennett v. Commissioner, 79 Tax Court 470 (1982). Yet in another Tax Court decision, where the settlor borrowed all income of the trust owning real estate, the settlor was treated as the owner of the entire trust for the taxable years the loan remained unpaid. Benson v. Commissioner, 76 Tax Court 1040 (1981.) As such, unless the settlor borrows all of the trust’s assets, no assurance can exist that the settlor will be treated as the owner of the entire income and corpus of the trust for income tax reporting purposes.

Planning with Loans: Because grantor trust status is predicated on actual borrowing, toggling grantor trust status on-and-off is possible. If the settlor wants to achieve grantor trust status in any particular year, the settlor could borrow all of the trust’s funds for a period of time during the year. If the trustee is neither a related nor a subordinate party to the settlor, the borrowing by the settlor should not provide for adequate security, but should provide for adequate interest for the trustee to avoid claims of breach of fiduciary duty. If the trustee is a related or subordinate party to the settlor, i.e. he or she is subservient to the settlor, the settlor’s borrowing may provide for adequate interest and security and the loan will still result in grantor trust status. The settlor would need to repay the entire amount of the loan, including interest, by the end of the taxable year so that the settlor could make an independent decision in the following years whether grantor trust status should be continued in that next year.

Conclusion: The by-word in estate planning these days is flexibility. Building flexibility into trusts is important to respond to changes in the tax laws and needs of trust beneficiaries, and in some cases the changing needs and goals of the trust’s settlor. Significant tax consequences flow from whether a trust is classified as a grantor trust or not. The ability to toggle that classification is something that all new trusts should consider, or those existing trusts that are being decanted.