6B.3 INCOME TAX ISSUES AND THE BENEFICIARY-TRUSTEE
When a trust is not a grantor trust,1 the income tax consequences of a beneficiary-trustee’s ability to make distributions2 to him or herself from a trust, even if limited by an ascertainable standard, are as follows.
6B.3(a) Beneficiary-Trustee’s Sole Power To Make Distributions
Generally, if a beneficiary-trustee has the sole power to pay trust principal or income to him or herself (or to pay trust income or principal disproportionately among a group of beneficiaries that include the beneficiary-trustee), the beneficiary-trustee will be treated as the owner of that portion of the trust property for income tax purposes. IRC section 678(a)(1). See, Mallinckrodt v. Nunan, 146 F.2d 1 (8th Cir. 1945), aff ’g 2 T.C. 1128 (1944), cert. denied, 324 U.S. 871 (1945); Rev. Rul. 81-6, 1981-1 C.B. 385; Rev. Rul. 67-241, 1967-2 C.B. 225; Priv. Letter Ruls. 200104005 and 9034004. Such a trust is referred to as a “beneficiary-owned” trust, or a “Mallinckrodt” trust. Thus, if there is only one trustee, and that trustee has the unrestricted power to distribute ordinary income to him or herself (or among a group of beneficiaries that include the beneficiary-trustee), that beneficiary trustee will be taxed on that income, whether or not it is distributed; and the beneficiary-trustee will be taxed on that income if it is paid to someone else (because the beneficiary-trustee could have paid the income to him or herself). Furthermore, if there is only one trustee, and that trustee has the unrestricted power to distribute principal to him or herself (or among a group of beneficiaries that include the beneficiary-trustee), that beneficiary-trustee will be taxed on the trust’s capital gains (because the beneficiary-trustee could have paid the principal [which is typically allocable to capital gains under normal fiduciary trust accounting rules] to him or herself). IRC section 678(a)(1). Note that there is no ascertainable standard exception to IRC section 678(a)(1) (concerning a beneficiary-trustee’s sole power to distribute income or principal to him or herself pursuant to an ascertainable standard). But see, U.S. v. Dale King De Bonchamps, 278 F.2d 127 (9th Cir. 1960). However, if there is an ascertainable standard concerning the right to income or principal, and the standard is not met, then the beneficiary-trustee presumably does not have the right to distribute property to him or herself, and consequently should not be taxed that year on the trust’s income or capital gains, as the case may be. However, the law is unclear on this point. Furthermore, there is no five-by-five exception to IRC section 678(a)(1), as there is for IRC sections 2514 and 2041. Thus, a power of withdrawal contained in a marital deduction trust or credit shelter trust, even if limited to the five-by-five safe harbor amount provided in IRC sections 2514(e) and 2041(b)(2), will still result in the beneficiary being taxed on the trust’s income and capital gains he or she could have withdrawn, even if the five-by-five power of withdrawal is never exercised. Rev. Rul. 67-241, 1967-2 C.B. 225; Priv. Letter Rul. 200022035.
6B.3(a)(1) Power Of Withdrawal
An unexercised five-by-five withdrawal right produces significant income tax complications by creating partial grantor trust status under IRC section 678(a) with regard to the withdrawal right beneficiary. This should be considered before granting a withdrawal right in the trust that comes into existence after the grantor’s death, such as the Family Trust, Children’s Trust or Descendants’ Trust. Furthermore, if unexercised withdrawal rights accumulate over the years, more of the trust income and corpus will be taxable (for income tax purposes) to the withdrawal right beneficiary. Rev. Rul. 67-241, 1967-2 C.B. 225; Priv. Letter Ruls. 200022035 and 9034004. See, Priv. Letter Ruls. 200104005 and 9034004, which refer to the formula for calculating the portion taxable to the withdrawal right beneficiary. See also, Treas. Reg. §1.671-3(a)(3).
Practice Point: To avoid the IRC section 678(a) problem associated with a noncumulative five-by-five withdrawal right, require the beneficiary’s right of withdrawal over the Marital Trust, Family Trust, Children’s Trust, or Descendants’ Trust to be exercisable only with the consent of a third party, such as a disinterested trustee who does not have a substantial and adverse interest in the trust or the power of withdrawal.
Practice Point: Grantor Trumps Beneficiary Under Grantor Trust Rules. If the grantor holds a power under IRC sections 673 through 677 and the beneficiary holds an IRC section 678 power (such as a Crummey withdrawal right) over the same income, the beneficiary’s power is disregarded, and the grantor is taxed as the owner of the trust income. IRC section 678(b). Note, however, that it is unclear whether the grantor will be taxed as the owner of the corpus, because IRC section 678(b) refers only to “income,” whereas IRC section 678(a)(1) refers to a beneficiary’s power to vest “corpus or the income therefrom.” Several commentators are of the opinion that this in congruency is a legislative drafting error, and that the grantor trumps the beneficiary as to both income and corpus.3 In several private letter rulings, the IRS has taken the position that the grantor is treated as the owner of the corpus (whenever possible) despite the existence of an IRC section 678 power (of withdrawal) held by a beneficiary.4 Priv. Letter Ruls. 200606006, 200603040, 200011054, 9321050, 9309023, 9226037, 9141027, 8701007, 8308033, 8326074, 8308033, 8142061, 8103074, and 7909031.
An additional incongruence is found in the language of IRC section 678(a)(2) itself, which refers to a beneficiary who has “previously partially released or otherwise modified such a power and after the release or modification retains such control as would, within the principles of IRC sections 671 to 677, inclusive, subject the grantor of a trust to treatment as the owner thereof.” (Emphasis added.) Note that the Code refers to a “release.” A release connotes an affirmative act on the part of the power holder. A lapse, on the other hand, requires no action by the power holder. Interestingly, Congress found it necessary to expressly state that a lapse of a general power of appointment is a “release” for estate and gift tax purposes. However, the failure of Congress to make a similar statement for income tax purposes appears to be an indication that Congress did not intend to equate a lapse with a release for the grantor trust rules.
Practice Point: If grantor trust status terminates during the grantor’s lifetime, the Crummey withdrawal right beneficiary may be treated, for income tax purposes, as a grantor of part of the ILIT. See, section 2.10(c)(1), above. Also, when the grantor dies, partial grantor trust status may also exist with regard to a Crummey withdrawal right beneficiary’s unlapsed withdrawal rights. See, section 2.11(a), above. It should be noted that the IRS has changed its position on the partial grantor trust status issue at least once. In Priv. Letter Rul. 9026036, the IRS ruled that the withdrawal right holder would be deemed the grantor after the death of the original grantor; however, in Priv. Letter Rul. 9321050 the IRS withdrew the earlier ruling without pro- viding any analysis for its action.5 Thus, as a result of these rulings, we can conclude that when the original grantor is the owner of the trust under the grantor trust rules, the Crummey powerholder is not treated as the owner of the trust under IRC section 678(a), either before or after the grantor’s death (assuming the Crummey withdrawal right ceases at the grantor’s death).
6B.3(b) Distributions Made With Consent Of Co-Trustee
However, if the beneficiary-trustee’s power to withdraw or distribute trust property can be exercised only in conjunction with a co-trustee or other third party (who may, but need not be adverse—such as the beneficiary-trustee’s beneficiary-sibling or a non-beneficiary sibling6), then the beneficiary-trustee will not be treated as the owner of the trust for income tax purposes. IRC section 678(a)(1) applies only to powers exercisable solely by the beneficiary-trustee. It does not apply to jointly exercisable powers. It may be desirable to limit the beneficiary-trustee’s power.
Drafting Example:
At any time when there is more than one trustee, no trustee who is also a beneficiary of any trust created under this trust agreement shall exercise any power solely by himself or herself as would cause such beneficiary-trustee to be treated as an owner of any portion of the trust under IRC section 678(a).
6B.3(c) Grantor Trust Status
If the grantor’s spouse serves as sole trustee of the ILIT, grantor trust status will be conferred on the grantor. This is because the powers held by the spouse are attributed to the grantor per IRC section 672(3). As trustee, the grantor’s spouse would have the ability to control the beneficial enjoyment of the trust property, and grantor trust status would exist with regard to the grantor. IRC section 674.
6B.4 TAX CONSEQUENCES OF DISTRIBUTIONS THAT DISCHARGE A TRUSTEE’S PERSONAL LEGAL OBLIGATIONS
6B.4(a) Estate And Gift Tax Consequences Of A Beneficiary- Trustee’s Discharge Of Personal Legal Obligations
Irrespective of the fact that a beneficiary-trustee’s power to distribute trust property to him or herself (or to another trust beneficiary) is limited by an ascertainable standard, a trustee’s ability to discharge his or her personal legal obligations (including the obligation to support a beneficiary, such as a spouse or minor child) constitutes a general power of appointment to the extent of that obligation (i.e., the ability of the trustee to use the trust property to discharge his or her personal legal obligations is considered a power of appointment exercisable in favor of the trustee or his or her creditors). Treas. Reg. §§20.2041-1(c)(1) and 25.2514-1(c)(1). See also, Priv. Letter Ruls. 199930036 and 9328015. This rule applies to both beneficiary-trustees and non-beneficiary-trustees, i.e., to all individual trustees. The mere existence of the trustee’s power or ability to discharge his or her legal obligation is sufficient to constitute a general power of appointment and cause the trust assets to be included in the trustee’s gross estate when he or she dies. Priv. Letter Ruls. 9036048 and 8924011. Cf., Estate of Virgil C. Sullivan v. Commissioner, T.C. Memo 1993-531. Furthermore, a distribution by the trustee to or for the benefit of the other beneficiary whom the trustee is legally obligated to support, will constitute the exercise of a power of appointment and result in a gift being made by the trustee to the other beneficiary. IRC section 2514(b).
An ascertainable standard does not protect the trustee from estate or gift tax consequences in this instance because the ascertainable standard exception relates to the health, education, support, and maintenance of the powerholder. IRC sections 2041(b)(1)(A) and 2514(c)(1); Treas. Reg. §§20.2041-1(c)(2) and 25.2514-1(c)(2); Rev. Rul. 79-154, 1979-1 C.B. 301. Thus, a beneficiary-trustee should be prohibited from making trust distributions that discharge his or her legal obligations, including the obligation to support a trust beneficiary.
An independent co-trustee can, however, make distributions to any beneficiary the other co-trustee is obligated to support. The independent co-trustee, by definition, will not possess a general power of appointment (concerning the discharge of personal legal obligations) since the distributions will be discharging the legal obligations of the other trustee(s) and not those of the independent co-trustee.
A divorce decree requiring the payment of a child’s college expenses should not be considered a support obligation for purposes of IRC section 2041. See, e.g., Aussie v. Aussie, 182 Mich. App. 454, 452 N.W.2d 859 (1990).
Practice Point: Prohibit a trustee from making any distributions that would have the effect of discharging the trustee’s personal legal obligations, including the obligation of support. A clause that prevents a trustee from using the trust property to discharge his or her personal legal obligations is typically referred to as an “Upjohn” clause, and is named after the case where the clause was used and discussed by the court. See, William John Upjohn v. United States, 72-2 U.S.T.C. ¶12,888 (W.D. Mich. 1972).
Drafting Example:
Notwithstanding any provision herein to the contrary, no trustee shall have the power to use or apply trust property (i) for the support and maintenance of anyone the trustee is obligated to support and maintain; or (ii) for the purpose of directly or indirectly discharging the personal legal obligations of the trustee.
6B.4(b) Super Support Exception
The ability of a trustee to use trust property for the “super sup- port” (i.e., beyond the requirements of legal support) should not constitute a general power of appointment. In Priv. Letter Rul. 9030005, the IRS ruled that a beneficiary-trustee’s power to distribute corpus to her children for “travel, camping trips, theater, ballet, music lessons, special schooling or instruction to enrich their lives…and college and post-graduate education expenses” did not constitute a general power of appointment.
6B.4(c) Income Tax Consequences Of Discharging A Personal Legal Obligation
The income tax consequences of a trustee’s power to distribute trust property to discharge a personal legal obligation are as follows. Sole power held by a sole trustee (or the sole power held by a co- trustee) to distribute trust property to discharge that trustee’s personal legal obligation (other than a personal legal obligation to support or maintain a dependent) causes that trustee to be treated as the owner of the trust property for income tax purposes. Treas. Reg. §1.678(a)-1(b). Mere possession by a trustee (as sole trustee or co-trustee) of the power (in a fiduciary capacity)7 to distribute trust property to discharge the trustee’s personal legal obligation to support or maintain a dependent does not in and of itself result in taxable income, except to the extent the income or principal is actually used or applied by the trustee. IRC section 678(c); Treas. Reg. §1.678(c)-1(a). If such support distributions are actually made, the trustee is taxed under IRC sections 661 and 662 (concerning DNI). Treas. Reg. §§1.678(c)-1(c) and 1.662(a)-4. However, mere possession of the power by the trustee may result in adverse estate tax consequences to the trustee, as discussed above.
A trustee’s use of trust property to discharge another person’s legal obligation will cause the trust property (that is so used) to be income taxed to the person whose legal obligation is discharged (i.e., the person whose legal obligation is discharged is treated as though the trust property were distributed directly to him or her). Treas. Reg. §1.662(a)-4.
6B.5 TAX CONSEQUENCES OF OVERLY-BROAD DISCRETIONARY POWERS OVER INVESTMENTS AND PRINCIPAL-INCOME MATTERS
Although State Street Trust Co. v. United States, 263 F.2d 635 (1st Cir. 1959) involved a grantor trustee of an irrevocable trust, the principles of that case could conceivably apply to a beneficiary-trustee under the appropriate set of facts. The rule to be gleaned from State Street is that an overly broad combination of discretion over investments and the allocation of receipts and expenditures could arguably constitute a general power of appointment under IRC section 2041 by enabling the beneficiary-trustee to favor one beneficiary over another by investing in wasting assets or allocating all receipts to income.
6B.5(a) State Street Rationale And The Regulations
Although State Street has been distinguished by later cases from the First Circuit, the regulations have reserved the right to apply the State Street rationale (in seemingly extreme cases). Treas. Reg. §§20.2041-1(b)(1) and 25.2514-1(b)(1) states: The mere power of management, investment, custody of assets, or the power to allocate receipts and disbursements as between income and principal, exercisable in a fiduciary capacity, whereby the holder has no power to enlarge or shift any of the beneficial interests therein except as an incidental consequence of the discharge of such fiduciary duties is not a power of appointment. Furthermore, the right in a beneficiary of a trust to assent to a periodic accounting, thereby relieving the trustee from further accountability, is not a power of appointment if the right of assent does not consist of any power or right to enlarge or shift the beneficial interest of any beneficiary therein.(Emphasis added.)
Practice Point: Make sure that the clause granting trustee powers in the governing instrument states that the trustee must exercise his or her powers in a fiduciary capacity.
Drafting Example:
Trustee must exercise his or her powers solely in a fiduciary capacity and shall possess no powers that would otherwise permit the enlarging or shifting of beneficial interests (except as an incidental consequence of the discharge of such fiduciary duties).
Practice Point: Section 104 of UPIA (1997) permits a trustee to make adjustments to income and principal, and to allocate capital gains to income. This power should not be held by a beneficiary-trustee; rather, the power to adjust should be held by a non-beneficiary trustee, such as an Independent Trustee. See, Priv. Letter Rul. 200334025. See, Paragraph 7.1(A)(9) of Sample ILIT.
6B.6 TAX CONSEQUENCES OF BENEFICIARY-TRUSTEE’S POWER TO AMEND OR TERMINATE TRUST
An individual beneficiary-trustee’s unrestricted power, as a sole trustee or as a co-trustee with another trustee who does not have a substantial and adverse interest in the trust, to amend8 or terminate a trust of which he or she is a beneficiary, may be a power to affect the beneficial enjoyment of the trust property or its income, and could constitute a general power of appointment for estate and gift tax purposes. Treas. Reg. §§20.2041-1(b)(1) and 25.2514-1(b)(1). See, Pittsburgh National Bank v. U.S., 319 F. Supp. 176 (W.D. Pa. 1970); Maytag v. U.S., 493 F.2d 995 (10th Cir. 1974). See also, section 8.1(d), above, concerning “substantial and adverse interest.”
Practice Point: Do not give the beneficiary-trustee, who is an individual, the authority to amend or terminate a trust of which he or she is a beneficiary. Rather, vest the authority exclusively in an independent trustee or a special power holder, or require judicial approval with objective criteria (that is contained in the trust instrument) as the basis for amendment or termination. See, Paragraph 8.2(C) of Sample ILIT.
6B.7 TAX CONSEQUENCES OF DISCLAIMER BY BENEFICIARY-TRUSTEE AND DISCRETIONARY DISTRIBUTIONS
For a disclaimer to be a qualified disclaimer under the Internal Revenue Code, the disclaimed property must pass without any direction on the part of the disclaimant. IRC section 2518(b)(4). If the disclaimant is a beneficiary-trustee and the trust to which the disclaimed property passes gives the disclaiming beneficiary-trustee discretion to distribute the disclaimed property among the trust’s other beneficiaries, the disclaimer will not be a qualified disclaimer unless the disclaiming beneficiary-trustee’s discretion is limited by an ascertainable standard. Treas. Reg. §25.2518-2(e)(1). See, Paragraph 7.1(C)(4) of Sample ILIT.
Practice Point: Before disclaiming the property, the disclaiming beneficiary-trustee could also irrevocably decline (i.e., disclaim9) to serve as trustee of the discretionary trust that will hold the disclaimed property. Or, the discretionary trust could contain prophylactic language concerning the effect of such a disclaimer. See, Paragraph 8.4 of Sample ILIT.
Practice Point: A disclaiming beneficiary-trustee cannot retain a beneficial interest in the disclaimed property. A special exception exists for qualified disclaimers by a surviving spouse. A surviving spouse can disclaim an interest in property and still retain a beneficial interest in the disclaimed property, provided the beneficial interest is not discretionary. Treas. Reg. §§25.2518-2(e)(1), (2) and 25.2518-2(e)(5), Examples 4 and 6.
6B.8 TAX CONSEQUENCES OF BENEFICIARY-TRUSTEE’S POWER TO REMOVE AND REPLACE A CO-TRUSTEE
If a beneficiary-trustee has the unrestricted power to remove and replace a co-trustee who holds tax-sensitive powers that, if held by the beneficiary-trustee would constitute a general power of appointment, the beneficiary-trustee will be deemed to hold a general power of appointment. Treas. Reg. §§20.2041-1(b)(1) and 25.2514-1(b)(1). However, the removal and replacement of a co-trustee for reasonable cause by a beneficiary-trustee will not result in the removed co-trustee’s tax-sensitive powers being imputed to the beneficiary-trustee. A beneficiary trustee will also not be deemed to hold a general power of appointment if he or she does not have the unrestricted right to remove a co-trustee and only has the power to remove and replace the co-trustee, under limited conditions which did not exist at the time of the beneficiary-trustee’s death. Treas. Reg. §§20.2041-1(b)(3) and 25.2514-1(b)(1). For example, if a beneficiary-trustee can remove and replace a co-trustee (who holds tax sensitive powers) only upon the beneficiary-trustee attaining the age of 50, and the beneficiary-trustee dies before age 50, the beneficiary-trustee is not deemed to hold the tax-sensitive powers of the co-trustee.
A beneficiary-trustee can also safely hold the unrestricted power to remove and replace a co-trustee who holds tax-sensitive powers if the trust instrument restricts the replacement trustee to a person who is not related or subordinate to the beneficiary-trustee, within the meaning of IRC section 672(c), i.e., the replacement trustee is an independent trustee. In Priv. Letter Ruls. 9746007, 9735025, and 9607008, the IRS extended its holding in Rev. Rul. 95-58, 1995-2 C.B. 191 to beneficiaries who were given the unqualified power to remove an existing trustee and appoint a replacement trustee who is not related or subordinate to the beneficiaries (within the meaning of IRC section 672(c)). See, section 1.7, above.
6B.9 LIMITING A TRUSTEE’S POWER TO AVOID ADVERSE ESTATE, GIFT, AND INCOME TAX TREATMENT
A comprehensive omnibus savings clause that automatically reduces a tax-sensitive power held by a beneficiary-trustee into a safe non-gener-al power and permits a beneficiary-trustee to appoint a special trustee to handle tax-sensitive powers, should be included in the trust agreement. See, Priv. Letter Rul. 9036048. See, Paragraph 7.1(C)(4) of Sample ILIT.
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