Chapter 13. Avoiding and Attracting Grantor-Trust Treatment

• Author: Jerold I. Horn
• Pages: 393-473

13

Avoiding and Attracting Grantor-Trust Treatment

Certain powers and interests have implications for inclusion of trust income

in, or exclusion 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 (consisting 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

configurations, 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 creditors 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

benefit 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 service an

obligation the future magnitude of which is unknown or only dimly

perceived. Others want to give gifts of fixed amounts, and no more. These

grantors want to avoid inclusion of the trust income in their gross income.

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 beneficiaries 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 obligation 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 benefit for transfer tax purposes.

This Chapter 13 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 qualified

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 treatment 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 powers that are described in

Code Section 675 appears in Part Two.

II. SPECIMEN TRUSTS

A. Code Section 2503(c) Trusts

As a first specimen, assume a trust that follows the statutory format of Code

Section 2503(c), including that no substantial restriction prevents the trustee

from distributing 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 following 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