Avoiding and Attracting Grantor-Trust Treatment

AuthorJerold I. Horn
ProfessionLawyer
Pages331-405
331
Certain powers and interests have implications for inclusion of trust income in, or exclu-
sion of trust income from, the gross income of the grantor of a trust. Although the rules
are discrete, they are neither clear nor sensible. The rules appear in Subpart E (consist-
ing of sections 671 through 679) of Part I of Subchapter J of Chapter 1 of the Internal
Revenue Code (“Code”). This analysis does not address Code Section 679, which deals
with foreign trusts.
Grantor-trust treatment easily can occur inadvertently. Many of the determinants
are subtle or unclear. As an example, in common congurations, a broadest form of
nongeneral power to appoint by will might cause grantor-trust treatment according to
Code Sections 673, 676, and 677. If these observations are correct, lawyers apparently
are ignoring them, or, less likely in the view of the writer, lawyers either are (i) excluding
as permissible appointees the grantor, the spouse of the grantor, their respective credi-
tors and estates, and the creditors of their respective estates or (ii) properly reporting a
very large (indeed, in the view of the writer, an unexpectedly large) number of trusts as
grantor trusts.
The avoidance of grantor-trust treatment is joined in importance with its obverse,
the attraction of grantor-trust status. A person who creates a trust must know whether
he or she or another will bear the tax on the income. Advisers to all grantors must know
how to exclude trust income from, and to include trust income in, the gross income of
the grantor.
Traditionally, a person who during life gave property to a trust for the benet of one
or more others not only wanted to exclude the trust estate from his or her gross estate
for estate tax purposes but also wanted to exclude the trust income from his or her gross
income for income tax purposes. Some grantors want to avoid the risk of having to ser-
vice an obligation the future magnitude of which is unknown or only dimly perceived.
Others want to give gifts of xed amounts, and no more. These grantors want to avoid
inclusion of the trust income in their gross income.
13
Avoiding and Attracting
Gra ntor-Trust Treatment
Chapter 13332
The grantor-trust rules are a barrier to the traditional objective of excluding income
from the gross income of the grantor. The principal purpose of the grantor-trust rules
is to prevent the grantor from fragmenting the family income and subjecting it to lower
tax rates but retaining enjoyment or control.
Today, during a regime in which trusts and beneciaries often are taxed at rates at
least as high as those at which grantors are taxed, a grantor has less incentive to exclude
trust income from his or her gross income. Indeed, if the grantor can retain an obliga-
tion to pay the income tax without the trust being included in his or her gross estate
for estate tax purposes, the family often suffers no detriment for income tax purposes
and, because the grantor can pay the tax without the payment being an additional gift
for gift tax purposes, enjoys a benet for transfer tax purposes.
This chapter is divided into two parts. Part One focuses on exclusion of trust income
from the gross income of the grantor. Part Two focuses on inclusion of trust income in
the gross income, coupled nevertheless with exclusion of the trust estate from the gross
estate, of the grantor.
PART ONE
EXCLUSION OF INCOME FROM
GROSS INCOME OF GRANTOR
I. METHODOLOGY
Part One is an analysis of the grantor-trust implications of the trusts that are described
in II, below, and of their respective powers and interests that are described in III, below.
Except for the contingent reversion that is described at (i) of III.A, the trusts, and the
powers and interests, do not include anything that the grantor explicitly retains. Grantor
retained annuity trusts, grantor retained unitrusts, grantor retained income trusts, and
qualied personal residence trusts are outside the scope of this Part One.
The methodology that is used in this Part One is to test in IV for grantor-trust treat-
ment according to Code Sections 673, 676(a), and 677(a) because of powers and interests
that permit the transfer of all or part of a trust estate to the grantor or the spouse of the
grantor or to the estate of the grantor or the estate of the spouse of the grantor, to test
in V for grantor-trust treatment of powers of disposition according to Code Section 674
and to test in VI for grantor-trust treatment of powers of withdrawal according to Code
Section 678. The conclusions in VII relate to the specimen powers and interests that are
described in III. The conclusions in VIII relate to the specimen trusts that are described
in II. An analysis of the effects, both income tax and transfer tax, of administrative pow-
ers that are described in Code Section 675 appears in Part Two.
333Avoiding and Att racting Grantor-Trust Treatment
II. SPECIMEN TRUSTS
A. Code Section 2503(c) Trusts
As a rst specimen, assume a trust that follows the statutory format of Code Section
2503(c), including that no substantial restriction prevents the trustee from distribut-
ing income and principal to the donee, that the trust estate is included in the gross
estate of the donee if the donee dies before the trust terminates, and that when the
donee attains age 21, the trust estate is distributed to the donee or is subject to the
right of the donee to withdraw all of the trust estate. See Code § 2503(c); Treas. Reg.
§25.2503-4(b)(1); Rev. Rul. 74-43, 1974-1 C.B. 285. Assume, also, that the trust is not
usable to discharge any legal obligation owed to the donee and that the trust includes
a proscription of the administrative powers that could cause grantor-trust treatment
according to Code Section 675.
B. Code Section 2642(c) Trusts
A trust that is described in Code Section 2503(c) is also described in Code Section 2642(c).
Potential formats of Code Section 2503(c) trusts are few, but potential formats of other
Code Section 2642(c) trusts are many. All trusts (including Code Section 2503(c) trusts)
that are described in Code Section 2642(c) share the characteristics that none of the trust
estate is distributable to other than the donee during the life of the donee and that the
trust estate is included in the gross estate of the donee if the donee dies before the trust
terminates. Additionally, each trust that is described in Code Section 2642(c) serves as
a receptacle for annual-exclusion gifts. Therefore, each possesses at least one of the fol-
lowing characteristics:
i.
The trustee must distribute the income currently to the donee (see Code §2503(b)),
ii. The trust is described in Code Section 2503(c) (see II.A, above), or
iii. The donee has a Crummey power with respect to each gift to the trust or, at least,
with respect to an aggregate of gifts each year that would qualify as annual-exclu-
sion gifts if outright to the donee of the Crummey power
See Code §2642(c)(3). As it is used in this chapter, “Code Section 2642(c) trust” refers
only to the type of trust that is described in (iii). Assume, in other words, as a second
specimen, that, consistently with Code Section 2642(c), the donee has a Crummey power
with respect to each gift to the trust and that the trust is included in the gross estate of
the donee if the donee dies before the trust terminates. Also, assume that the trust is not
usable to discharge any legal obligation owed to the donee and that the trust includes
a proscription of the administrative powers that could cause grantor-trust treatment
according to Code Section 675.

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT