IRS Issues Ruling Providing Roadmap for Grantor Trusts
[Ed note: WS+B Trust and Estate Expert Hal Terr stops by to discuss a recent IRS ruling that helps clarify the proper way to structure a grantor trust. Now, on to Hal:]
Estate planners have often discussed the benefits of grantor trusts with their high net worth clients. With a grantor trust, an individual can make a completed gift to an irrevocable trust for gift tax purposes but be treated as the owner of the trust for income tax purposes. The benefit of this technique is when the grantor pays this income tax, it is a tax-free gift to the trust. Consider the following example:
Parent has IBM stock with a fair market value of $100,000 and cost basis of $0. If the parent gifts the stock to their child, the child has a carryover basis in the stock of $0. If the child sells the stock — and assuming a 15% long-term capital gain tax rate — the child is left with $85,000 in cash. If instead, the parent gifts the stock to an irrevocable grantor trust and the trust sells the stock, the trust retains the $100,000 and the parent pays the $15,000 of income tax. This transfers more wealth to the next generation and the payment of the income tax reduces the parent’s eventual taxable estate.
A common drafting technique by attorneys to create a grantor trust has always been to include a provision to allow the grantor, in a non-fiduciary capacity, to reacquire trust assets by substituting other property of equivalent value under IRC Section 675(4)(C). Under Revenue Ruling 2011-28, the IRS has provided a safe harbor for the provisions that should be included in the trust document so that the granting of this ability to the grantor would not include the property in the grantor’s estate. In its ruling the IRS stated:
A grantor’s retention of the power, exercisable in a non-fiduciary capacity, to acquire property held in trust by substituting other assets of equivalent value will not, by itself, cause the value of the property to be includible in the grantor’s gross estate provided the trustee has a fiduciary obligation (under local law or the trust instrument) to ensure the grantor’s compliance with the terms of this power by satisfying itself that the properties acquired and substituted by the grantor are in fact of equivalent value. The ruling provided that the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries. A substitution power cannot be exercised in a manner that can shift benefits if:
(a) the trustee has both the power (under local law or the trust instrument) to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries; or
(b) the nature of the trust’s investments or the level of income produced by any or all of the trust’s investments does not impact the respective interests of the beneficiaries, such as when the trust is administered as a unitrust (under local law or the trust instrument) or when distributions from the trust are limited to discretionary distributions of principal and income.
High net worth individuals, when meeting with their advisors to consider taking advantage of the $5.12M gift exemption available in 2012 should consider the benefits of grantor trusts as part of their estate plan.
