In “Adversity, Inconsistency, and the Incomplete Nongrantor Trust,” Professor Grayson M.P. McCough discusses in considerable detail the concepts of adversity for gift tax and grantor trust purposes and their application in private letter rulings with respect to what are generically called “incomplete nongrantor” (ING) trusts.
Background
By creating a trust that’s not a grantor trust,1 the transfers to which aren’t completed gifts, some property owners are able to achieve two potential beneficial consequences: First, for an individual who otherwise would be in the top federal tax bracket, having their income taxed at such rates if earned by a non-grantor trust isn’t necessarily adverse. And therefore, being able to avoid state income tax with a trust that the grantor otherwise would face may be viewed as quite beneficial, assuming the trust is structured to avoid state income tax. Structuring trusts to avoid state income taxes isn’t always simple but often can be achieved.2 And avoiding state income tax with nongrantor trusts has been approved, at least in some contexts, by the U.S. Supreme Court.3
Second, transfers that are regarded as incomplete don’t result in the imposition of gift tax under Internal Revenue Code Section 2501 or the use of the credit against gift tax allowed under IRC Section 2505. Transfers may be regarded as incomplete when grantors may revest the trust property in themselves and still be regarded as incomplete when the grantors’ only power is to name new beneficiaries or to change the interests of the beneficiaries as among themselves, unless the power is a fiduciary power limited by a fixed or ascertainable standard.4 However, if these powers of control may be exercised only with the consent of an adverse party, the transfer may be regarded as complete.5
Some practitioners believe that it’s impossible for a transfer to a trust to be incomplete for gift tax purposes and yet prevent the trust from being a grantor trust. The apparent reason is that, subject to exceptions, a trust over which the grantor (or, in some cases, anyone) can control the beneficial enjoyment of the trust property is a grantor trust under IRC Section 674(a). That section provides generally that a trust is a grantor trust if the beneficial enjoyment of the corpus or income is subject to a power of a disposition. But the real scope of that section is shown by the exceptions contained in Sections 674(b), 674(c) and 674(d).
The ING Trust PLRs
The ING trust PLRs turn, however, on another aspect of avoiding grantor trust status: allowing benefits from the trust to be conferred or controlled only with the joinder or consent of an adverse party. Indeed, Section 674(a) itself excepts from its application a power of disposition that can be exercised only with the approval or consent of an adverse party. Over 50 of these rulings have been issued over the past couple of decades based on that.6
Prof. McCough acknowledges that “With careful planning, a trust may be designed to avoid the gift tax as well as the grantor trust rules….”7 He doesn’t disclose how that might be accomplished but essentially says that the structure used for the trusts that were subject to the rulings likely doesn’t accomplish avoiding the gift tax and grantor trust rules because his “analysis reveals gaps and contradictions which call into question the viability of the ING trust as a planning technique.”8
In the most current versions of the trusts that were the subject of the PLRs: (1) the grantor held a testamentary power of appointment (POA) over the trust (the grantor’s testamentary power); (2) the trustee, pursuant to the direction of a majority of the distribution committee members (all of whom were trust beneficiaries), with the written consent of the grantor, must distribute to any beneficiaries such amounts of the trust’s corpus or income as directed by the distribution committee (called the “grantor’s consent power”); (3) at any time, the trustee, pursuant to the direction of all of the distribution committee members, other than the grantor, must distribute to any beneficiary such amounts of the net income or principal as directed by the distribution committee (called the “unanimous member power”); and (4) at any time, the grantor, in a nonfiduciary capacity, may, but isn’t be required to, direct the trustee to distribute to any one or more beneficiaries, other than the grantor, such amounts of the principal (including the whole thereof) as the grantor, acting in a non-fiduciary capacity, deems advisable to provide for the health, maintenance, support and education of said beneficiaries (the grantor’s sole power).
Essentially, the PLRs turn on finding that one or more individuals involved in the administration of the trusts were adverse parties for grantor trust purposes but not adverse for gift tax purposes. Prof. McCough’s essay indicates that ING trusts may not “work” to avoid grantor trust status and prevent gift completeness, essentially it seems, because the distribution committee members may not be adverse for grantor trust purposes and gift tax purposes. Before turning to whether that’s always so, it seems appropriate to note that his statements leading up to that contention may not be correct.
Beneficiaries’ Interests
It seems that one of the professor’s main arguments is that the members of the distribution committee aren’t adverse parties for grantor trust purposes. He seems to intimate that an individual without a general POA lacks an adverse interest that would seem to foreclose the members of the distribution committee from being adverse.9 However, several of the examples in the regulations provide that someone is adverse even though not holding a general POA.10
Section 672(a) defines “adverse party” for grantor trust purposes. Essentially, to be an adverse party, the individual must have a beneficial interest in the trust that’s substantial and would be adversely affected by the exercise or non-exercise of their power over the trust. Much of the power over an ING trust is vested in the individuals who are members of the distribution committee. Although those individuals are the presumptive remainder beneficiaries, Prof. McCough states:
[T]he interests of the beneficiaries as remainder takers at the grantor’s death are subject to divestment by an exercise of the grantor’s testamentary special POA. In these circumstances, even if any member of the distribution committee is viewed as holding a beneficial interest rather than an expectancy, it’s difficult to see how such an interest could be treated as substantial.11
This latter contention seems to be inconsistent with an example in the regulations.12
In discussing the grantor trust testamentary power exception in Section 674(b)(3), Prof. McCough states that the grantor’s special testamentary power only protects the gift of the corpus to avoid gift tax.13 However, the trust isn’t a grantor trust when the grantor’s testamentary power applies not just over corpus but also over income that’s accumulated with the consent of an adverse party. The IRS has consistently held that the accumulation of income occurs only with the consent of the members of the distribution committee, whom it concludes are adverse to such accumulation. As one of the PLRs states:
Grantor will retain a limited power to appoint Trust property (and accumulated income) to other family members. By reason of Grantor’s limited power of appointment, Grantor will have the power to change the beneficiaries of Trust. Therefore, for purposes of the gift tax, Grantor will continue to possess dominion and control over the property transferred to Trust and the irrevocable transfer to Trust will not be a completed gift. (Emphasis added.)14
If that conclusion by the IRS is correct, then the grantor’s testamentary power doesn’t trigger grantor trust status. The courts have ruled that whether someone is adverse is a question of fact,15 so it’s not possible to discern with complete certainty that the members of the distribution committee are adverse to the accumulation of income, as the IRS had concluded.
PLRs’ Conclusions
The PLRs essentially hold that the accumulation of income during the grantor’s lifetime may occur only with the consent of the distribution committee whom the IRS finds are adverse parties and that prevents grantor trust status from being triggered. At the grantor’s death, the power and the committee disappear. The grantor’s testamentary power, according to the IRS, makes the gift to the trust incomplete, and nothing during the grantor’s lifetime detracts from that power.
Further Study
Prof. McCough presents many questions about the efficacy of ING trusts. Over 50 PLRs conclude they “work.” However, in Revenue Procedure 2021-3, Section 5(9)(17), the IRS announced that ING trusts are being studied and, accordingly, no new PLRs will be issued (apparently, at least until the study is completed). One option if there’s concern that they won’t work may be to provide in the trust that, if the dual goals of nongrantor trust status and gift incompleteness can’t be achieved, the trust instrument must be construed and the trust administered to accomplish whichever the grantor wishes must be accomplished. Courts have consistently ruled that once a grantor’s intent is ascertained, the instrument must be construed to accomplish that intent.16 The U.S. Tax Court has similarly ruled.17
Endnotes
1. A grantor trust is one in which the income, deductions and credits against tax are attributed to the grantor (or, in one case, to a beneficiary) pursuant to Internal Revenue Code Section 671.
2. See Richard W. Nenno, “Bases of State Income Taxation of Nongrantor Trusts,” www.dinsmore.com.
3. See generally Jonathan Blattmachr and Martin M. Shenkman, “State Income Taxation of Trusts: Some Lessons of Kaestner,” Estate Planning 3 (October 2019).
4. Treasury Regulations Section 25.2511-2(c).
5. Treas. Regs. Section 25.2511-2(e).
6. A list of some of the rulings can be found in Professor McCough’s article (McCough article) at p. 425, n. 32. The list doesn’t include the first of these rulings, Private Letter Ruling 9016079 (Jan. 25, 1990).
7. Ibid., at p. 419.
8. Ibid.
9. “[T]he only plausible basis for treating the committee members as adverse parties is that they collectively hold a general power of appointment over the trust property.” Ibid., at p. 464.
10. See, e.g., Treas. Regs. Section 1.672(a)-1(c), (d).
11. McCough article, at p. 430.
12. Treas. Regs. Section 1.671-2(d) (second sentence). Note that the phrase “if he is then living” demonstrates that the remainder beneficiary’s interest is contingent on survival of the 10-year term set forth in the example.
13. McCough article, at pp. 434-435.
14. PLR 200148028 (May 18, 2020).
15. See, e.g., Paxton v. Commissioner, 57 T.C. 627 (1972), aff’d, 520 F.2d 923 (9th Cir. 1975), cert. denied, 423 U.S. 1016 (1976).
16. “The prime consideration here as in all construction proceedings is the intention of the testator as expressed in the will. All rules of interpretation are subordinated to the requirement that the actual purpose of the testator be sought and effectuated as far as is consonant with principles of law and public policy.” Matter of Fabbri, 2 N.Y.2d 236, 239-240 (1957).
17. Estate of Reid v. Comm’r, T.C. Memo. 1982-532.