Grantor Trusts and Substitution Powers, Part 3

Some cautions when exercising substitution powers

I would like to acknowledge Paul Hood’s assistance - namely the sharing of his monograph on swap powers, as previously presented to Leimberg Information Services Inc. (LISI) and others. For a deeper read on this subject, Paul’s write-ups can also be found as a two-part series in LISI Estate Planning Newsletter #2817 (August 25, 2020) and LISI Estate Planning Newsletter #2819 (September 1, 2020). Please note, however, that the thoughts reflected below are my own where attribution to Paul is not provided.

Table of Contents

1. Where We Left Off

2. Revisiting Rev. Rul. 2008-22

3. Valuation and Adjustment Clauses

4. Condiotti and Benson Opinions

5. Key Takeaways

Where We Left Off

Substitution powers are perhaps the most widely-used intentional grantor trust power. As discussed in prior articles in this series, substitution powers achieve the important goal of creating a wholly-grantor trust (with respect to all corpus and trust income, other than perhaps voting stock under 2036(b) as discussed in the prior article) while also giving the grantor control to turn off grantor trust status by “releasing” the substitution power assuming no other grantor trust powers are retained.

The actual exercise of the grantor trust power can itself be a boon. For example, a grantor holding high-basis assets can swap then for low-basis assets in the grantor trust through the substitution power. This could allow for a basis-step up at death, especially given the possibility that assets in a grantor trust don’t automatically get a step-up without gross estate inclusion (as illustrated in Rev. Rul. 2023-2).

But, the exercise of the substitution power raises interesting questions. What if, for example, the grantor does not have sufficient personal assets to swap with the trust. Could a promissory note be swapped? Does a substitution of all assets run headlong into the trustee’s own duties under the trust, independent of the substitution power? These are just some of the issues that might arise. To properly examine these issues, let’s rehash Rev. Rul. 2008-22.

Before diving into this analysis, however, I caution you that this article does not give firm answers or safe harbors. Your goal in reading it should be to become a better issue-spotter, by recognizing that the choice of assets and even the other terms of the trust itself (outside of the substitution power) matter when it comes to exercise of that power.

Revisiting Rev. Rul. 2008-22

While perhaps oversimplified, Rev. Rul. 2008-22 sets forth the following requirements for a substitution power, by itself, to avoid subjecting the grantor of the trust to IRC Sections 2036 or 2038:

• The assets the grantor transfers into the trust must be equivalent to the assets the grantor receives in exchange.

• The trustee has a fiduciary duty to ensure that the assets exchanged are of equivalent value.

• The power must be exercisable by the grantor in a nonfiduciary capacity, and in particular the grantor should be prohibited from becoming trustee.

• The power cannot be exercised in a manner that can shift benefits among the trust beneficiaries.