Grantor Trusts and Substitution Powers, Part 1

Examining existence, but not exercise

Table of Contents

1. Where We Left Off

2. All In

3. IRC Section 675(4)(C)

4. Release of Substitution Power

   1. Unintentional Release

   2. Affirmative Release

5. Key Points for Practitioners

Where We Left Off

In the prior grantor trust article, we discussed how grantor trusts differ from a traditional pass-through entity or disregarded entity when it comes to the question of reimbursing the grantor’s (but not necessarily the beneficiary’s) income taxes attributable to the income generated by the trust.

One key difference not brought up in the prior article is that an equity owner for a pass-through or DRE only runs into the phantom income problem – i.e., income taxed to the owner but retained (in the form of cash) in the entity – if there are no actual distributions. But in a grantor trust, a grantor should not retain any right or option to receive distributions if a goal is to remove the assets from the grantor’s gross estate for estate tax purposes. In other words, the grantor is taxed on trust income regardless of whether there is cash flowing into, or out of, the trust.

Any distribution right to, or even the receipt of distributions itself by, the grantor can be enough to trip IRC Sections 2038 or 2038 at the grantor’s death. Tax distributions usually fall into this trap, unless they comply with both Rev. Rul. 2004-64 and the broader principles of IRC Sections 2036 and 2038. (Note that Rev. Rul. 2004-64 did not speak to the application of IRC Section 2038 – only 2036 – which could raise issues as well. That is, however, a subject for another time.)

Keep in mind as well that Rev. Rul. 2004-64 only speaks to an (independent) trustee’s fully discretionary power to reimburse the grantor’s income taxes. It does not speak to the actual exercise of that power. It may or may not surprise you, however, to discover that this is not the only area or ruling addressing the intersection of grantor trust powers and retained interests. In this vein, we discover perhaps the most frequently-used grantor trust power – the right of substitution, also known as a “swap” power or “substitution” power. We find here another Revenue Ruling – 2008-22 – dealing again with the intersection of this power with retained interests for purposes of IRC Sections 2036 and 2038. We also find in this Ruling a focus on the existence of power itself for purposes of that analysis, with room remaining for the manner of exercise to create an issue.

These issues should bring us pause, but for now note that there is a difference between the existence of a substitution power and the exercise of a substitution power. When creating a grantor trust, we are often only focused on the former based on the comfort of Rev. Rul. 2008-22. Without further adieu, let’s dive into some basics and table the harder questions for another article.

All In

A common theme in this article series has been that it is preferable for a grantor trust to be a 100% grantor trust. What does this mean? It means that the grantor, or a beneficiary, is the deemed income tax owner of all trust income and corpus. If you cannot achieve this all-in status, it is better to not have any of the grantor trust rules apply at all.