Section 2B: Income Tax Issues[Continued]

2B.6 RELATED OR SUBORDINATE PARTY DEFINITION

In Rev. Rul. 95-58, 1995-2 C.B. 191, the IRS adopted the related or subordinate party definition of IRC section 672(c). The 1995 ruling (which revoked Rev.Ruls. 81-51, 1981-1 C.B. 458 and 79-353,1979- 2 C.B. 325, and modified Rev. Rul. 77-182, 1977-1 C.B. 273) holds that a grantor’s reservation of an unqualified power to remove an existing trustee and appoint a replacement trustee who is not related or subordinate to the grantor (within the meaning of IRC section 672(c)) is not a reservation of the trustee’s discretionary powers of distribution that might cause trust corpus to be included in the grantor’s estate under IRC sections 2036(a) and 2038(a)(1) (concerning retained interests or the ability to affect the beneficial enjoyment of gifted property). See, sections 4.3(a) and 11.9, below, for further discussion of the power to remove a trustee.

Caution: The following individuals, if they are a non- adverse party,1 are treated as related and subordinate to the power holder: (1) the power holder’s spouse if living with the power holder; (2) the power holder’s father, mother, issue, brother, or sister; (3) a corporation, or any employee of a corporation, in which the power holder’s voting control is significant; and (4) a subordinate employee of a corporation in which the power holder is an executive. In the absence of a preponderance of the evidence to the contrary, a related and subordinate party is presumed for purposes of IRC section 672(f ), 674, and 675, to be subservient to the wishes of the grantor with regard to the exercise or non- exercise of a power. However, the following individuals are not related or subordinate parties under IRC section 672(c), as concerns the power holder: (1) the power holder’s nieces and nephews, (2) the power holder’s grandparents; (3) spouses of the power holder’s children, grandchildren, brothers, or sisters; and (4) partners of the power holder. Treas. Reg. §1.672(c)-1.

2B.7 INCOME TAXATION OF ILIT AND THE GRANTOR (THE GRANTOR TRUST RULES)39

An ILIT is a separate taxpayer (IRC section 641) unless the ILIT is (1) a grantor trust under sections 671-67740 (in which case the income, credits, and deductions of the ILIT are attributed to the grantor41 and are included in determining the grantor’s income tax liability under IRC section 671—regardless of who actually receives the cash distributions)2; (2) a foreign trust under IRC section 679 that has both a U.S. grantor and at least one U.S. beneficiary (in which case the grantor will be taxed on the ILIT’s income),3 or (3) a no grantor (such as a beneficiary) is treated as the owner of the trust for income tax purposes under IRC section 678 (in which case the non-grantor will be taxed on the trust’s income4). Grantor trust status may be partial or full, depending on the powers held by the grantor (or beneficiary in the case of IRC section 678(a)).5 Application of the grantor trust rules is not elective—the grantor (or beneficiary as the case may be under section 678) cannot elect out of the grantor trust rules if they otherwise apply (the grantor may, however, be able to relinquish grantor trust status by releasing the power that triggers grantor trust status).

One of the key transfer tax benefits of grantor trust status is that the payment of the trust’s income taxes by the grantor permits the trust to grow “income tax free.” The income taxes paid by the grantor on behalf of the trust is gift tax free, and removes that amount from the grantor’s gross estate for federal estate tax purposes. See, sections 3.18 and 4.2(b), below, for further discussion on the gift and estate tax con- sequences of the grantor’s payment of the trust’s income taxes.

Caution: Not all states follow the federal grantor trust rules concerning the state income taxation of trusts.

2B.7(a) Power Or Interest Held By Grantor’s Spouse Attributable To Grantor

 For transfers in trust after March 1, 1986, the grantor of an irrevocable trust is treated as having any power or interest of the grantor’s spouse. IRC section 672(e)(1). Therefore, if the spouse is the trustee or beneficiary of the trust, the trust should be treated as a grantor trust for income tax purposes, and the trust’s income will be taxed to the grantor. If the spouse is not a trustee, beneficiary, or grantor of the trust, but the spouse holds the power to substitute trust assets under IRC section 675(4)(C) or the power to borrow the trust corpus or income for adequate interest but without any security under IRC section 675(2), the trust should be treated as a grantor trust under IRC section 672(e) for income tax purposes, and the trust’s income will be taxed to the grantor. However, the attribution to the grantor of the spouse’s power and interest over the trust property does not apply to transfers made to the trust when (i) the parties are married but legally separated, (ii) the parties are legally divorced. In such an instance, grantor trust status may be “partial” to the grantor (concerning trans fers that occurred before the legal separation or divorce (see IRC section 672(e)(1)(A)), or (iii) the spouse resigns as a trustee and the successor trustee is not a related or subordinate person, and the trust may be a separate taxpayer with regard to transfers occurring after the separation, divorce, or resignation of the spouse-trustee. However, the death of the grantor’s spouse (but not their divorce,) will end the spouse’s powers and interests being attributed to the grantor, and grantor trust status because of the spousal attribution rules will terminate at that time.6 IRC section 672(e)(2).

2.7(b) Power To Control The Beneficial Enjoyment Of The Trust Property

A grantor’s power to control the beneficial enjoyment of the trust property (for income tax purposes) includes the power of a non- adverse party (as defined under IRC section 672(b), i.e., someone other than the grantor, the grantor’ spouse, a trust beneficiary or a holder of a general power of appointment over the trust property) to add additional trust beneficiaries (other than after-born or adopted children), such as spouses of beneficiaries, the grantor’s nieces and nephew, and/or charities. IRC sections 674(a),(c), and (d). Treas. Reg. §1.674(d)-2(b).

A common method of creating full grantor trust status is by permitting an independent trustee,7 who is a non-adverse party, to add or remove charitable beneficiaries and the spouses of the grantor’s descendants during the grantor’s lifetime and to make discretionary distributions to such beneficiaries.8 Bernard and Joyce Madorin v. Commissioner of Internal Revenue, 84 T.C. 667 (1985); (non-adverse, independent trustee’s power to add charitable beneficiaries held to cause grantor trust status); Pvt. Letter Ruls. 200030018, 199936031, 9709001, 9010065. See also, Priv. Letter Ruls. 9838017 (power of independent trustee to add and make distributions to charitable beneficiaries and spouses of grantor’s issue after a trust ceased to be a GRAT), and 199936031 (power to add charitable beneficiaries after the termination of a charitable lead annuity trust was effective to make the lead trust a grantor trust).

This grantor trust power can be relinquished9 by the holder of the power. Because of the adverse estate tax consequences triggered by IRC sections 2036 and 2038, neither the grantor nor a donor of property to the trust should be given the power to add beneficiaries. Also, if the grantor or donor holds the power to add beneficiaries, any gifts to the trust will be incomplete for gift tax purposes. Treas. Reg. §25.2511-2(c); Priv. Letter Rul. 200612002.

Practice Point: To avoid creating a general power of appointment in the person who holds the power to add beneficiaries, the power holder should not be able to add him or herself, his or her estate or the creditors of either as a beneficiary. See, IRC sections 2041 and 2514.

Practice Point: Another way to create grantor trust status under ITC section 674(a) is to permit a related trustee, such as the grantor’s spouse (see, section 2.6, above for the definition of a “related” person) the power to distribute income and principal among the grantor’s descendants, without limiting this power to an ascertainable standard.

2B.7(c) Power Of Independent Third Party To Affect Beneficial Enjoyment Of Trust Property

If the grantor appoints a special power holder (who is not an adverse party or a trustee) with the discretionary power to appoint the trust assets during the grantor’s lifetime to two or more trust beneficiaries without any fiduciary requirement, without any ascertainable standard, without the appointed property being chargeable against the proportionate share of corpus held in trust for the payment of income to the beneficiary as if the corpus constituted a separate trust (see, IRC section 674((b)(5)(B)), and without any requirement to make compensating adjustments between beneficiaries who do not receive the appointed property, IRC section 674(a) will cause the grantor to have full grantor trust status over the trust property that is subject to the special power holder’s discretionary non-fiduciary power of appointment.See, section 11.1, below concerning the appointment of a special power holder.

2B.7(d) Power To Substitute Property Of Equal Value

A common method of creating full grantor trust status is by including a power in the trust instrument allowing the grantor, the grantor’s spouse, or a non-adverse party (as defined under IRC section 672(b)), acting in a non-fiduciary capacity and without the approval or consent of any person acting in a fiduciary capacity, to substitute trust property with other property of an equivalent value. IRC section 675(4)(C); Treas. Reg. §1.675-1(b)(4). Because the power to substitute trust property must be held in a “non-fiduciary capacity” and must not require the consent of a fiduciary, this power should not be given to a trustee. This grantor trust power can be relinquished by the holder of the power. The power of substitution, if held by the grantor, does not prevent a gift to the trust from being a completed gift under IRC section 2511. Priv. Letter Ruls. 9415012, and 9227013.

This power, held in a nonfiduciary capacity, should not result in the trust property being included in the grantor’s gross estate, and will cause the trust’s income and capital gains to be taxed to the grantor.10 Estate of Anders Jordahl v. Commissioner, 65 T.C. 92 (1975), acq. 1977- 2 C.B. 1 (where grantor-insured’s power to substitute life insurance policies was expressly held in a fiduciary capacity).11 See, Rev. Rul. 82-5, 1982-1 C.B. 131; Pvt. Letter Ruls. 200434012, 200001015, 200001013, 199922007, 9843024, 9713017, 9548013, 9413045, and 9227013. The power of substitution can also be held by a non- adverse third party. Pvt. Letter Ruls. 200434012 (grantor’s father held power of substitution), 199908002 (grantor’s brother held power of substitution), 9810019 (the Karmazin ruling, where a disinterested party held the power of substitution), 9037011 (co-trustee held power of substitution, and 9026036 (grantor’s spouse held power of substitution). See also, Pvt. Letter Ruls. 9713017, 9642039, 9227013, and 9247024. If a third party holds the power to substitute assets, there is less risk of the IRS attempting to include the trust assets in the grantor’s gross estate under IRC sections 2036, 2038, or 2042. However, when a third party holds the power of substitution, the grantor trust power under IRC section 675(4)(C) will terminate upon the third party’s death or resignation, unless a new non-adverse third party is appointed before the death or resignation of the current third party holder of the power of substitution. Priv. Letter Ruls. 199908002 (trust instrument appointed a successor to the non- adverse party powerholder), and 9548013 (grantor/powerholder retained the power to appoint a successor powerholder).

Practice Point: The determination of whether the power of substitution is exercisable in a fiduciary or a nonfiduciary capacity depends on all the terms of the trust and the circumstances surrounding its creation and administration. Treas. Reg. §1.675-1(b)(4); Pvt. Letter Ruls. 9713017, 9437023, and 9437022. Because of the facts and circumstances test that must be employed to determine if the power is held in a non-fiduciary capacity, it may be wise to rely on other grantor trust powers, or to bundle the power of substitution with other grantor trust powers to ensure grantor trust treatment. Pvt. Letter Rul. 9413045. See, Rev. Proc. 2007-3, 2007-1 I.R.B. 108, section 3.01(47).12 See also, Treas. Reg. §1.675-1(a), which states as a general rule, “Section 675 provides in effect that the grantor is treated as the owner of any portion of a trust if under the terms of the trust instrument or circumstances attendant on its operation administrative control is exercisable primarily for the benefit of the grantor rather than the beneficiaries of the trust.”

Practice Point: If the grantor’s power to substitute assets does not extend to all of the trust assets (e.g., the trust instrument prohibits the grantor’s substitution of IRC section 2036(b) stock and/or life insurance policies on the grantor’s life), the grantor will not have grantor trust status over the assets that are “excluded” from the power of substitution. Consequently, it will be necessary to rely on other grantor trust powers to achieve grantor trust status over the “excluded” assets. In Pvt. Letter Ruls. 200514001 and 200514002, the grantor had the power to substitute trust assets other than IRC section 2036(b) stock, the trust held 2036(b) stock and other substantial assets, the grantor proposed to sell a life insurance policy to the trust for full an adequate consideration, and the trust proposed to pay for the policy using trust assets other than the 2036(b) stock. The IRS ruled that that the sale of the policy to the trust was not a transfer for value but a transfer to the insured because the trust assets that were to be used to purchase the policy were taxable (for income tax purposes) to the insured-grantor and, therefore, the insured-grantor was treated as owning the purported consideration both before and after the transaction pursuant to Rev. Rul. 85-13, 1985-1 C.B. 184.

Practice Point: In addition to creating grantor trust status, an advantage of using the power of substitution is that it provides the grantor with the opportunity to substitute low basis assets in the trust with high basis assets or cash. As such, if the low basis assets remain in the grantor’s estate, they will obtain a stepped-up basis at the grantor’s death. In Priv. Letter Rul. 200603040, the IRS ruled that neither the grantor nor the trust would recognize any income or loss upon the grantor’s exercise of the power of substitution, nor would the exercise of the power be treated as a gift to the trust by the grantor.

Caution: If the grantor transfers pre-IPO stock or publicly traded corporate securities to the trust, be mindful of the insider trading rules under section 10(b) of the Securities and Exchange Act of 1934, and Rules 10b-5 and 10b5-1. The ability to reacquire the securities may be construed as an option, and the reacquisition of the securities may give rise to a charge by the U.S. Securities and Exchange Commission of insider trading. Therefore, in such situations, do not use the power of substitution to create grantor trust status, and do not use a trustee who is a corporate insider with respect to the shares of stock. Also, if the trust makes an in kind distribution of restricted stock to the grantor, the grantor may be able to tack on the trust’s holding period for purposes of Rule 144.

2B.7(e) Power To Borrow Money From The Trust For Adequate Interest But Without Any Security

Another common method of creating full grantor trust status is by giving the grantor, the grantor’s spouse, or a non-adverse party (as defined under IRC section 672(b)) the power to borrow the trust corpus or income for adequate interest but without any security, provided the trustee does not have the power under a general lending provision to make loans to any person without adequate interest or security. IRC section 675(2). Pvt. Letter Ruls. 199942017, 9645013, and 9525032. This grantor trust power is typically triggered by giving an independent trustee (as defined under IRC section 672(c)) the power to make loans to the grantor (or the grantor’s spouse) without any security but with an adequate rate of interest; provided loans during the grantor’s lifetime to all other persons must bear an adequate rate of interest and be adequately secured. This grantor trust power can be relinquished by the holder of the power.

Caution: The ability of the grantor to borrow trust funds without adequate interest may result in the inclusion of the trust property in the grantor’s gross estate under IRC sections 2036 and 2038. Furthermore, if the grantor has the power to borrow trust assets for less than full and adequate consideration, this, too, may risk the trust property being included in the grantor’s gross estate under IRC sections 2036 and 2038.

Practice Point: Any amounts actually borrowed by the grantor or the grantor’s spouse should be evidenced by a promissory note bearing adequate interest but without any security.13 This means the note must bear the minimum interest rate under IRC section 1274 to avoid a deemed gift of forgone interest under IRC section 7872. If the grantor desires to maximize the amount that he or she can transfer to the trust “gift tax free,” consider a higher rate of interest, similar to what a bank might charge for an unsecured loan, e.g., the interest rate charged by a credit card company (typically 18% to 24%). However, do not charge of rate of interest that is usurious. Because the trust will be a grantor trust, the grantor’s payment of interest on the promissory note should be ignored for income tax purposes, i.e., the grantor will not be entitled to an interest expense deduction and the interest received by the trust will not be subject to income taxation, since the payments and receipts are transactions between the grantor and his or her grantor trust. Rev. Rul. 85-13, 1985-1 C.B. 184.

2B.7(f) Actual Borrowing Of Money From The Trust For Adequate Interest But Without Any Security

A supplement to the IRC section 675(2) power to borrow rules, and a way to create full grantor trust status if an existing trust does not have other grounds or means for becoming a grantor trust, is for the grantor or the grantor’s spouse to actually borrow income and/or corpus (directly or indirectly) from the trust and not fully repay the loan before the beginning of the trust’s taxable year in which the loan is made. IRC section 675(3). Thus, any loan made to the grantor (or the grantor’s spouse) after the beginning of the trust’s taxable year (e.g., a loan made on or after January 1, 2007) will result in grantor trust status for the entire tax year, even if the loan is repaid before the close of the trust’s taxable year (e.g., the grantor repays the loan in full on March 3, 2007).14 This grantor trust power can be relinquished or “turned off ” by not borrowing for any day during the tax year in question. The loan can be made by an independent trustee (in which case an adequate rate of interest must be charged, but no security must be given), or the loan can be made by a trustee who is related or subordinate to the grantor (in which case the subordinate or related trustee can charge interest and obtain security for the loan, or not charge any interest and/or not obtain any security). However, to avoid potential gift tax implications under IRC section 7872 and to avoid estate tax inclusion under IRC sections 2036 and 2038, it is best for the grantor to pay an adequate rate of interest under IRC section 1274 but provide no security for the loan, regardless of the identity of the trustee.

In William K. M. Mau v. United States, 355 F. Supp. 909 (D. Haw. 1973), the court held that the actual borrowing of trust corpus or income by a grantor at any time during a taxable year would result in the grantor being taxed on trust income for that entire year under IRC section 675(3). See also, Rev. Rul. 86-82, 1986-1 C.B. 253, where the IRS ruled that a grantor-trustee who had both borrowed the entire trust corpus and repaid the borrowed funds plus interest in the same year would be treated for federal income tax purposes as the owner of the entire trust for that year. The ruling stands for the proposition that if the grantor of a trust borrows trust corpus or income at any time during the trust’s taxable year, the grantor is taxed on the trust income for the entire year under IRC section 675(3).56 Once the loan is repaid in full, grantor trust status ceases under IRC section 675(3) for the tax- able year succeeding the year in which the loan is repaid (e.g., if a loan is made January 2, 2006 and repaid January 3, 2007, the grantor is treated as the owner of the trust for tax years 2006 and 2007, but not for succeeding tax years in which there is no borrowing).

In Larry W. Benson v. Commissioner, 76 T.C. 1040 (1981), the grantor borrowed all the trust income, which consisted of rental income, but did not borrow any of the trust corpus, which consisted of a commercial building (hence the rental income), and the court ruled that the grantor “borrowed all the trust income and that income was derived from the entire trust corpus. Thus, it is clear that …[the grantor] should be treated as owner of the entire trust.”

If the grantor borrows less than all of the trust’s income or corpus, the authorities are unclear regarding the portion of the trust the grantor is treated as owning under IRC section 675(2). The Code says that the grantor is treated as the owner of “any portion of a trust in respect of which” he has borrowed the corpus or the income. What is the “portion” where the grantor has borrowed less than all of the trust assets?

In O’Neil Bennett v. Commissioner, 79 T.C. 470 (1982), the grantor borrowed less than all of the income of the trust. The Tax Court held that the grantor should be taxed on that fraction of the current year’s trust income the numerator of which equaled the total unpaid loans at the beginning of the taxable year and the denominator of which equaled the sum of the income of the trust for prior years plus the income of the trust for the current year.

In the Estate of Jonathan Holdeen v. Commissioner, 34 T.C.M. (CCH) 129 (1975), the grantor, Jonathan Holdeen, borrowed less than all of the trust corpus (to wit, approximately 28% of the total trust corpus) for the period of 1951 to 1953, and the Tax Court (applying the 1939 Internal Revenue Code, and interpreting the “portion” issue under IRC section 675(3) of the 1954 Internal Revenue Code) ruled:

It is clear that the loan, including interest, was not completely repaid before the beginning of the taxable year 1951 or 1952 or 1953. The question remains whether under the regulations the entire income of Trust 45-10 or only the income from $80,000 of the assets of Trust 45-10 is taxable to Holdeen. The regulations [to the 1939 Internal Revenue Code] do not specifically limit the tax- able amount to the income of the “portion” of the trust, as do the provisions of the 1954 Code, section 675(3), supra, which are in perimetria. A court may properly look to subsequent legislation as an aid to statutory construction. [Citations omitted.] The administrative control referred to in the regulations [pertaining to the 1939 Code provision in question] was exercised primarily for the benefit of the grantor only with respect to the $80,000 loan and not with respect to the total assets of the trust, which amounted to $278,000 in 1948 and $696,000 in 1954. We hold that the income from $80,000 of the trust’s assets is taxable to Holdeen rather than the entire income of Trust 45-10 in the years 1951, 1952 and 1953.” Id. at 193.

In Richard L. Patsey v. United States, 84-1 U.S. Tax Cas. (CCH) 9304 (N.D. Cal. 1984), the grantor borrowed more than 50% of the trust corpus and nearly all of the trust’s income. The court held that all of the trust’s income was taxable to the grantor. In its opinion, the court stated:

Patsey borrowed the trust funds without security, and had not made any principal or interest payments on the loans before the beginning of 1974 or the beginning of 1975, the taxable years at issue here. Thus, under §675(3), the ‘portion of [the] trust in respect of which’ Patsey borrowed is treated as being owned by him. In 1973 Patsey received an unsecured loan $97,000, of which $90,000 was corpus and $7,000 was interest. These figures represent approximately 60% of the trust’s total corpus (assuming it is $152,000), and nearly 100% of its 1973 income (the trust had total interest income of $7,117.08). In 1974 Patsey received an additional $53,300, of which $40,000 was corpus and $13,300 interest. By the end of 1974, then, Patsey had over 85% of the trust’s corpus ($130,000 out of $152,000) and borrowed over 90% of its 1974 income (out of $13,903.44). These figures clearly show that by the beginning of the 1974 and 1975 tax years, Patsey had evidenced control and dominion over the entire trust, and all of the trust’s income is taxable to him. See, Benson v. Commissioner, 76 T.C. 1040 (1981). Id. at 83,667 Thus, we can conclude the following:

  • If the grantor borrows all of the trust corpus, the grantor is taxed on all of the trust’s income for the tax years that any part of the loan remains unpaid. IRC section 675(3); Rev. Rul. 86-82, 1986-1 C.B. 253; Mau, supra.
  • If the grantor borrows all of the trust’s income, the grantor is taxed on all of the trust’s income for the tax years that any part of the loan remains unpaid. Benson, supra.
  • If the grantor borrows some of the trust’s income, the grantor is taxed on a proportionate share of the trust’s income for the tax years that any part of the loan remains unpaid. Bennett, supra.
  • If the grantor borrows some of the trust’s corpus, the grantor is taxed on a proportionate share of the trust’s income for the tax years that any part of the loan remains unpaid. Holdeen, supra.
  • If the grantor borrows a significant portion of the trust corpus (i.e., more than 50%) and/or borrows a significant portion of the trust’s income, the grantor is taxed on all of the of the trust’s income for the tax years that any part of the loan remains unpaid. Patsey, supra.

Practice Point: Any amounts actually borrowed by the grantor or the grantor’s spouse should be evidenced by a promissory note bearing adequate interest but without any security.15 This means the note must bear the minimum interest rate under IRC section 1274 to avoid a deemed gift of forgone interest under IRC section 7872. If the grantor desires to maximize the amount that he or she can transfer to the trust “gift tax free,” consider a high- er rate of interest, similar to what a bank might charge for an unsecured loan, e.g., the interest rate charged by a credit card company (typically 18% to 24%). However, do not charge of rate of interest that is usurious. Because the trust will be a grantor trust, the grantor’s payment of interest on the promissory note should be ignored for income tax purposes, i.e., the grantor will not be entitled to an interest expense deduction and the interest received by the trust will not be subject to income taxation, because the payments and receipts are transactions between the grantor and his or her grantor trust. Rev. Rul. 85-13, 1985-1 C.B. 184.

Practice Point: Grantor trust status under IRC section 675(3) may be difficult to achieve where the only asset of the trust is a life insurance policy that has no cash surrender value. But, if the ILIT contains other assets, such as cash (including cash received as a withdrawal or loan from the policy) and the grantor actually borrows all the trust’s cash (i.e., trust corpus) and all the trust’s income (i.e., trust income), grantor trust status should arguably apply for the tax years in question. Creating grantor trust status is important concerning the transfer for value rule, which is discussed in section 2.5, above, and special care must be taken when there are outstanding policy loans. See, section 2.5(b)(2), above, concerning policy loans.

Practice Point: Actual borrowing from an irrevocable trust is to obtain grantor trust status incongruent with the notion of an installment sale to the trust.

2B.7(g) Payment Of Income To Spouse Or Payment Of Premiums Of Life Insurance On Life Of Grantor Or Spouse

If a non-adverse trustee is required (or has the discretion) to dis- tribute (or can hold and accumulate for future distribution) income from the ILIT to or for the benefit of the grantor’s spouse,16 grantor trust status will be triggered, and the trust’s income will be taxed to the grantor under IRC sections 677(a)(1) and (2). Treas. Reg. §§1.677(a)- 1(b)(2) and 1.677(a)-1(g), Example 1.61 Grantor trust status under IRC section 677(a) will end when the spouse dies or becomes divorced (IRC section 682) or legally separated from the grantor. Treas. Reg. §1.677(a)-1(b)(2). This grantor trust power is more difficult to relinquish by the holder of the power because it is typically part of the ILIT’s dispositive provisions, whereas the other grantor trust powers (discussed above) are typically administrative powers. Also, if a non- adverse trustee can use income from the ILIT for the payment of premiums on the life of the insured grantor or the grantor’s spouse, grantor trust status will be triggered, and the trust’s income will be taxed to the grantor. IRC section 677(a)(3). Grantor trust status is not triggered if the life insurance is irrevocably payable for a charitable purpose described in IRC section 170(c). This grantor trust power terminates: (i) if the spouse predeceases the grantor, (ii) the grantor and the spouse become legally separated or divorced (see, Paragraph 10.1 of Sample ILIT), (iii) the spouse makes a qualified disclaimer of his or her beneficial interest within 9 months of the creation of the ILIT, or (iv) the spouse makes a non-qualified disclaimer of his or her beneficial interest in the ILIT—in which case the spouse may be treated as making a taxable gift to the other ILIT beneficiaries of the spouse’s disclaimed interest in the ILIT. This grantor trust power is difficult to relinquish, and may require a court proceeding to remove the spouse as a beneficiary of the ILIT.

Practice Point: If a non-adverse trustee can distribute both income and principal to the grantor’s spouse, the IRS has ruled that full grantor trust status will exist as to the grantor, even if the trustee’s power is discretionary (Priv. Letter Rul. 200606006) and the trustee can also distribute income and principal to other trust beneficiaries (Priv. Letter Rul. 200603040). However, when the spouse dies or becomes divorced or legally separated from the grantor, full grantor trust status will cease under this Code section. Treas. Reg. §1.677(a)-1(b)(2). Lost of grantor trust status could result in recognition of gain, if the trust property is subject to debt in excess of the property’s basis. Treas. Reg. §1.677(a)-1(b)(2).

Practice Point: If the grantor’s spouse holds an intervivos limited power of appointment over trust corpus, the grantor will be deemed to own the corpus for income tax purposes. IRC sections 674(a) (concerning power of disposition over corpus exercisable by the grantor) and 672(e) (grantor is treated as holding any power or interest held by any individual who was the spouse of the grantor at the time of the creation of the power or interest). Thus, the spouse’s power of disposition over corpus is attributed to the grantor for income tax purposes. See, Priv. Letter Rul. 9141027.

Practice Point: Do not overlook the need to have a non- adverse trustee if relying on this grantor trust provision. Many family trustees are adverse parties. See, footnotes to section 2.6, above, for a definition of “non-adverse party.”

Practice Point: Do not permit the trustee to use the income or principal to discharge the grantor’s legal obligations, such as the legal obligation to support the grantor’s spouse or children, because this will cause the trust property to be included in the grantor’s gross estate for federal estate tax purposes. See, section 4.2(a), below.

Practice Point: Cases concerning life insurance premium payments triggering grantor trust status (which were decided under the predecessor to IRC section 677(a)(3)) held that grantor trust status applies only if trust income is actually used to pay the life insurance premiums. Lorenz Iversen v. Commissioner, 3 T.C. 756 (1944); Joseph Weil v. Commissioner, 3 T.C. 579 (1944), acq., 1944 C.B. 29; Frank C. Rand v. Commissioner, 40 B.T.A. 233 (1939), acq., 1939-2 C.B. 30, aff ’d, 116 F.2d 929 (8th Cir. 1941), cert. denied, 313 U.S. 594 (1941); and Genevieve F. Moore v. Commissioner, 39 B.T.A. 808 (1939), acq., 1939-2 C.B. 25. See also, Corning v. Commissioner, 104 F.2d 329 (6th Cir. 1939); Rev. Rul. 66-313, 1966-2 C.B. 245. Also, the IRS will not issue a private letter ruling on grantor trust status where an ILIT trustee can use income to pay life insurance premiums.17 Consequently, this grantor trust power should be used in conjunction with another grantor trust power, particularly if the grantor wants to be assured of being treated as the grantor of both the trust’s income and corpus for income tax purposes.18
Caution: The grantor of an ILIT should not retain the following grantor trust powers: (1) the power to control the beneficial enjoyment of the trust property (IRC section 674), since this will result in the ILIT property being includable in the grantor’s gross estate under IRC section 2038; (2) the power to revoke the trust (IRC section 676), because this will result in the ILIT property being includable in the grantor’s gross estate under IRC section 2038; (3) the power to borrow trust assets without adequate security (IRC section 675(2))—as concerns life insurance policies or shares of stock described in IRC section 2036(b), because this may result in the ILIT property being includable in the grantor’s gross estate under IRC section 2036 and 2042; (4) the right to the trust’s income (IRC section 677), because this will result in the ILIT property being includable in the grantor’s gross estate under IRC section 2036; or (5) the power to substitute trust property in a non-fiduciary capacity (IRC section 675(4)(C); Priv. Letter Rul. 200408015)—as concerns life insurance policies or shares of stock described in IRC section 2036(b), because this may result in the life insurance proceeds or IRC 2036(b) stock being includable in the grantor’s gross estate under IRC sections 2036 and 2042.

2B.7(h) Transfers Between A Grantor And A Grantor Trust

As previously mentioned, transfers between a grantor and a grantor trust (or transfers between a grantor trust and another grantor trust concerning the same grantor) are not recognized for income tax purposes. Rev. Rul. 85-13, 1985-1 C.B. 184; Rev. Rul. 2007-13, 2007-11 I.R.B. 684 (3/12/2007). See also, Pvt. Letter Ruls. 8718046 and 8636053. Grantor trust status provides potential planning opportunities if the ILIT trustee desires to subsequently sell the life insurance policies for full and adequate consideration to another grantor trust under the transfer for value rule exception of IRC section 101(a)(2). Pvt. Letter Rul. 9413045. Grantor trust status also permits the grantor to sell assets to the ILIT without gain being recognized by the grantor. See, Rev. Rul. 85-13, 1985-1 C.B. 184 and Pvt. Letter Ruls. 8718046 and 8636053. Another area of flexibility provided by the grantor trust rules concerns loans made by the grantor to the ILIT. Such loans may be made because the grantor does not desire to make gifts to the ILIT, or desires to provide additional funds to the ILIT above the annual gift tax exclusion amount. Provided such loans are properly documented and contain the rate of interest required by IRC sections 7872 and 1274 (or, for the more conservative and cautious, the IRC 7520 rate), the interest paid by the ILIT on the funds it borrows from the grantor should not result in any taxable income to the grantor during the grantor’s life, and should not result in a gift of foregone interest being made by the grantor to the ILIT. (However, after the grantor’s death, the ILIT will cease to be a grantor trust for income tax purposes and any payment of loan interest by the ILIT to the grantor’s estate will result in taxable income to the grantor’s estate.) The grantor’s lending of money to the ILIT to pay premiums does not constitute a retained interest in the ILIT or an incident of ownership in the underlying life insurance policies for estate tax purposes, provided the loan is not secured by a collateral assignment of the policy on the grantor’s life and the ILIT has some “independent equity” to pay the loans (other than the loaned amounts). Pvt. Letter Rul. 9809032.19 However, depending on how long the grantor lives, the ILIT’s indebtedness on annual loans used to pay premiums may eventually exceed the policy’s death benefit. If this happens, the ILIT trustee may be liable for breach of its fiduciary duty20 Also, under the final split dollar regulations issued in 2003, the grantor’s lending of money to the ILIT (particularly if the only asset of the ILIT is a life insurance policy) may constitute a private split- dollar arrangement21 that must comply with the regulation’s “loan regime” rules where each payment of the premium (or loan of money) by the grantor is treated as a separate loan22 for federal tax purposes. See, Treas. Reg. §§1.61-22 (split dollar generally, and the “economic benefit regime” rules); 1.61-22(b) (definition of split-dollar life insurance arrangement); 1.61-22(b)(3) (application of split-dollar loan rules); 1.7872-15 (split-dollar loan rules generally, and the “loan regime” rules)); 1.7872-15(a)(2) (definition of split-dollar loan); 1.7872-15(a)(4) (payment of split-dollar loan interest by insured- donor may be disregarded and treated as an additional loan without adequate interest)23; 1.7872-15(b) (definition of split-dollar life insurance arrangement and split-dollar loan); 1.7872-15(d)(2) and 1.7872-15(j)(2)(ii) (special one-time written representation by the insured-donor and the ILIT that must accompany their income tax returns concerning a non-recourse split-dollar loan—to keep the loan from being treated as a “contingent” payment that is subject to unfavorable assumptions when testing the loan for adequate stated interest). It is recommended that loans by the insured or other family members to the ILIT require that interest be paid annually, rather than accumulated.

The payment of a defective grantor trust’s income tax liability by the grantor does not result in the grantor making an additional gift to the trust beneficiaries. Rev. Rul. 2004-64, 2004-2 C.B. 7. However, the grantor’s right to be reimbursed by the trust for the payment of the incomes taxes may have adverse estate tax consequences to the grantor. See, section 4.2(b), below.

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