Recently, attention has been given to non-grantor trusts for multiple reasons, including the fact that incomplete non-grantor trusts in certain jurisdictions can provide state income tax savings. In addition, non-grantor trusts may be able to preserve state and local income tax deductions that have now been curtailed for individual taxpayers. The default rule is that all trusts are non-grantor trusts. However, if the grantor retains, or is deemed to retain, certain powers or interests in a trust, then the trust’s income, deductions and credits will be attributed to the grantor and the trust will be a grantor trust (Treasury Regulations Section 1.671-2(d)).
There are a number of circumstances in which a trust will be a grantor trust. Under Internal Revenue Code Section 673(a), a trust will be a grantor trust if the grantor has a reversionary interest in either the trust principal or income that exceeds 5 percent of the value of such property. Similarly, if a grantor retains certain administrative powers (IRC Section 675), revocation powers (IRC Section 676) and/or income interests (IRC Section 677(a)), grantor trust status is triggered. Note that a grantor is deemed to have the same powers and beneficial interests as the grantor’s spouse (IRC Section 672(e)).
Practitioners often ensure that the grantor is treated as the income tax owner of a trust by having the grantor retain one or more administrative powers. Such powers include the power to reacquire trust assets by substituting property of equivalent value (IRC Section 675(4)(C)) or the power to borrow without adequate interest or adequate security (IRC Section 675(2)). Fortunately, the grantor can retain one or more administrative powers initially for estate planning purposes and subsequently renounce such powers without gift or estate tax consequences.
IRC Section 674
The provisions of Section 674 can also cause a trust to be a grantor trust. Estate planners seeking to create a non-grantor trust or attempting to revoke grantor trust status must be careful to avoid triggering grantor trust status under Section 674. This IRC section initially provides that a trust will be a grantor trust if the beneficial enjoyment of the trust property is controlled by the grantor, the grantor’s spouse and/or a non-adverse party (IRC Section 674(a)). Independent trustees aren’t adverse parties. Beneficiaries also aren’t adverse parties if they’re prevented by the trust instrument from voting on distributions to themselves or to other beneficiaries. Unless an exception to Section 674 applies, a trust that permits distributions to be made without the consent of an adverse party will be a grantor trust even if the estate planning practitioner didn’t intend such a result.
Four Commonly Used Exceptions
There are eight exceptions under Section 674(b) and an additional exception under Section 674(c) that avoid triggering grantor trust status under Section 674(a). The following are the four most commonly used by practitioners:
- HEMS. The trustee’s power to make distributions is constrained by a reasonably definite standard such as health, education, maintenance or support (HEMS) (IRC Section 674(b)(5)(A));
- Pro rata shares. The trust has multiple beneficiaries, but income and principal is distributed to such beneficiaries in accordance with their respective shares (IRC Section 674(b)(5)(B));
- Single beneficiary. The trust has only one current beneficiary, and the income and principal must be paid to such beneficiary (or such beneficiary’s estate) or to appointees designated by the beneficiary (IRC Section 674(b)(6)); and
- No real control. Neither the grantor nor the grantor’s spouse is serving as trustee, and no more than one-half of the trustees are related or subordinate to the grantor (IRC Section 674(c)).
These exceptions are critical for practitioners to understand. Renouncing a substitution power created pursuant to Section 675(4)(C) may appear to change the status of the trust from a grantor trust to a non-grantor trust, however, doing so may not be enough under Section 674.
As an example, if a grantor’s spouse and brother are co-trustees, then the trust is a grantor trust under Section 674. Options to avoid triggering Section 674 include decanting to add a HEMS standard, dividing the trust into separate share trusts, and changing trustees so that the grantor’s spouse no longer serves as a trustee and the number of independent trustees equals or outnumbers the related and subordinate trustees.
Identity of Trustees
When reviewing or drafting a trust, practitioners must carefully determine whether the provisions of the trust will trigger grantor trust status. Central to this analysis is not only a search for typical grantor trust powers, but also a careful review of the identity of the trustees. As noted above, if the grantor’s spouse is a co-trustee, then, unless an adverse party is a co-trustee, the trust will be a grantor trust. While grantor trust status has many advantages, under the latest tax regime, individuals may increasingly prefer to have non-grantor trusts. Careful planning is critical in preventing inadvertent and potentially harmful income tax consequences.