Ing Trusts and the State of California

• Jurisdiction: California,United States
• Author: Diana M. Hastings*
• Publication year: 2020
• Citation: Vol. 26 No. 1

ING TRUSTS AND THE STATE OF CALIFORNIA

Diana M. Hastings*

MCLE Article

I. INTRODUCTION

Many clients wish to create trusts that benefit children or other beneficiaries but are concerned about later needing those assets themselves. Preserving the right to receive distributions, however, may expose the client's assets to his or her creditors. Moreover, some clients are hampered in such planning by the undesirable payment of gift tax that an irrevocable gift could entail. A client may solve these problems by creating an irrevocable trust in a jurisdiction that allows the client/grantor to receive trust distributions without losing creditor protection. These trusts are commonly referred to as "ING Trusts."¹

Because California has the highest marginal income tax rates in the country,² many clients also are intrigued by the idea of avoiding an immediate payment of state fiduciary income tax on income that would otherwise be accumulated, without requiring that the client establish residency elsewhere. The potential California income tax may be deferred until a distribution to a beneficiary or the grantor resident in California is made. If a distribution is made from accumulated income, California would tax the accumulated distribution in the hands of a California resident as if the income had been taxed contemporaneously with its accumulation, but without the payment of interest. In the interim, the trust in question earns a return on the putative tax.³

II. STRUCTURE OF AN ING TRUST AND ITS STATUS AS A NON-GRANTOR TRUST A. Typical Terms of an ING Trust

An ING Trust typically has the following terms:

The selected beneficiaries and the grantor are the trust's wholly-contingent beneficiaries.

Any distributions to a beneficiary or the grantor must have the approval of a non-fiduciary distribution committee ("Distribution Committee," also sometimes known as a power of appointment committee) composed of the beneficiaries themselves.

Distributions may be made (a) by the unanimous consent of the Distribution Committee (unanimous member power), (b) by the consent of a majority of the Distribution Committee plus the consent of the grantor (grantor's consent power), or (c) by the direction of the grantor to the trustee to make a distribution to any of the beneficiaries for the "health, maintenance, support or education" of such beneficiary (grantor's sole power).

No distribution may satisfy any individual's obligation to support a beneficiary.

At all times during the grantor's life, the Distribution Committee must include at least two persons who are eligible to receive trust distributions. The Distribution Committee dissolves upon the grantor's death or if the number of Distribution Committee members drops below two.

If the Distribution Committee is dissolved, the trustee has wholly discretionary powers of distribution. The trustee may not exercise this discretionary power while the Distribution Committee is in existence.

The grantor also reserves the broadest possible limited power of appointment. The grantor retains a power to appoint the assets of the trust at death to anyone, other than his or her estate, creditors, or creditors of the estate (grantor's testamentary power).

Under the terms of the trust, the grantor designates the law of the state having jurisdiction over the trustee as the law to be applied to the trust.

For purposes of this analysis, it is assumed that the grantor has no existing or known creditors or potential creditors and has no reason to believe that he or she will acquire such creditors in the future.

B. Applicable Grantor Trust Rules

Sections 673 through 679 of the Internal Revenue Code ("IRC") prescribe the circumstances under which a grantor will be taxed on the income of a trust. None of these sections apply to an ING Trust.

The grantor does not retain a reversionary interest, so IRC section 673 does not apply. Assuming none of the circumstances set forth in IRC section 675 are contained in the trust instrument or arise during the ING Trust's operation, that section also does not apply.⁴ Because the grantor does not retain the power to revoke the trust, IRC section 676 does not apply. Finally, as this transfer is not to a foreign trust, IRC section 679 does not apply.

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1. Sections 674 and 677 of the IRC

The unanimous member power and the grantor's consent power are implicated in sections 674 and 677 of the IRC. Section 674 of the IRC provides that the income of a trust will be taxed to the grantor if the grantor has the power to change the beneficial enjoyment of the trust income or principal (the "Grantor's Consent Power"), without the approval or consent of a party "adverse" to the exercise of the power for income tax purposes. Section 677 of the IRC provides that the income of a trust will be taxed to the grantor (whether or not the grantor is treated as the owner of the trust under section 674) if the income may be distributed to the grantor or the grantor's spouse (the "Unanimous Member Power"), without the approval or consent of a party "adverse" to the exercise of the power for income tax purposes.

Each member of the Distribution Committee, however, is adverse to the exercise of either the Unanimous Member Power or the Grantor's Consent Power. "Adverse" party is defined in IRC section 672(c) as "any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust." Accordingly, section 672 of the IRC provides three elements for a party to be "adverse" to the exercise of the Unanimous Member Power or the Grantor's Consent Power: (a) the party must have a discretionary power over the trust, (b) the party must have a "substantial beneficial interest" in the trust, and (c) the exercise or non-exercise of the power must adversely affect the party's beneficial interest.⁵

To be applicable, the powers of the adverse parties must be discretionary and not fixed,⁶ and thus the powers of the Distribution Committee pass muster under the first prong. Present or remainder interests are beneficial interests for these purposes.⁷ An interest is a "substantial interest" if its value in relation to the total value of the property subject to the power is not "insignificant," and the interest may be substantial even if the interest is not vested under local law.⁸ In an ING Trust, the ability of a member of the Distribution Committee to receive a distribution of any or all of the trust assets makes his or her trust interest "substantial," and so the second prong is met.

Whether the exercise of the power by a member of the Distribution Committee would be "adversely" affected (and thus whether the third prong is met) is a factual question and requires a finding that the power-holder's interest would be changed by the exercise or non-exercise of the power. Obviously, the member's interest in the ING Trust would be changed by any exercise of the power in favor of a beneficiary other than the member or the grantor. In the 1991 case of Water Resource Control,⁹ the tax court suggested that a discretionary interest in distributions subject to a fiduciary's sole discretion might not be a "substantial beneficial interest." However, that case is not germane to ING Trusts as the grantor in Water Resource Control had the unfettered power to amend the trust and thus could re-vest title in himself under IRC section 676. Also, in Paxton v. Commissioner,¹⁰ a trustee had the power to terminate the trust and to make distributions of income, which would result in a proportionate distribution of assets to those who contributed. The taxpayers contended that the trust arrangement created a "last survivor take all" scenario and thus the trustee was adverse to the taxpayers, but the court disagreed. The court found that the trustee's 3.84% interest in the trust was not sufficient to create adversity as to the entire trust, but only as to his share.¹¹ By contrast, the ING Trust does not create separate shares of trust assets; instead, it allows the entire trust assets to be distributed to a beneficiary or the grantor.

With regard to the "Grantor's Sole Power," IRC section 674(b)(5)(A) provides that the grantor's power to change the beneficial enjoyment of the trust's income or principal will not cause the income of a trust to be taxed to the grantor if the power to distribute principal or income is limited by a "reasonably definite standard." The regulations approve the power to distribute for a beneficiary's "education, support, maintenance, or health" and do not limit such powers to those which are fiduciary.¹² Thus, the Grantor's Sole Power to direct distributions for the health, education, maintenance, and support (HEMS) of a beneficiary will not cause the trust's income to be taxed to the grantor.

2. Section 677 of the IRC and the Need for Future Creditor Protection

With limited exceptions, the regulations under section 677 of the IRC also provide that the income of a trust will be taxed to the grantor if, in the discretion of the grantor or a nonadverse party, or both, the income may be applied in discharge of a legal obligation of the grantor or their spouse.¹³ If the grantor's creditors would have access to the trust assets, these regulations presume that the grantor has the power to dispose of the beneficial enjoyment of the income or principal by relegating his or her creditors to the trust property.¹⁴

California Probate Code section 15304, subdivision (a) provides that any restraint on the voluntary or involuntary transfer of a grantor-beneficiary's interest (a "spendthrift clause") in a trust instrument is invalid against any creditors (including future unknown creditors) of the grantor. The validity of the remaining trust provisions is not affected. Under section 15304, subdivision (b), if the grantor is the beneficiary of a trust instrument under which the trustee may make discretionary distributions of income or principal...