The transfer of assets by gift, sale or loan to an irrevocable dynasty trust that’s a grantor trust for income tax purposes has become a cornerstone of sophisticated wealth transfer planning.1 As a grantor trust, even though assets have been transferred out of the taxable estate for gift, estate and generation-skipping transfer (GST) tax purposes and the trust is, in fact, the legal owner of the transferred property, the grantor is still treated as the owner of those assets for income tax purposes. This has important ramifications in that: (1) all items of income, expense and depreciation are reported on the grantor’s income tax return; (2) the sale of appreciated assets by the grantor to the trust doesn’t trigger taxation of gain; and (3) interest paid or accrued on loans by the grantor to the trust isn’t taxable. Furthermore, because the grantor is paying tax on income they haven’t received, the payment (and the loss of the use of those funds over time) reduces their estate with no gift or GST tax ramifications. In the absence of the grantor trust rules of Internal Revenue Code Sections 671 through 679, the grantor paying the trust’s income taxes would be considered a gift to the trust with negative gift and GST tax consequences. In effect, as a result of the grantor trust rules, it’s as if the grantor made a gift, estate and GST tax-free transfer to the trust equal to the taxes paid by the grantor allowing trust assets to grow undiminished by income taxes.
Turning Off Status
Frequently, it’s desirable to turn grantor trust status off.2 For example:
- The trust may be selling a highly appreciated asset, and the grantor doesn’t want to include the gain on their income tax return.
- The trust may be life settling a life insurance policy (that is, selling the policy to investors via the secondary market), thereby generating substantial taxable ordinary income as well as capital gains.
- The grantor may no longer want to pay the income taxes on the grantor trust’s taxable income due to changes in circumstances, such as family disputes, the fact that the annual trust income has become quite substantial or because the grantor simply no longer wants to pay taxes on assets that he doesn’t own.
- Finally, late last year, the House Ways and Means Committee proposed legislation that would have caused substantial negative gift tax consequences for new as well as existing grantor trusts funded by post-enactment gifts. Although that legislation didn’t advance beyond the Committee, the ability to turn grantor trust status off, especially for irrevocable life insurance trusts (ILITs), would have been essential.3
Typically, it’s a relatively straightforward matter to turn grantor trust status off. For example, a trust protector or independent trustee, if permitted under the terms of the trust, can revoke the powers that cause the trust to be a grantor trust, and the trust will continue to be outside of the grantor’s taxable estate. If the trust is drafted properly, the grantor or the grantor’s spouse can also have the right to revoke these powers.
More Complicated Matter
For an ILIT, however, creation and termination of grantor trust status is a more complicated matter due to IRC Section 677(a)(3). Unlike virtually every other power under Sections 671 through 679 that creates a grantor trust, Section 677(a)(3) may create grantor trust status for an ILIT even if there’s no explicit language in the trust instrument. In case law based on IRC Section 167(a), the predecessor to Section 677(a), the most important factor in determining if an ILIT is a grantor trust seemed to be whether the trust actually owned a policy and used trust income to pay premiums, even if it violated a specific prohibition in the trust document. One view is that for Section 677(a)(3) to trigger grantor trust status, an ILIT has to: (1) own a policy on the life of the grantor or the grantor’s spouse; (2) have taxable income; and (3) have a non-adverse party who, without the approval or consent of an adverse party, actually paid premiums. However, this ignores the actual language of Section 677(a)(3), which states the trust is a grantor trust if the income “may be” used to pay premiums. This raises the issue of whether a trust that doesn’t even hold a policy might be a grantor trust if such action in the future is permissible. But most practitioners and the case law, albeit based on the predecessor of Section 677(a)(3), conclude that there must be a policy held by the trust to trigger such language. Therefore, in ensuring that grantor trust status is turned off, the safer approach is to assume Section 677a(a)(3) has a broader reach. On the other hand, if the goal is for the ILIT to be a wholly grantor trust, then other Section 671 through 679 powers should be included such as a Section 675(4)(C)
substitution or “swap” power.
As discussed in greater detail below, the ILIT will be a grantor trust (although possibly only partially) under Section 677(a) if a non-beneficiary trustee may unilaterally use trust income to pay premiums on a life insurance policy owned by the trust insuring the grantor or grantor’s spouse, or if the grantor’s spouse is an income beneficiary or income may be accumulated for the spouse’s benefit.4 It’s possible to terminate grantor trust status by adding a beneficiary trustee (adverse party) whose approval or consent is required to pay premiums or, if that isn’t possible, other solutions may be called for.
It’s important to note that a termination of grantor trust status is treated as a transfer to another taxable entity and a taxable sale or exchange if there are outstanding loans in excess of the trust’s basis. As a result, prior to termination, take care to evaluate the income tax consequences of terminating grantor trust status.5
Section 677(a)
Section 677(a) provides that the grantor is treated as the owner of that portion of a trust:
whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be
- Distributed to the grantor’s spouse;
- Held or accumulated for future distribution to the grantor’s spouse; or
- Applied to the payment of premiums on policies insuring the grantor or the grantor’s spouse.
We’ll refer to these three uses of income as “677(a) purposes.”6 It’s important to note that under Section 677(a), “income” is defined as income for federal tax purposes, not trust accounting income.7
Adverse and Non-Adverse Parties
The approval or consent of an adverse party (or lack thereof) to apply income for Section 677(a) purposes can determine grantor trust status under this section. Section 672(a) defines an “adverse party” as “any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or non-exercise of the power which he possesses respecting the trust.” Treasury Regulations Section 1.672(a)-1(a) provides that “an interest is a substantial interest if its value in relation to the total value of the property subject to the power is not insignificant.” (A definition that doesn’t really shed much light on the term!) Therefore, most typically, an adverse party is a trust beneficiary (such as the grantor’s spouse, child or even grandchild) who has a substantial beneficial interest in the trust. Such a beneficiary who’s also a trustee of the trust will be referred to as a “beneficiary trustee (adverse party).” Treas. Regs. Section 1.672(a)-1(a) provides that “a trustee is not an adverse party merely because of his interest as trustee.”
Section 672 provides that the term “nonadverse party” means any person who’s not an adverse party. For the sake of simplicity, we’ll define any trustee who’s not a beneficiary as a “non-beneficiary trustee (non-adverse party).” Such a non-adverse party would include the grantor’s relative (brother or sister, parent, aunt, uncle or cousin), an advisor (CPA, attorney or investment advisor), a friend or a professional trustee such as a trust company or bank trustee.8 Whether a relative’s contingent remainder interests in the trust (for example, siblings who take if the grantor’s spouse and descendants don’t survive the termination of the trust ) are “substantial” and, therefore, adverse must be resolved on a facts and circumstances basis.9
The adverse party may only be partially adverse. Section 677(a) indicates that: “the grantor is treated as the owner of that portion of a trust…” (emphasis added). Treas. Regs. Section 1.672(a)-1(b) provides that: “[O]rdinarily, a beneficiary will be an adverse party, but if his right to share in the income or corpus of a trust is limited to only a part, he may be an adverse party only as to that part.” During the grantor’s lifetime, a beneficiary might be partially adverse if the trust has divided into shares, for example, one share per child or, in the case of a second marriage, one share for each spouse’s child. Likewise, a beneficiary with a life interest in income only (a life estate) may only be partially adverse. Typically, a trust won’t divide into shares until after the grantor’s death and, until then, a trustee’s distribution powers won’t be limited to a specific portion of trust assets. Because the definition of “adverse party” is dependent on a facts and circumstances test, as is the portion of the trust over which the party is adverse, if the goal is for the ILIT to be a wholly grantor trust, the best course of action is not to rely solely on Section 677(a) but rather to include other powers under Sections 671 through 679, such as a swap power to create a wholly grantor trust.
We’ll now focus on the effect of Section 677(a)(3) in determining whether an ILIT is a grantor trust and managing that status assuming: (1) there are no other grantor trust powers granted in the ILIT document or that they’ve all been turned off; and (2) a “beneficiary trustee (adverse party)” is adverse with respect to 100% of the trust income and principal.
Is the ILIT a Grantor Trust?
Based on those simplifying assumptions, an ILIT is a grantor trust if the trust:
- only has a non-beneficiary trustee or trustees (non-adverse party or parties); or
- has beneficiary and non-beneficiary trustees, but the use of income for Section 677(a) purposes by a non-beneficiary trustee (non-adverse party) doesn’t require the approval or consent of the beneficiary trustee (adverse party).
Many trusts fall into one of these two categories. For example, the trust may only have an independent trustee (non-adverse party) such as a professional trustee with discretion to make distributions for Section 677(a) purposes. Or the trust may have co-trustees, one of whom is adverse, but an independent trustee holds the absolute unilateral discretion to make distributions for Section 677(a) purposes without obtaining the consent of the adverse trustee.
An ILIT isn’t a grantor trust if the trust:
- only has one or more beneficiary trustees (adverse parties), for example, when all of the trustees are beneficiaries of the trust such as the grantor’s spouse or adult children; or
- has one non-beneficiary trustee (non-adverse party) as well as one or more beneficiary trustees (adverse party), and a majority is required to apply trust income for Section 677(a) purposes.
Turning Off Grantor Trust Status
The best way to ensure that an ILIT is no longer a grantor trust is to introduce a beneficiary trustee (adverse party) whose approval or consent is required to use income for Section 677(a) purposes. For example:
- A sole non-beneficiary trustee (non-adverse party) may be able to resign and appoint a beneficiary trustee (adverse party) as a successor trustee.
- A majority of adult beneficiaries, a trust protector or other party may have the authority to remove a sole non-beneficiary trustee (non-adverse party) and replace them with a beneficiary trustee (adverse party).
- When the trust requires a majority or unanimity to act, a beneficiary trustee (adverse party) may be appointed as a co-trustee along with a non-beneficiary trustee (non-adverse party).
- Provided the grantor doesn’t remove and replace a trustee, they can hold the power to appoint a trust beneficiary (even though a Section 672(c) related or subordinate party), if the then-acting trustee resigns or can no longer act.
If there’s a trust beneficiary who has the capacity to serve as a trustee, but the trust terms don’t allow one of the preceding alternatives, it may be possible under the state’s decanting law to create a new trust that allows one or more of the preceding alternatives. If the state’s decanting law doesn’t allow the desired change, it may be possible to obtain a judicial modification or move the situs of the trust to a jurisdiction whose decanting statute would allow it, although that will likely require appointing a new co-trustee with sufficient contacts in that jurisdiction. In some cases, the ILIT may authorize the trustee to distribute or appoint assets to another trust, one with more favorable provisions with respect to the trustee.
When relying on a beneficiary trustee (adverse party) to prevent the trust from being a grantor trust, be careful when a beneficiary trustee (adverse party) is removed or resigns and the sole remaining trustee is a non-beneficiary trustee (non-adverse party) because the trust, without further restrictions discussed below, would automatically become a grantor trust.
Restricting Trustee’s Use of Income
In many cases, a suitable beneficiary trustee (adverse party) may not be available. For example, many grantors don’t want a beneficiary, typically a child or grandchild, to serve as a trustee or hold an approval or consent power because all of the beneficiaries may be minors, not yet mature enough to fill the trustee role, or there may be conflicts among them. If there are no trust beneficiaries who have the capacity to serve as a trustee, it could be possible to add restrictive language prohibiting a non-beneficiary trustee from unilaterally applying income to pay premiums. Again, that language might be added by a trust protector, by decanting the trust or by a judicial modification. If these steps aren’t feasible, it may be possible to sell the policy to a new trust with favorable provisions, and some trusts allow the trustee to distribute or appoint assets to another trust.
The effectiveness of the restrictive language is based on the fact that income for federal tax purposes is only income in the taxable year in which earned and reported. Mirroring Section 677(a), Treas. Regs. Section 1.677(a)-1(b)(2) provides support for this position, substituting the phrase “income for the taxable year” for the word “income” in the statute. That regulation provides:
the grantor is treated, under section 677, in any taxable year as the owner … of a portion of a trust of which the income for the taxable year … is, or in the discretion of the grantor or a nonadverse party, or both (without the approval or consent of any adverse party) may be.” (Emphasis added.)
Therefore, a non-beneficiary trustee (non-adverse party) should be able to use income for federal tax purposes to pay premiums in years after it’s earned and reported and avoid grantor trust status provided: (1) the trust prohibits the use of such income for Section 677(a)(3) purposes during the tax year in which it’s earned; and (2) that taxable income from the prior year is properly segregated, for example, in a checking account devoted to that purpose. Although this strategy rests on sound principles, there’s no clear authority authorizing it, and as a result, this solution isn’t entirely risk free.
Gifts, Loans or 1035 Exchange
Many ILITs are “unfunded,” meaning they’re funded by gifts alone. As a federal tax matter, gifts aren’t income. If a gift is deposited in a checking account and used immediately to pay a premium, it couldn’t be characterized as “income” provided it’s been segregated from current taxable income the whole time.
In fact, if a non-beneficiary trustee (non-adverse party) can unilaterally only pay premiums with gifts, loans or IRC Section 1035 exchange (1035 exchange) proceeds, the ILIT shouldn’t be a grantor trust based on Section 677(a)(3) alone. However, because Section 677(a) refers to income that “is or … may be… (3) Applied to the payment of premiums on policies insuring the grantor or the grantor’s spouse,” (emphasis added), the mere existence of that power, whether or not exercised, may cause the ILIT to be a grantor trust. Therefore, to ensure that the ILIT isn’t a grantor trust, the trust document should:
- Explicitly prohibit a non-beneficiary trustee (non-adverse party) from using income to pay insurance premiums without the approval or consent of a beneficiary trustee (adverse party); and
- Clearly state that a non-beneficiary trustee (non-adverse party) may only unilaterally pay premiums with gifts, loan proceeds, a 1035 tax-free exchange or, optionally, income in years after it’s earned and reported (provided it’s been properly segregated).
These restrictions should also be clearly communicated to the trustee because a court ruled, based on the predecessor statute to Section 677(a)(3), that a trustee’s use of income in violation of restrictive provisions still caused a trust to be a grantor trust.10
These restrictions are even important for an unfunded ILIT that owns no assets other than one or more permanent cash value life insurance policies because those policies may create taxable income to the extent of: (1) built-in gain (cash surrender values in excess of cost basis) in a sale or a surrender of the policy; or (2) a withdrawal of cash values in excess of basis. Because a distribution from a policy that’s a modified endowment contract (MEC) creates taxable income first to the extent of built-in gains, for purposes of Section 677(a), an ILIT owning a MEC could inadvertently be a grantor trust without the appropriate restrictions.
A 1035 exchange is a special case because, as a tax-free exchange, built-in gain isn’t recognized and, therefore, the exchange doesn’t trigger income for federal tax purposes. Therefore, a non-beneficiary trustee (non-adverse party) may unilaterally execute the exchange because the new policy isn’t being funded with trust income.
Whether premiums are paid by gifts or loans, best practice is to: (1) have the insured pay each annual premium directly (in effect, gifting or loaning the exact amount of each annual premium to the trust); or (2) deposit gifts or loans into a trust checking account that merely acts as a conduit to the insurance company with premiums being paid as soon as possible. Importantly, trust income, in the year it’s earned, shouldn’t be placed in the conduit checking account holding gifted or loaned assets that will be used to pay premiums. Rather, that taxable income should be segregated in a separate account (such as a brokerage account) and can be moved into the premium-paying checking account in the year after the taxable income is earned and reported. Finally, the checking account is also a useful tool to establish that any Crummey power holders have a realistic ability to exercise their rights of withdrawal, because the checking account could fund such withdrawal.
Many existing as well as new ILITs continue to rely on Crummey and hanging demand powers to qualify gifts for the $16,000 annual gift tax exclusion. In that case, best practice is for the trustee to wait the appropriate lapse period, typically 30 to 60 days, before paying the premium. Alternatively, the trustee could pay the premium immediately without waiting the 30 to 60 days and, in the unlikely event that a beneficiary exercises their demand power, the trustee could satisfy that demand with funds in the premium-paying checking account, a loan to the ILIT from a third party or with an in-kind distribution of trust assets.11
In the case of private annual premium loans from the grantor, each annual loan should be documented and administered in accordance with the Treas. Regs. Section 1.7872-15 loan regime split-dollar rules because, unless there’s a side fund held in the trust, the repayment of the loan will be made from the policy or policy proceeds. As such, each premium is a separate loan at the appropriate applicable federal rate based on the month during which the loan is made and the duration of the loan. Those regulations allow accrual of interest and lifetime term loans, features that dovetail nicely with the insurance coverage. In designing the coverage, allow for the fact that the cumulative loans plus accrued interest will reduce the death benefit. Provided the ILIT isn’t defective and is therefore a separate taxpayer from the grantor (lender), annual loan interest paid by the trust or the annual increase in accrued interest is taxable to the grantor. As an alternative to a private loan from the grantor, the ILIT could borrow funds from a commercial lender to pay premiums. The commercial loan interest could be paid with gifts from the grantor.12 Finally, consider the option of policy loans to pay premiums.
For a funded ILIT (an ILIT holding income-producing assets other than the life insurance), whether a commercial loan or a split-dollar loan provided that the non-beneficiary trustee (non-adverse party) is prohibited from using income to pay insurance premiums without the approval or consent of an adverse party, payment of loan interest from trust income shouldn’t render the trust defective based on Section 677(a).
Sale to a New ILIT
In many cases, an existing ILIT won’t have appropriate restrictions, an available beneficiary trustee (adverse party) or a protector with sufficient authority to modify the ILIT as needed. As an alternative to reforming, decanting or modifying the trust, the policy insuring the grantor (and other trust assets) could be sold to a new ILIT in exchange for cash or a promissory note.
Generally, the new ILIT should initially be a grantor trust to address two issues that arise when selling a policy (and other trust assets) from an old to a new trust.13 First, if the policy and other assets’ fair market value (FMV) exceed the cost basis, the sale to the new trust may trigger recognition of gain by the old trust. If both trusts are grantor trusts with respect to the same grantor, then gain won’t be recognized. However, if the two trusts aren’t grantor trusts with respect to the same grantor, as a sale to a separate taxpayer, gain will be recognized. Second, the sale of the policy is subject to the transfer-for-value rule and, if the sale isn’t within one of the exceptions to the rule, the policy death proceeds lose their income tax free character.14 Because a transfer to the insured is an exception to the rule, if the new ILIT is a grantor trust with respect to the insured, the transfer-for-value rule won’t apply. Likewise, there are other exceptions to the rule, for example, a transfer to a partner of the insured is an important exception when the insured and new ILITs each own interests in the same partnership or limited liability company (taxed as partnerships).
Drafting New ILITs
It’s important to draft new ILITs to allow maximum flexibility for controlling grantor trust status from inception. That is, the trust should be drafted to allow for turning grantor trust status on or off, which will address the unique challenges posed by Section 677(a). In many cases, it may be desirable for the ILIT to be a grantor trust from inception, for example, if: (1) income-producing assets will be contributed to the trust, and it’s desirable that the grantor include the trust’s income in the grantor’s own taxable income; or (2) an existing in-force policy insuring the grantor will be sold to the trust for FMV to avoid violating the transfer-for-value and the three-year rules. Create and turn grantor trust status on and off with powers under Sections 671 through 679 other than Section 677(a). In addition, consider grantor trust status if Crummey powers are used that are in excess of the greater of 5% or $5,000 with respect to the holder of the withdrawal right, because Section 678 protects the Crummey power holder from grantor trust status with respect to the trust in favor of the original grantor (so long as the original grantor remains the grantor for purposes of Sections 671 through 679). Finally, grantor trust status provides the ability to plan with as much flexibility as possible in the event a gain recognition event is about to occur. The grantor can decide at any time prior to the occurrence of the event if the grantor should pay: (1) all of the tax on the gain (by continuing grantor trust status); (2) part of the tax on the gain (by terminating grantor trust status over a portion of the trust); or (3) none of the gain (by terminating grantor trust status all together).
Endnotes
1. The term “grantor trust,” as referred to in this article, is an irrevocable trust that’s a grantor trust under Internal Revenue Code Sections 671 through 679.
2. See Andrew S. Katzenberg, “Unlocking the Trapdoor of IRC Section 677(a)(3),” Trust & Estates (April 2016).
3. Proposed IRC Section 2901.
4. A discussion of an irrevocable trust in which the grantor is a permissible income beneficiary and the trust isn’t included in the grantor’s taxable estate is outside the scope of this article.
5. The renunciation of grantor trust powers is considered a triggering event for recognition of capital gains. Treasury Regulations Section 1.1001-2(a) provides generally that “the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition.” See also Example 5 of Treas. Regs. Section 1.1001-2(c). The termination of a grantor trust during the grantor’s lifetime is also a triggering event for capital gains recognition. See Technical Advice Memorandum 200011005.
6. Although this article focuses on Section 677(a)(3), spousal lifetime access trusts (SLATs) face many of the same issues pursuant to Section 677(a)(1) and (2), and grantor trust status can be managed with the same strategies discussed herein. For example, an independent trustee of a SLAT holding the unilateral power to make income distributions to the grantor’s spouse or accumulate income for their benefit would fall under Sections 677(a)(1) and (2).
7. Treas. Regs. Section 1.671-2(b) provides: “… when it is stated in the regulations under subpart E that ‘income’ is attributed to the grantor or another person, the reference, unless specifically limited, is to income determined for tax purposes and not to income for trust accounting purposes. When it is intended to emphasize that income for trust accounting purposes (determined in accordance with provisions set forth in § 1.643(b)-1) is meant, the phrase ‘ordinary income’ is used.”
8. If a beneficiary who’s a trustee’s interest in the trust isn’t considered “substantial,” then that beneficiary trustee would be a non-adverse trustee.
9. How old are the beneficiaries, how many, how healthy and how likely is it for the contingent beneficiaries to become vested in the trust? Note also that a creditor of the trust is an adverse party, to the extent of the debt, but a creditor probably isn’t the best choice of trustee.
10. Rand v. Commissioner, 40 B.T.A. 233 (1939), acq. 1939–2 C.B. 30, aff’d 116 F.2d 929 (8th Cir. 1941), cert. denied 313 U.S. 594 (1941). It should be noted that the taxpayer was both the grantor and the trustee.
11. Take care that such immediate payment doesn’t interfere with the beneficiary’s right to withdraw the funds and qualify as a present interest for purposes of the $16,000 annual gift tax exclusion.
12. Loan interest on debt used to acquire a life insurance policy isn’t deductible. IRC Section 264(a)(4).
13. Following the sale and after waiting sufficient time, grantor trust status could be terminated by turning off the swap power or other power.
14. IRC Sections 101(a)(2)(A) and (B).