Tag: Grantor Trust Series

IRC 674

Posted on by Peter Harper

After covering Section 675 of the Internal Revenue Code, or IRC, in our previous article, let’s go into the next section that clients want to learn more about: IRC Section 674.

What is a Grantor Trust?

Before we begin, let’s start with a simple understanding of what a grantor trust is before going into how financial processes such as IRC can apply to it. Every grantor trust begins with a grantor, defined as any person who either creates a trust, i.e. the settlor, or directly or indirectly makes an excessive property transfer to a trust. A grantor is, therefore, the person with administrative powers to make a gratuitous transfer of their trust property, whether it is the grantor’s estate, trust assets, items of income, or capital gains from an investment. 

Hence, a grantor trust is a trust where the grantor has control over the trust to the extent that they will be recognized as the owner/taxpayer of all or any part of the trust for possible federal income tax purposes. That way, they are directly taxed on the income and any other tax attributes belonging to the trust as if it did not exist. The IRS disregards the trust for federal income tax purposes and treats the grantor/primary taxpayer as the deemed owner of the trust assets and trust property included. 

What Grantor Trusts Are Used For

Grantor trusts have mainly been used for estate and gift planning purposes to avoid an income tax, gift tax, or estate tax, as well as to best reg trust assets according to the grantor’s wishes. These trusts are sometimes called Intentionally Defective Grantor Trusts (IDGT). 

See below for some of the grantor trust methods used by estate planners to reduce and minimize taxes:

    • In the case of a revocable grantor trust, probate can be avoided;
    • However, an irrevocable trust cannot be changed unless given consent from the beneficiaries involved. The purpose is to reduce or eliminate taxes after the grantor passes, though some, including gift tax if a gift exceeds $15,000;
    • As a “leveraging” tool to grow the impact of giving to designated donees such as using a Grantor Retained Annuity Trust (GRAT);
    • As a protection structure for trust assets, providing adequate security for particular business interests such as possible creditors or claimants (if the circumstances involve business succession planning).
Funding The Grantor Trust – Who is the Grantor? 

Essentially, a trust’s grantor is that trust’s settlor (or ‘notional settlor’). They are defined as any person who either creates a trust, i.e., the settlor, or directly or indirectly will make a gratuitous transfer of a trust property or items of income (grantor’s estate, capital gains, etc.) to a trust and is regarded as the primary funder.

Provisions Triggering Grantor Trust Status

The rules within the Internal Revenue Code’s Subchapter J, Subpart E govern when the trust income is taxable under a grantor trust status to the grantor or another person who is deemed to be the substantial owner of the trust (and, therefore, the primary taxpayer). This rule was designed primarily for federal income tax purposes instead of the trust itself or its beneficiary. Thus, they are granted administrative powers over the trust when the said grantor trust status is recognized and finalized by the IRS.

These provisions for grantor trust status are also contained in IRC 671-679:

  • IRC 671 – Sets forth the overall principle that if the grantor is recognized as the owner of the trust, then they must include the trust’s income when calculating their taxable income and income tax;
  • IRC 672 – Sets forth the definitions and rules when applying the grantor trust provisions to a subordinate party;
  • IRC 673 – 678 sets out the rules to decide when the trust’s existence can be ignored for federal income tax purposes, including if a grantor can reacquire corpus if they substitute the trust corpus with property or asset of similar value, adequate interest, and adequate security;
  • IRC 679 – sets out the rules to determine when a foreign trust will be regarded under grantor trust status with or without income tax applied.

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IRC Section 674 – Power to Control Beneficial Enjoyment

Now that we understand the general provisions for a grantor trust and what may trigger a status, let’s look more closely at what Section 674 can do for you.

IRC Section 674 General Rule

IRC §674(a) puts forward the general rule for power to control beneficial enjoyment that the grantor will be recognized as the owner of any trust portion concerning the corpus or income’s beneficial enjoyment. Therefore, they are liable to a power of disposition used by either the grantor or a nonadverse party (or, in unique cases, both) without any adverse party’s consent or approval.

Exceptions for Certain Powers

This particular section of the Internal Revenue Code allows certain powers not only for the grantor but for a subordinate party and or the items of interest within a trust, such as beneficiaries, the will, income, and corpus:

Power to Apply Income to Support of a Dependent

Any power to distribute trust income to support a beneficiary the grantor has been deemed or deems themselves legally obligated to support does not automatically trigger the trust as a grantor trust unless it is used for other beneficial interest purposes. This exception applies even if the grantor or the grantor’s spouse holds this power. Support for a beneficiary that may not be included includes premiums and gifts over $15,000, which can be subject to a gift tax. However, the grantor may be exempt from income tax under IRC 677(b).

Power Affecting Beneficial Enjoyment Only After Occurrence of Event

A grantor won’t be recognized as the owner of any portion of the trust established by a such power to affect the trust’s beneficial enjoyment if that power is not exercisable for an extended period of time. Such a period of time should be long enough that, had the postponed power been a reversionary interest stipulated in IRC 673, it would not have triggered grantor trust status (most common periods used are by taxable year). Therefore, control over beneficial enjoyment will not trigger a grantor trust status if the grantor can’t exert it for a period of time. If the power had become a reversionary interest at any point, the trust should have a value of less than 5%. If this happens and to decide if this criterion was met, it is mandatory to determine the prevailing and adequate interest rate and check the applicable IRS Tables under the treasury regulations for confirmation. However, after the expiration of a stated time has occurred, and the power instantly becomes exercisable, the grantor will be recognized as the owner only if they have not relinquished the power earlier. 

Power Exercisable Only by Will

A grantor shall not be recognized as a trust’s owner based on a power to alter beneficial interest and enjoyment if they possess a power exercisable only by a will. The only exception is for a power of appointment to accumulated income of the trust by the will if the trust allows the grantor or a nonadverse party to provide mandatory or discretionary accumulation of trust income.

Power to Allocate Among Charitable Beneficiaries

A grantor shall not be recognized as the owner of any portion belonging to a trust if they have the power to decide the beneficial enjoyment of the trust income or trust corpus when the income or corpus is irrevocably payable for a philanthropic purpose by one or more charitable beneficiaries as defined in IRC §170(c). 

Power to Distribute Corpus

A grantor shall not be recognized as the owner of a trust based on if they have the power to distribute corpus to beneficiaries of the trust. In contrast, the grantor’s power to dispense the corpus has been subjected to a reasonably definite standard outlined in the trust instrument. 

Powers of Distribution Primarily Affecting Only One Beneficiary

The principal and income must be paid to the said beneficiary (or such beneficiary’s estate and any estate tax attached) or to appointees designated by the beneficiary.

Powers of Distribution Affecting More Than One Beneficiary

The principal and income are distributed to such beneficiaries following their respective shares.

Power to Withhold Income Temporarily

A grantor shall not be recognized as the owner of any portion belonging to a trust if they have the power to distribute or apply the trust income to any present beneficiary or to accumulate the trust income if the accrued income and income tax must be paid eventually to one of the following individuals:

      • The beneficiary whom the income was withheld from;
      • The beneficiary’s estate and any estate tax attached;
      • The beneficiary’s designatees;
      • The present income beneficiaries are within one or multiple shares fixed by the trust instrument. 
Power to Withhold Income During Disability of a Beneficiary

The grantor shall not be recognized as the trust’s owner merely because they (or a nonadverse party) hold power to distribute income and accumulate and reg income before adding it to a principal during a period of time in which the income beneficiary possesses a legal disability. Furthermore, any income withheld during such periods does not need to be ultimately payable to the income beneficiary or to their estate and any estate tax attached. It may be payable to whomever the trust declares as the recipient of the trust principal.

Power to Allocate Between Corpus and Income

IRC §674(c) catalogs powers that shall not trigger a grantor trust status if they are to or are being held by an independent trustee, who may be given relatively broad powers over beneficial interest and enjoyment without triggering the grantor to be treated as owner. 

Some examples are as listed:

      • Power to divide and provide income amongst particular income beneficiaries;
      • Power to build accumulated income without needing to pay the income to a beneficiary whom it was withheld from at any time;
      • Power to invade corpus for particular beneficiaries (including persons who aren’t income beneficiaries).
Exception for Certain Powers of Independent Trustees

An independent trustee can be given broad powers over beneficial enjoyment without triggering owner recognition towards the grantor unless they cannot due to nonfiduciary capacity. Examples are:

    • Power over diving and sharing income amongst particular income beneficiaries;
    • Power to build accumulated income without needing to pay the income to a beneficiary whom it was withheld from at any time;
    • Power to invade corpus for particular beneficiaries (including persons who aren’t income beneficiaries).
Power to Allocate Income If Limited by a Standard

The grantor rules mustn’t be applied to a power solely exercisable (without the consent of any adverse party) by a trustee or trustees who are not the grantor or their spouse (who must still be living with the said grantor. Power to distribute, accumulate, or apportion income for or to one or more beneficiaries, or from, within, or to a class of beneficiaries (even if the conditions of Subsection (b), paragraphs (6) or (7) are satisfied), is restricted by a reasonably definite and external standard that is presented by the trust instrument. However, a power cannot fall within the powers described above if any person uses it to add to two or more beneficiaries or a class of beneficiaries to receive the corpus or income. One exception would be where such an action is to provide for after the adoption or birth of children.

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Commonly Used Exceptions by Practitioners

The above powers and exemptions are pursuant to understanding the benefits and setbacks IRC 674 can provide for individuals surrounding a trust. However, exceptions can affect how much an individual within a specific role can receive their distribution, whether because of limitations due to income tax purposes, the number of roles involved, or if a role is deemed a nonadverse party possesses nonfiduciary capacity within the trust. 

Hems

The trustee’s power to make distributions are restricted because of an understandable and absolute standard like health, maintenance, support, or education (HEMS) (IRC Section 674(b)(5)(A));  

Single Beneficiary

There is only one current beneficiary belonging to a trust, and the principal and income must be paid to the said beneficiary (or such beneficiary’s estate and any estate tax attached to it) or to any appointees that the beneficiary has decided (IRC Section 674(b)(6)); 

Pro Rata Shares

The trust possesses two or more beneficiaries, but the principal and income have been distributed to those said beneficiaries based on their relevant shares (IRC Section 674(b)(5)(B));

No Real Control

The grantor nor the grantor’s spouse do not serve as the trust trustee, and less than one-half of trustees are subordinate or related to the grantor (IRC Section 674(c));

Identity of Trustees

Careful consideration should be taken by advisors and estate planners when drafting the trust deed for clients when it comes to rules for any portion of the trust. The central point of this article isn’t just an analysis of typical powers around a grantor trust status. Still, it is also a careful exploration of the identity of the trustees. For instance, if the grantor’s spouse has the co-trustee role, the trust will trigger and become a grantor trust unless an adverse party is a co-trustee. While grantor trust status has many taxable advantages and grants the power of appointment, under the latest tax regime, taxpayers may increasingly prefer to have non-grantor trusts. Careful planning is critical in preventing inadvertent and potentially harmful income tax consequences.

Think that IRC 674 may be for you? Speak with one of our consultants to learn how to proceed forward.

Shaun Eastman

Peter Harper

IRC Section 679 – When is a Trust a Foreign Grantor Trust?

Posted on by Peter Harper

In our last installment of the Grantor Trust Series, Peter Harper, Asena’s managing director and CEO, explains IRC Section 679, addressing foreign trusts, and the stipulations of having a foreign trust in the US.

This vlog is for anyone that owns assets in a foreign trust and is moving to the US.

To watch the full video, click play below:

Check out our new blog for a quick guide to everything Grantor Trusts: https://staging-asenaadvisorscom-stgngasenaad.kinsta.cloud/blog/grantor-trust/

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IRC Section 678 – Someone Other Than the Grantor is the Owner of Trust

Posted on by Peter Harper


In our 8th installment of the grantor trust series, Peter Harper, our managing director and CEO, explains IRC Section 678 and the circumstances in which someone other than the grantor can be the owner of the trust.

This vlog is for anyone that owns assets in a foreign trust who has a US beneficiary.

To watch the full video, click play below:

Check out our new blog for a quick guide to everything Grantor Trusts: https://staging-asenaadvisorscom-stgngasenaad.kinsta.cloud/blog/grantor-trust/

IRC Section 678 – Quick Guide Blog

What is IRC Section 678?

Section 678 was added to the grantor trust provisions by the IRS as a result of the decision in Mallinckrodt v. Commissioner by the United States Court of Appeals for the Eighth Circuit. In that case, the grantor created a trust for the benefit of a beneficiary and the beneficiary’s family. The trust instrument provided that the trustees were to distribute trust income generated from the trust assets to the beneficiary upon his request. The Eighth Circuit held that, because the beneficiary could essentially direct the timing and amount of distribution of income from the trust, the beneficiary had the equivalent of ownership of the trust income for income tax purposes and the taxpayer should include these distributions including capital gains in his taxable income as it does not constitute a non-grantor trust. 

The most common form of a Mallinckrodt power is a general power of appointment over the trust income or corpus that enables the holder to appoint it to himself or herself during the holder’s lifetime. (See also PLR 8545076 ; PLR 9220012)

A Mallinckrodt power also exists if a beneficiary has a demand or Crummey (See, e.g., PLR 201039010) power as to a limited portion of the additions to the trust. 

A Mallinckrodt power renders a third person taxable under §678(a) only if the power is exercisable by the third person alone. If the exercise of the power requires the consent of any other person, whether or not adverse, §678(a) does not apply.

Example: Beneficiary B is one of three trustees who must act by majority vote to make distributions to the beneficiaries. Absent an actual distribution, B is not taxed on the trust income. Section 678(a) does not apply. (See PLR 8213140. See also PLR 201718012, PLR 201718010–PLR 201718003 (trust beneficiaries serving as distribution committee members not trust owners because none has power exercisable alone to vest trust income or corpus to himself), PLR 201436008–PLR 201436032 (trust beneficiaries serving on distribution committee not treated as owners of trust where no single member can direct distributions of trust income and all distributions require consent of majority of committee members), PLR 201426014 (same; revoked on other grounds by PLR 201642019 (trust is grantor trust to settlor under §673 because corpus reverts to settlor if both his children cease to serve on distribution committee or committee has less than two members)), PLR 201410001–PLR 201410010 (same).)

General Rule

What makes a Section 678 trust stand out from the other grantor trust provisions is that under this tax law provision a person or taxpayer other than the grantor/decedent or a transferor to the trust could be the deemed owner of all or a portion of the trust assets for income tax purposes by the IRS and any distributions – interest, capital gain etc will be taxable income. 

The general rule of a Section 678 trust is that a person or taxpayer other than the grantor shall be treated as the owner of any portion of a grantor trust’s assets with respect to which:

  1. such person or taxpayer has a power exercisable solely by himself (power of appointment) to vest the trust corpus/trust assets or the income therefrom in himself, or
  2. such person or taxpayer has previously partially released or otherwise modified such a power of appointment and after the release or modification retains such control as would, within the principles of sections 671 to 677, inclusive, subject a grantor of a trust to treatment as the owner of the trust assets.

Any trust regarded as a grantor trust in terms of Section 678 is also sometimes referred to as a “beneficiary‐deemed owner trusts” (“BDOTs”). The beneficiary is regarded as the grantor of the trust. 

There are certain tax benefits when a beneficiary is regarded as the grantor of the trust. One of these income tax benefits relates to life insurance rules. 

A beneficiary can sell a life insurance policy insuring themselves to a BDOT without triggering the transfer for value rule. 

An Exception to IRC Section 678 Grantor trust

Exception Where Grantor is Taxable

There is however an exception in tax law to the grantor trust provision which stipulates that if the grantor/decedent or transferor (which IRC 679 applies to – foreign grantor trusts) are treated as the owner of trust income, the grantor trust rules of IRC §§ 674 through 677 trump application of IRC § 678(a) to the third party taxpayer. 

A plain reading of subsection (b) implies that, if a third person holds a withdrawal power over the trust principal (power of appointment), Section 678(b) would not apply, and therefore the person with the withdrawal power would be taxed as owner of the trust and the trust assets. The key reconciling this seeming inconsistency between Section 678(b) treatment of a withdrawal power over income and a power over principal seems to be in the definition of the word “income” 

Obligations of Support

Section 678(c) provides another exception in relation to grantor trust status, where a third person, in his or her capacity as trustee or co-trustee, will not be treated as the owner of the trust assets if he or she has the power merely to apply the income of the trust, including capital gains to the support or maintenance of a person whom such third person is obligated to support or maintain, except to the extent that such income is so applied. Therefore there is no withdrawal power to vest in himself and no taxable income due to Grantor trust status not being applicable. The support obligation is in terms of asset protection for the beneficiaries. 

In cases where the amounts so applied or distributed are paid out of trust corpus or out of other than income of the taxable year, such amounts shall be considered to be an amount paid or credited within the meaning of paragraph (2) of section 661(a) and shall be taxed to the holder of the power under section 662.

This grantor trust status exception, however, does not apply if the third person holding the withdrawal power can exercise the power by himself or herself in any capacity other than that of a trustee or co-trustee.

Effect of Renunciation or Disclaimer

Subsection (a) grantor trust status shall not apply with respect to a grantor trust power which has been renounced or disclaimed within a reasonable time after the holder of the power first became aware of its existence.

It is important to understand what constitutes a “reasonable time” and how the IRS will interpret the same to determine grantor trust status. 

A valid disclaimer is a matter for determination by state law, since neither Code Section 678 nor the regulations provide any guidelines as to what will constitute a valid disclaimer for these purposes while Sections 2518(a) and 2046 provide substantial guidance with respect to what constitutes “qualified disclaimer” for federal gift tax and estate tax purposes. The IRS has been quite vague on this regarding to it’s application for income tax purposes. 

It is realistic to believe that if one meets the §2518(a) statutory standard and disclaims the trust assets within nine months of the date of its transfer or, if the third person is a minor, within nine months of attaining age 21, the disclaimer will be timely for income tax purposes. 

Generally the estate and gift tax effect of general powers of appointment (and lapses) are unaffected by a powerholder’s incapacity. IRC §678(a) is similar – see Rev. Rul. 81-6, holding that a minor beneficiary with a withdrawal right (Crummey power) is deemed the substantial owner for §678 purposes even if local law requires a court appointed guardian and none has ever been appointed.

The IRS has taken the position that a trust beneficiary who disclaims the trust income remains taxable on the trust income (capital gain, interest, etc.) realized prior to the disclaimer. 

The disclaimer of a Code Section 678 power did not allow the disclaimant to avoid income taxation on the income earned by the trust on the trust assets prior to the disclaimer for income tax purposes. 

Cross Reference

Section 678(e) of the Code refers to section 1361(d) as the provision under which a beneficiary of a trust is treated as the owner of the portion of the trust assets which consists of stock in an electing small business corporation.

Section 1.671-4(b) of the Income Tax Regulations provides that in the case of a trust, when the same individual is both grantor and trustee, and that individual is treated as owner for the taxable year of all of the assets of the trust by the application of section 676, a Form 1041 should not be filed with the IRS for tax return purposes. Instead, all items of income, deduction, and credit from the trust should be reported on the individual’s Form 1040 in accordance with its instructions provided by the IRS for taxable income on his tax return. 

Section 1361(a)(1) of the Internal Revenue Code provides that the term “S corporation” means, with respect to any taxable year, a small business corporation for which an election under section 1362(a) is in effect.

Deciphering the Term ‘Income’ Under Internal Revenue Code Section 678

In the context of the Internal Revenue Code section 678, “income” likely refers to “taxable income” such as capital gains disclosed in your tax return, as opposed to “trust accounting income’ for grantor trust purposes. 

Treas. Reg. section 1.671-2(b) specifies that for purposes of the grantor trust rules the term “income” refers to income for income tax purposes and not trust accounting purposes and that if trust accounting income is being referenced the term “ordinary income” would be used. IRC section 678(b) uses the unmodified term “income” which refers to taxable income pursuant to the regulation.  Accordingly, in terms of the grantor trust rules, if a grantor and a third person are both deemed the owner of income allocable to either trust corpus or accounting income, then under IRC § 678(b) the grantor would be treated as the owner (i.e., IRC sections 674 through 677 trump IRC section 678(a)).

IRC section 643(b) (which does not apply to grantor trusts) specifies that the term “income” refers to “income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law” (i.e., trust accounting income under a state’s principal and income act) for the purposes of Subparts B, C, and D of Part I of Subchapter J (Irrevocable trust).  The grantor trust rules are in Subpart E, clearly omitted from the IRC section 643(b) reference. 

Ducking the IRC Section 678 Bullet

Designing a trust to derive tax benefits and to avoid application of the grantor trust rules to the grantor may be a sound strategy if a goal is to avoid trust tax attributes appearing on the grantor’s tax return. In connection with that strategy many may want to provide access to trust assets by allowing the trustee or some other person with withdrawal power to make distributions to one or more individuals or a class of individuals, while still providing asset protection. 

Please be careful when trying to argue exemption from the grantor trust rules for such trusts. Avoiding grantor trust rules should be dealt with the same as that sticker on a box of breakables being transported. Handle with care! The IRS will not be lenient when you try to argue non-grantor trust classification and could trigger some unforeseen gift or estate tax implications for such trusts. 

By way of an example, a trust granting a trustee withdrawal power to make distributions to descendants of the grantor “within the sole discretion of the trustee” will trigger application of the grantor trust rules to the trustee if the trustee is a descendant of the grantor/descendant.

There are however ways to address this grantor trust provisions. The easiest exemption method is to add an additional restriction on the trustee’s withdrawal power (fiduciary power) to make a decision by requiring approval from another person. This could then be regarded as a non-grantor trust and still provide asset protection. 

Two Common Planning Scenarios Could Land You in a Malpractice Trap if You Don’t Know This Rule

Trap 1:  Fourie Du Preez is retired and for estate planning purposes wants to protect some real property and other income generating assets for future use. A non-grantor trust could be a solution to estate planning to ensure estate inclusion to obtain a stepped-up basis on trust property.  The trustee in their fiduciary capacity will be given discretionary authority to make distributions of income and principal among Fourie Du Preez’s descendants, and appoints his son, Arno as sole trustee of the non-grantor trust.

Trap 2:  Fourie Du Preez’s last will and testament leaves most of his assets to a testamentary trust and the trust property is for the benefit of his descendants. The trustee, his son Arno has discretion to distribute income of the trust and trust property among his descendants until the youngest living at the decedent’s death has attained age 21.

Issue : In both scenarios the sole trustee is one of the children of the settlor/testator/decedent. Further, the trustee’s discretion is unlimited. Both trusts will therefore be treated as owned by the trustee for income tax purposes and not classified as a non-grantor trust, which makes the estate planning irrelevant. 

Shaun Eastman

IRC Section 677 – When A Right to Income Makes a Trust a Grantor Trust

Posted on by Peter Harper


In this week’s vlog, the managing director and CEO of Asena Advisors, Peter Harper examines Section 677 of the Internal Revenue Code: the Grantor Trust Rules and the ability for a grantor to still receive the income from a trust.

This vlog is for anyone that owns assets in foreign trusts and is moving to the US or facing a liquidity event.

To watch the 7th installment of our series, click play below:

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Check out our new blog for a quick guide to everything Grantor Trusts:
https://staging-asenaadvisorscom-stgngasenaad.kinsta.cloud/blog/grantor-trust/

IRC Section 676 – How a Power of Revocation Makes a Trust a Grantor Trust

Posted on by Peter Harper


​​In the 6th installment of our Grantor Trust Series, Peter Harper, managing director and CEO of Asena Advisors, discusses Section 676 of the Internal Revenue Code and the power of revocation with a grantor or someone who is not adverse to the grantor.

This vlog is for anyone that owns assets in foreign trusts and is moving to the US or facing a liquidity event.

To watch the full video, click play below:

Check out our new blog for a quick guide to everything Grantor Trusts: https://staging-asenaadvisorscom-stgngasenaad.kinsta.cloud/blog/grantor-trust/

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IRC Section 675 – Do Your Trust Powers Make a Foreign Trust a Grantor Trust?

Posted on by Peter Harper


​​In this week’s vlog, the managing director and CEO of Asena Advisors, Peter Harper, discusses Section 675 of the Internal Revenue Code and the non-market value consideration provisions within the specific trusts powers of a deed.

This vlog is for anyone that owns assets in foreign trusts and is moving to the US or facing a liquidity event.

To watch the full video, click play below:

Check out our new blog for a quick guide to everything Grantor Trust: https://staging-asenaadvisorscom-stgngasenaad.kinsta.cloud/blog/grantor-trust/

Asena advisors. We protect Wealth.
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