Take-Away: About a year ago I wrote about a trustee that refuses to go along with a trust settlor’s retained right to substitute assets of equivalent value with the trust. This is an update to that earlier missive, as there has been another court decision that addressed the trustee’s refusal to go along with the settlor’s retained right to substitute assets of equivalent value with the trust. The law remains unsettled with what is expected of the trustee. This missive ends with something of a ‘checklist’ a professional trustee should look for (or require) if it is asked to serve as the trustee of an intentionallly defective grantor trust.

Background: A popular estate planning strategy for the past several years has been the sale of an appreciating asset, like closely held business interests, to an irrevocable trust that is intentionally created as a grantor trust for income tax purposes. If the trust is classified as a grantor trust, then the sale of the appreciated asset to the trust does not trigger capital gain recognition to the settlor, and the interest paid on the promissory note given by the trustee to the settlor-seller in exchange for the appreciated asset is not reported as taxable income. The settlor pays the income tax on the trust’s income, which has the effect of being a gift tax-free transfer of wealth to the trust beneficiaries. Hence the popularity of this estate planning strategy.

Swap Power: The common technique used to create a grantor trust is for the trust’s settlor to retain the right to substitute assets of equivalent value with the trustee; the mere presence of that retained substituion right is sufficient for the settlor to be treated as the owner of the trust’s assets for income tax reporting purposes, but not for estate tax purposes.

The swap power is found in a straight-forward Tax Code provision, IRC 675(4)(C): A power of administration is exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity [is] a power to reacquire the trust corpus by substituting other property of equivalent value.

Revenue Ruling: The IRS expressly deals with this Swap Power in Revenue Ruling 2008-22. That Ruling requires that if the trustee is not satisfied that what is to be received in exchange for trust assets is of equivalent value has a duty to resist or oppose any attempted substitution of assets worth less than the value of the trust assets sought by th grantor.

The Tension Between the Grantor’s Right and the Trustee’s Duty to Resist: The issue that has appeared in a handful of court decisions is the trustee’s disagreement with the settlor’s tender of substitution property, normally promissory notes, when the settlor attempts to exercise his/her retained right to substitute assets of equivalent value. Despite having several decades in which to provide guidance on this question, the IRS has never defined in its Regulations what constitutes equivalent value, which tends to explain why this dispute is now showing up in courtrooms across the country these days.

Court Decisions: In the earlier missive on this topic, some court decisions were summarized which addressed the issue of equivalent value when the settlor tendered a promissory note to the grantor trustee in exchange for the appreciating asset held by the trustee, precipitating the trustee’s refusal to accept the tendered promissory note on the grounds that the trustee would be violating its fiduciary duty to the trust beneficiaries. To repeat the summary of those decisions:

In re Matter of Condiott (2015 Colorado Court of Appeals, No. 14CA0969, unpublished) where the settlor offered in substitution a 9-year interest only $9.5 million promissory note and a balloon payment of principal with interest on the note at 1.27%. The trustee responded that the proposed note was not equivalent value. The Colorado Court of Appeals supported the trustee’s refusal, but it did so on as separate ground, finding the proposed note was the equivalent of a loan from the trust, and the trust instrument expressly prohibited loans from the trustee to the settlor.

In re Dino Rigoni Intentional Grantor Trust, (2015 WL 4255417, Michigan Court of Appeals), where two separate 30% interests in an LLC were transferred to two trusts, the subsequent proposed substituted assets were promissory notes. The dispute, which was presented by competing expert appraisers, was the value of the two 30% LLC interests, and the concern that the interest rate in the proposed promissory notes would not provide the same risk or rate of return as the LLC interest then held in the trusts. The Michigan Court of Appeals, sustained the trial court’s decision that the trustee’s refusal to accept the tendered promissory notes was reasonable:  “Nothing in the language of the substitution clause requires the trustee to accept any tender of property as substitution for trust assets; rather, the substitution clause prohibits the trustee from declining to comply with Rigoni’s substitution of equivalent value property. A necessary precondition to that substitution is that equivalent value be established…. Once Rigoni has tendered property of equivalent value, the trustee lacks the discretion to deny the substitution. The trustee, however, still possessed the power and duty to determine whether the attempted substitution complied with the requirements of the substitution clause.” 

Benson v.Rosenthal, (2016 WL 2855456, E. D. La) where the owner of the New Orleans Saints and Pelicans attempted to substitute self-adjusting valuation promissory notes in exchange for hard-to-value nonvoting interests in those two professional teams he previously transferred to children from prior marriages. In this case, the trustee’s refusal to accept the proposed promissory notes was rejected by the District Court as unreasonable. The trustee claimed that the value to be exchanged had to be  simultaneous with the transfer of the business interests held by the trustee, and awaiting a post-transfer valuation adjustments of those interests in the notes’ principal was not simultaneous. The Court noted that the trustee does not have the power to prevent the proposed exchange, concluding that if the values proved with hindsight to not be equivalent, the trustee always had the remedy to sue the grantor for additional value, much like an award in a property condemnation situation, where the property is immediately taken and the property owner is then entitled, post-taking, to sue for more if the condemnation award is deemed inadequate. Who has the burden of proof as to the value of the proposed substituted asset: the grantor or the trustee? Revenue Ruling 2008-22 implies the grantor, but the Benson Court seems to say that the trustee has the burden of proof that what was proposed in substitution is not equivalent.

Schinazi v. Eden, 792 S.E.2d 94 (Ga Ct of Appeals, 2016) where the grantor proposed to substitute a promissory note in the amount of $58.290 million to the trustee in exchange for limited partnership interests previously sold to a trust created for a child. The concern of the trustee was that just before the proposed substitution, the limited partnership had negotiated a highly favorable sale to a pharmaceutical company, so that the proposed promissory note would not have reflected the price that would have been paid to the trustee for the limited partnership interests that it held. The trial court held that the trustee’s refusal to accept the proposed note (apparently. unsecured, leading to the trustee’s concern that the proposed interest rate did not reflect the additional risk it would be taking on) was reasonable. The Court of Appeals sustained part of that decision.

Manatt v. Manatt, 2018 WL 3154461 (S.D. Iowa, 2018) is the most recent decision on the balancing the trustee’s fiduciary duty to beneficiaries to resist a proposed exchange that might not result in equivalent value against the grantor’s retained right to substitute assets of equivalent value with the trust’s assets. In this case, the dispute arose over the timing of the trustee’s duty to accept the proposed exchange of assets. The trustee argued that the its duty to ensure that the substituted asset is of equivalent value becomes a condition precedent to the substitution of assets. In rejecting this interpretation of the grantor’s substitution power, the District Court found:

This interpretation contradicts the plain language of the Swap Power, which allows that the grantor, ‘during his lifetime’ and ‘acting alone in his individual and not in any fiduciary capacity’ can reacquire trust assets by substituting other property of equivalent value and in doing so, ‘neither the consent of the trustee nor the consent of any other person shall be required….A plain language reading of the substitution provision compels the conclusion that the grantor had the unilateral right of substituting assets. The trustee’s fiduciary duty to determine whether the substitution of assets was of equivalent value did not abridge, delay, or block the grantor’s right of substitution.

Checklist: If called upon to serve as the trustee of a grantor trust with a Swap Power, the trustee might consider demanding that the following be included in the trust instrument:

  1. Assume that the Swap Power will be exercised at some future date and the trustee will be forced to contest that proposed substitution on the basis of equivalent value.
  2. The current law permits the trustee the discretion to reimburse the grantor for any income taxes the grantor must pay with regard to the trust’s taxable income. If that flexiblity is desired by the grantor, then that discretion to reimburse the grantor for his/her income tax liability needs to be clearly spelled out.
  3. Since the right of substitution can be released, or re-established, i.e. toggling the grantor trust status, make sure that the intent to toggle, i.e. when the Swap Power is released, how it is released, how it is re-established, is clearly outined in the trust.
  4. The trust needs to identify an established procedure with regard to certifying the equivalent value of the proposed substituted asset.
  5. If the proposed transfer is intended to take immediate effect, then then the trustee needs to be protected from claims filed by the trust beneficiaries against claims of breach of trust for not protecting trust assets or for dissipating trust assets.
  6. While IRC 675(4)(C) does not explicitly say this, the trust should equate equivalent value with fair market value being the floor of value, so that there is at least a common standard that appraisers can follow, both as to the assets going out of the trust and the promissory note coming into the trust.
  7. The trust should be clear if an agent acting for the grantor under a durable power of attorney possesses the authority to exercise a Swap Power.
  8. The trust should expressly address if promissory notes can constitute property of equivalent value, and if so what terms will be considered necessary, e.g. collateral security, self-adjusting principal note balances as post-transfer appraisals are obtained, interest rates greater than the applicable AFR rates,  etc.
  1. Prohibit the assignment of the Swap Power, as a creditor protection mechanism, so that only the grantor individually can exercise the power.
  2. If a Swap Power results in the delay in an exchange of property interests, the trust should address when the risk of loss passes from the trustee to the holder of the Swap Power.
  3. Since Revenue Ruling 2008-22 contemplates limitations on the exercise of a Swap Power by the grantor, those limitations should be expressly included in the grantor’s retained right of substitution.
  4. The trust should build-in some delay on the transfer of the hard-to-value asset out of the trust and to the grantor, in order to enable an appraiser adequate time to appraise the property, as well at the proposed substituted property, so as to not have to take the grantor’s ‘word’ as to its value.
  5. Finally, to best protect the trustee, consider requiring a condition to the grantor’s exercise of the Swap Power by requiring a veto to its exercise by a non-adverse party who acts in a non-fiduciary capacity.

Conclusion: While grantor trusts are popular estate planning tools to shift wealth out of a taxable estate, a trustee needs to take steps to protect itself, especially if it is presented with a demand to substitute income producing assets from the trust in exchange for a promssiory note.