Grantor Trusts, and Transfers Between Trusts

Identity of grantor, powers of appointment, and more

Table of Contents

1. Where We Left Off

2. Look-Through Rules of Treasury Regulation Section 1.671-2(e)

3. No Intra-Trust Attribution of Grantor Trust Powers

4. Beneficiary or Trust as Deemed Owner, and Attribution

5. Conclusion, and Key Takeaways

Where We Left Off

Early in this grantor trust series, we discussed how grantor trusts are not like disregarded entities for a variety of reasons, not the least of which was the interaction between the income tax rules and estate tax rules that might apply to the grantor’s retained powers or interests necessary to create a grantor trust. For example, while a disregarded entity can freely make tax distributions to its owner, that might not be a good idea for a grantor trust not complying with Rev. Rul. 2004-64 and, even then may not bee a good idea under IRC Section 2036(a). Likewise, a grantor trust can have a grantor or beneficiary be treated as a deemed income tax owner of only a portion of the trust’s income or corpus – a result not possible in a disregarded entity since the disregarded entity rules focus solely on equity ownership/contributions, and not on specific retained rights.

There is another key difference, however – in short relating to the attribution of deemed ownership between entities. Let’s say we have an individual who is the sole member of an LLC that we will call the “parent LLC,” thus causing the parent LLC to be a disregarded entity. In turn, the parent LLC is the sole member of another LLC – that we will call the “subsidiary LLC” – which is also a disregarded entity. Here is a quick illustration of the structure:

In this case, the individual would have the income not just of the parent LLC, but also of the subsidiary LLC, reported on their income tax return. In other words, disregarded entity status and the associated income tax “ownership” can be stacked. Which raises the question – is this possible with trusts, especially when we get into decanting or exercises of powers of appointment?

To answer this question, we must first dive into the Treasury Regulations.

Look-Through Rules of Treasury Regulation Section 1.671-2(e)

In the introductory article of this series, we discussed how grantors are often considered to be individuals who create a trust, and/or make a gratuitous transfer to a trust. But grantors don’t have to just be individuals. In fact, Treas. Reg. 1.671-2(e)(4) directly states that a (tax) partnership or corporation can be a grantor by making a gratuitous transfer to a trust. Likewise, Treas. Reg. 1.671-2(e)(5) allows a trust to be the grantor of another trust.

There are, however, some look-through rules for these situations where an entity might make a gratuitous transfer.

Diving into this further, Treas. Reg. 1.671-2(e)(4) goes on to clarify that a partnership or corporation is only a grantor if the gratuitous transfer to a trust is made for a business purpose of the partnership or corporation. If instead the transfer is for a personal purpose of a partner or shareholder, then that partner or shareholder will be the grantor of the trust by virtue of a “constructive distribution” mechanism (whereby the partnership or corporation is deemed to have first made a distribution to the partner or shareholder, who in turn makes the gratuitous transfer to the trust in question).

Keep in mind, however, that this is simply a rule of identity. In other words, we are just determining “who” the grantor might be. From there, we must determine whether the identified “grantor” retains the necessary powers under IRC Sections 673-677 to cause deemed income tax ownership. So, for example, if the sole shareholder of an S corporation caused the S corporation to fund a charitable remainder trust for the shareholder’s own purposes (as opposed to the S corporation’s business purposes), the status of that trust as a grantor trust would depend solely on the question of whether or not the shareholder in question retained any grantor trust powers over the trust. Alternatively, if the S corporation was setting up a trust to administer an employee benefit plan, the business purpose could make the S corporation the grantor, but it wouldn’t make the S corporation the deemed income tax owner solely by virtue of being the grantor.

This creates an odd dynamic when compared to the example above with stacked disregarded entities. In the image in the introduction, the sole member of the parent LLC was also the taxpayer for income tax accruing to the subsidiary LLC, based on the fact that the parent LLC was the sole member of the subsidiary LLC. But this stacking does not work the same way where these entity rules for grantor trusts are applied, since (1) the grantor trust rules do not deal with equity ownership and (2) since these entity rules function solely to identify the grantor. Instead, we have to determine whether the identified grantor (even if separated by a partnership, corporation, or another trust in the middle) has retained powers over the target trust.

This problem gets exacerbated when one trust makes a transfer to another.

No Intra-Trust Attribution of Grantor Trust Powers