Adverse Enough to Be a Nongrantor Trust

• Publication year: 2020
• Author: By Justin T. Miller and W. Martin Behn

Adverse Enough to Be a Nongrantor Trust

By Justin T. Miller and W. Martin Behn¹

Synopsis: In this article, Miller and Behn analyze whether a trust will qualify as a nongrantor trust for federal tax purposes if an adverse party who is a close relative or subordinate employee of the grantor has the power to distribute trust assets to the grantor, and the grantor retains the right to determine whether that adverse party ever gets any assets from the trust.

I. INTRODUCTION

If a grantor² creates a nongrantor trust under Internal Revenue Code sections 671-679, subpart E of subchapter J (commonly referred to as the "grantor trust rules"), the grantor will not be subject to federal income taxes on the trust's income and the trust will be a separate taxpayer for federal tax purposes, regardless of whether the transfer is a completed gift for estate and gift tax purposes.³ If the nongrantor trust is formed under the laws of a state such as Delaware or Nevada, the trust may receive better asset protection from creditors and may avoid being subject to state income taxes in the grantor's home state. In addition, the nongrantor trust could receive the benefit of its own 20 percent deduction for qualified business income under section 199A, $10,000 deduction for state and local income taxes under section 164(b)(6), and $10,000,000 exclusion from capital gains for qualified small business stock under section 1202.⁴

However, the grantor trust rules are not clear about what happens when a grantor sets up a trust to take advantage of all the nongrantor trust benefits, but still is able to get trust assets back at a later date. If the trust instrument requires trust assets to be distributed to the grantor, then the trust most likely would be a grantor trust under sections 673(a) and 677(a). On the other hand, a grantor may be able to avoid grantor trust status and still get trust assets back in the future if the right to distribute assets back to the grantor is controlled by an "adverse party" as defined in section 672(a)—that is, a person who has a substantial beneficial interest in the trust that would be adversely affected by the distribution—even if that adverse party is "related or subordinate" to the grantor within the meaning of section 672(c). Additional guidance is needed from the Internal Revenue Service ("IRS") and Treasury Department to determine whether a trust will qualify as a nongrantor trust if an adverse party who is a close relative or subordinate employee of the grantor has the power to distribute trust assets to the grantor, and the grantor retains the right to determine whether that party ever gets any assets from the trust.

II. BACKGROUND

There are numerous tax and non-tax reasons for creating a trust, and a variety of trust planning strategies that are permitted under the Code and Treasury Regulations to achieve both tax and non-tax objectives, such as grantor retained annuity trusts ("GRATs"), charitable remainder unitrusts and annuity trusts ("CRUTs" and "CRATs"), charitable lead annuity trusts ("CLATs"), qualified personal residence trusts ("QPRTs"), and intentionally defective grantor trusts ("IDGTs"). As a result of recent tax reform, commonly referred to as the Tax Cuts and Jobs Act of 2017 ("TCJA"), the federal income tax benefits for nongrantor trusts—especially incomplete gift nongrantor trusts ("INGs"), as discussed below—have substantially increased. Consequently, the TCJA has led to an exponential growth in the popularity of utilizing INGs and other nongrantor trusts as a planning strategy.⁵ However, it is not clear under the Code and Treasury Regulations whether a trust will be entitled to nongrantor trust treatment under the grantor trust rules if it is possible for trust assets to be distributed back to the grantor.

A. Principal Purpose for Trust

A grantor may have a desire to transfer assets during life—inter vivos—to an irrevocable trust for a number of different reasons that are unrelated to federal income tax. The grantor may want to create a vehicle that will provide financial assistance to relatives or other loved ones over a period of time. Ongoing professional asset management may be desired to protect one or more beneficiaries, who might otherwise make poor investment decisions or receive bad investment advice from an unscrupulous financial advisor. The grantor may want to protect assets for loved ones and future descendants from creditors and potential ex-spouses. In addition to greater asset protection and better financial management by professional trust companies, another consideration for establishing a trust unrelated to federal income tax may be more favorable state laws for the administration of trusts, such as so-called silent trust or quiet trust statutes.⁶ The grantor also may have certain estate planning objectives, including the potential for estate, gift and generation skipping transfer tax savings.

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B. Benefits of Nongrantor Trusts

There are a multitude of situations where it would be in the grantor's best interest for an irrevocable trust to be treated as a nongrantor trust under the grantor trust rules, which would mean that the grantor would not be subject to income taxes on the trust's income and the trust would be a separate taxpayer for tax purposes.⁷ The grantor may not want to pay taxes on the income of the trust, or may not have sufficient financial liquidity to pay the income taxes. The grantor also may desire greater asset protection from future creditors by taking advantage of a state with stronger asset protection laws—such as Delaware or Nevada.⁸ In addition, the grantor may be interested in minimizing or avoiding state income taxation in the state where the grantor resides or is domiciled by setting up a nongrantor trust in a state without a state income tax.⁹ The grantor also may want the nongrantor trust to receive the benefit of its own 20 percent deduction for qualified business income under section 199A and $10,000 deduction for state and local income taxes under section 164(b)(6), which may be possible as long as the principal purpose of creating the nongrantor trust is not avoiding federal income tax.¹⁰

To the extent the grantor has qualified small business stock ("QSBS") under section 1202, the grantor may be able to transfer the QSBS to a nongrantor trust in order to exclude an additional portion or all of the capital gain in the event of a future sale or exchange of the QSBS.¹¹ In general, section 1202 provides that a portion or all of the gain from the sale or exchange of QSBS will be excluded from gross income, provided that the QSBS has been held for more than 5 years.¹² The QSBS exclusion allows investors to exclude up to 100 percent of their gain on the sale of QSBS acquired after September 27, 2010, capped at the greater of $10,000,000 and 10 times the investor's tax basis in the stock.¹³ The requirement that the QSBS be received directly from the issuing company does not apply to QSBS received as a result of a gift or by death.¹⁴ In other words, the recipient of a gift of QSBS—such as a nongrantor trust—is treated as having received and held the QSBS in the same manner as the grantor, and for the same time period as the grantor.¹⁵Therefore, if a grantor transfers QSBS to a nongrantor trust, the nongrantor trust should be able to separately qualify for the QSBS exclusion and have a separate cap—the greater of $10,000,000 and 10 times tax basis—on the maximum gain excluded.

To the extent a grantor is interested in the benefits of a nongrantor trust for income tax purposes, but does not want to pay any gift taxes, the grantor could reserve a special limited power to appoint the trust principal to beneficiaries other than the grantor, so that the transfer is treated as an incomplete gift for gift tax purposes—meaning that there would be no gift tax consequences or utilization of the grantor's lifetime exemption and no requirement to file an IRS Form 709 "United States Gift (and Generation-Skipping Transfer) Tax Return."¹⁶ As an incomplete gift, the trust assets would continue to be included in the grantor's gross estate at death, which means the assets would receive the additional benefit of a step-up in basis at death under section 1041(a). Such a trust is commonly referred to as an incomplete gift nongrantor trust or ING trust. If the ING trust is created in a state such as Delaware, Nevada or Wyoming, it may be referred to as a DING, NING or WING, respectively.

There are a significant number of IRS private letter rulings ("PLRs") acknowledging that a grantor's transfer of assets to an ING trust is an incomplete gift for gift tax purposes, but a completed transfer for income tax purposes—making it a nongrantor trust.¹⁷ In several of the more recent PLRs, the grantor was provided with an inter vivos special power of appointment for health, education, maintenance and support of the beneficiaries in a non-fiduciary capacity, and the powers of the distribution committee members, which included the beneficiaries, were only exercisable in conjunction with the grantor.¹⁸ Thus, a nongrantor trust may be able to eliminate state income tax liability attributable to the sale of an asset—which could be up to a 13.3 percent tax savings for a state such as California¹⁹—while avoiding or deferring a gift for federal gift tax purposes, even if the grantor is able to get all of the trust property back at a later date.²⁰

Consider the following hypothetical situation:

Example 1: Gary is a resident of California who owns 50 percent of the outstanding shares of a C corporation he acquired directly from the company six years ago, with a zero basis in the shares for tax purposes.²¹ The shares qualify as QSBS for purposes of section 1202. The company may be purchased by a strategic or tactical buyer in the near future for $40,000,000—that is, $20,000,000 for Gary's shares—and there is no currently pending transaction that would trigger the "anticipatory

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