There's Nothing Defective About a Grantor Trust

• Publication year: 2023
• Author: By Bruce Givner, Esq.* and Owen Kaye, Esq.*

THERE'S NOTHING DEFECTIVE ABOUT A GRANTOR TRUST

By Bruce Givner, Esq.* and Owen Kaye, Esq.*

I. INTRODUCTION

A. Client Meeting

John and Jane Smith meet with Eloise, their estate planning lawyer. John and Jane have an apartment building worth $30,000,000, not subject to debt. That, plus their other assets, means there will be a large estate tax on the survivor's death.

Eloise explains a way to reduce the ultimate estate tax. Many details are required due to our complex property tax rules, which we will not recount here. However, the plan's essence is to:

(i) contribute the building to a family limited partnership;⁰¹
(ii) get the building appraised;
(iii) get the limited partnership interests appraised;⁰²
(iv) set up a trust for the children of John and Jane; and
(v) make a part-gift, part-sale of limited partnership interests to the children's trust.

John and Jane understand (they are very bright) and like the plan. However, since they paid $4,000,000 many years ago for the building, they have a question: "Won't a sale to the children's trust require us to recognize a large taxable capital gain?"

"No," Eloise explains. "That won't occur because the children's trust will be an intentionally defective grantor trust."

"Why," John and Jane ask, "would we want to set up a defective trust?"

B. Definition

"Defective" is an adjective defined as "having a defect or flaw: imperfect in form, structure or function."⁰³ "Defect" is a noun defined as "an imperfection or abnormality that impairs quality, function, or utility."⁰⁴

C. Structure of Subchapter J

The sections governing the taxation of trusts are in:

Title 26 of the U.S. Code - The Internal Revenue Code

Subtitle A - Income Taxes

Chapter 1 - Normal Taxes and Surtaxes

Subchapter J - Estates, Trusts, Beneficiaries, and Decedents

Part I - Estates, Trusts, and Beneficiaries

Part I (Internal Revenue Code sections 641-685) consists of five subparts. Three are relevant for our purposes:

Subpart B "Trusts Which Distribute Current Income Only" (not the most common form of irrevocable trust);

Subpart C "Estates and Trusts Which May Accumulate Income or Which Distribute Corpus" (what we normally refer to as "complex" trusts); and

Subpart E "Grantors and Others Treated as Substantial Owners" (the main topic of this article).

The key takeaway is that grantor trusts—the subject of Subpart E—are, at least from the perspective of their placement in the Internal Revenue Code (hereafter "IRC"), every bit as normal as complex trusts, the subject of Subpart C.

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D. Usage

Practitioners often refer to an "Intentionally Defective Grantor Trust" and its acronym "IDGT."⁰⁵ However, there is nothing "defective" about a grantor trust. In fact, the first sentence of section 671 of the IRC begins by telling us that grantor trusts are the norm, not the exception:

Where it is specified in this subpart that the grantor or another person shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account under this chapter in computing taxable income or credits against the tax of an individual.

Lawyers are not the only ones who refer to grantor trusts as "intentionally defective grantor trusts" and IDGTs. Accountants, insurance agents, financial planners and other advisors are so used to the term IDGT that, upon hearing the phrase "grantor trust," they are often confused: "What the heck is a grantor trust?"

E. The Internal Revenue Code Is Not a Law

One obvious source of confusion is that lawyers and other advisors think of the Internal Revenue Code as a law. In truth, it is not a law. It is, at least, two different bodies of law:

(i) the income tax (Subtitle A, sections 1-1564); and
(ii) the transfer taxes (Subtitle B, sections 20012801).

Most people think the word "own" is English. Indeed, as an adjective it is defined as "belonging to oneself or itself—usually used following a possessive case or possessive adjective;" and as a verb it is defined as "a. to have or hold as property. b. to have power or mastery over."⁰⁶

However, the word "own," for our purposes, is not English. It is defined in the Internal Revenue Code. And, since the Internal Revenue Code is—for our purposes—two different bodies of law, the word "own" has two different meanings.

As a result of those two bodies of law and two different meanings, we have a system that (i) many lawyers, (ii) almost all accountants and other professionals, and (iii) clients cannot understand, under which there can be four different types of trusts:

	Income Tax Ownership	Transfer Tax Ownership
Living ("Revocable" or "Inter Vivos" or "Family") Trust	Yes	Yes
Children's Trust (typically done for estate tax planning)	Yes	No
Incomplete Gift Complex, Discretionary Children's Trust (Nevada incomplete gift non-grantor trust)	No	Yes
Completed Gift Complex, Discretionary Children's Trust (Nevada completed gift non-grantor trust)	No	No

F. Horror Story

You are being sued in an estate planning matter by a disgruntled client. It is essentially a frivolous claim which, unfortunately, got past summary judgment and is now at trial in front of a jury.

The plaintiff's counsel interrogates you. "Tell us, Mr. Lawyer. Did you prepare this trust?"

You answer: "Yes, I did."

Plaintiff's counsel continues: "Did you tell your client that the trust had an imperfection that impaired its function?"

You answer: "Of course not. It has no imperfection that impaired its function."

Plaintiff's counsel continues: "Isn't it true that you intentionally made this a defective trust?"

Of course, you will: (i) have an explanation and (ii) introduce an expert who will testify that the phrase "intentionally defective grantor trust" does not, in fact, refer to a trust which is defective or, if it is, it is "defective" to achieve a certain desired result. However, the jury may not be sophisticated enough to understand the explanation. The word "defective" (with its meaning of "imperfect in function") may still be ringing in their ears during their deliberations.

II. HOW WE GOT HERE

A. Grantor Trusts: Once Bad, Now Good

The bacterium Clostridium botulinum is one of the most toxic substances known to humanity.⁰⁷ However, now, in the form of Botox®, it is widely used to remove the frown lines from people worried about the uncertainties caused by the current Administration's Green Book.⁰⁸

The grantor trust rules have a similar 180-degree history. They began life in 1946 as the Clifford regulations,⁰⁹ a way to prevent taxpayers from "splitting" income with lower bracket irrevocable trusts. They were then embodied in the

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1954 Act as IRC, sections 671 through 679, that generally followed the regulations. By 2004, instead of something to be avoided, they had become an object of desire in planning for wealthy clients.¹⁰

B. 1970s Usage of Complex Trusts

In the 1960s and 1970s, grantor trust status was intended to be avoided since, at that time, trusts were in lower income tax brackets.

Assume Dr. Smith, in 1977, was making $233,000 per year. As a part of a married couple filing jointly, she was in the 70% tax bracket for income above $203,000.¹¹ She established an irrevocable complex trust for the benefit of her children. The complex trust acquired the equipment needed for the medical practice. According to an appraisal, the annual fair market rent for the equipment was $30,000. The complex trust, taxed as a single person, was in the 45% tax bracket below $34,000.¹² The complex trust entered into a rental agreement with the medical practice pursuant to which $30,000 per year was shifted from the medical practice to the children's trust. Dr. Smith and her husband were able to use the complex trust's after-tax profits to pay expenses for their children which might have included private elementary and high school,¹³ along with summer camps. Shifting $30,000 from Dr. Smith to the irrevocable, complex children's trust saved significant taxes each year for the family unit.

However, the Tax Reform Act of 1986¹⁴ flattened the individual tax rates and virtually eliminated lower brackets for trusts.¹⁵ As a result, that type of planning virtually disappeared.

How did the word "defective" come to be associated with a grantor trust?¹⁶ Four years after the 1986 Tax Reform Act, Congress passed another major tax act: the Revenue Reconciliation Act of 1990.¹⁷ This new Act added Chapter 14, entitled "Special Valuation Rules." This new chapter governing transfer taxes provided certain new valuable tools, e.g., grantor retained annuity trusts ("GRATs")¹⁸ and qualified personal residence trusts ("QPRTs").¹⁹ Both of those new structures needed to be disregarded for income...