Grantor Trusts and Substitution Powers, Part 4
Joint Contributors, and Related Issues
Table of Contents
Where We Left Off
Previously, we discussed some issues that can arise when a grantor exercises a substitution power – both from a tax law perspective, and from a state law perspective. Choice of assets and intent both matter, not to mention the meaning and confirmation of equivalence of value.
An upcoming article will cover issues with the release of a substitution power, but in the meantime there is one issue that often arises where there are multiple donors to a trust – the scope of the substitution power itself. One must be cautious to line up the intent for grantor trust treatment with the contributions by multiple individuals to an irrevocable trust.
Definition of “Grantor”
Often, a substitution power refers to the actual grantor of the trust – whether in terms of the holder of the substitution power itself, or the person reacquiring trust property in exchange for their own property. This definition refers to the creator of the trust which may go by any number of interchangeable legal terms such as settlor, trustor, trustmaker, grantor, etc.
However, a grantor is not the only person who can make contributions to a trust. As noted in prior articles in this series, Treas. Reg. 1.671-2(e)(1) acknowledges that a grantor (for purposes of the grantor trust rules) is not just the creator of a trust but also includes a person making a gratuitous transfer to the trust. In fact, without actually contributing property, it is difficult for an individual to be treated as the income tax owner of such property. This Treasury Regulation goes on to note:
However, a person who creates a trust but makes no gratuitous transfers to the trust is not treated as an owner of any portion of the trust under sections 671 through 677 or 679.
Later, we will discuss how this can split the income reporting of a trust between multiple grantors who make gratuitous transfers. Where two grantors are indicated as joint creators of a trust, care must be taken to draft a substitution power such that it applies to each grantor. But, is this enough? Should we account for anybody who makes a gratuitous transfer? Let’s look at where this might arise.
Crummey Powers
Often, Crummey withdrawal rights are drafted by reference to the donor of property – leaving room for others to make annual exclusion gifts to trust beneficiaries. Any Crummey withdrawal right can come with its own “baggage” if a substitution power is terminated (such that the actual “grantor” is no longer the income tax owner of the trust itself). This is because of the operation of IRC Sections 678(a)(1) and (a)(2), which kick in if the grantor is not the deemed income tax owner under the priority rule of IRC Section 678(b).
Simply put, anyone other than the grantor who makes a transfer to the trust that is subject to a Crummey power may not be able to shift the income taxation of that contributed property to the grantor as discussed above. But, this also raises the question – is there a mechanism for such a donor to have the grantor trust rules apply to their own contribution?
If a substitution power is the relied-upon grantor trust power, and the substitution power is drafted only to apply to the actual grantor of the trust, then the donor of Crummey gifts may not be able to claim deemed income tax ownership (nor might they want to do so). However, this likely means that the power holders of the Crummey withdrawal rights get taxed on income generated by the property contributed by donors other than the grantor under 678(a).
Third-Party Lifetime Gifts and Sales
This same principle might extend to a situation where a donor wishes to make larger gifts to the trust, or perhaps wishes to sell assets to a grantor trust for which they are not the actual grantor.
For example, let’s say a spouse (as grantor) creates a trust for their children and descendants and funds it with gifts of their separate property. Later, in an effort to use their own lifetime gift tax and GST exemptions, the non-grantor spouse wishes to contribute additional property. Would we still have a grantor trust with respect to the non-grantor spouse?
It seems intuitive to think this would be the outcome if, for example, the spouses file jointly for income tax purposes. But, there must be a mechanism for a retained grantor trust power to extend to the non-grantor spouse making the contribution to begin with. If the substitution power is not drafted to apply to anyone other than the actual grantor of the trust itself, the contributions by the non-grantor spouse may not be enough by themselves to create deemed income tax ownership. And while spousal attribution may apply here to still create a 100% grantor trust, the power of substitution may not extend to the non-grantor spouse if they wish to utilize its benefits.
On the other hand, one could argue that perhaps IRC Section 1041 would kick in to treat this as a transfer to the grantor spouse – as deemed income tax owner – thus curing any defect in the scope of the substitution power itself as pertains to grantor trust status. To get there, however, we would need to be sure that the substitution power extends to all trust assets contributed by the grantor spouse at the very least. This could also create an odd outcome where the release of the substitution power by the grantor spouse could create (at the moment of release) a “gratuitous transfer” of the non-grantor spouse’s contributed assets – treated as originating from the grantor spouse themselves – which transfer simultaneously (1) becomes subject to the substitution power and then (2) has that power released. In other words, the substitution power ironically cannot extend to the non-grantor spouse’s contributed assets until it is released.
Taking this a step further, let’s say it is a grandparent who wishes to gift to their grandchildren in this same existing trust that is set up by a parent of such grandchildren. Again, we run into the same dynamic in terms of the scope of the substitution power, but this time with no ability for spousal attribution or IRC Section 1041 to save us.
And in either scenario, we would need to be conscious of whether there is a need to guarantee and preserve 100% grantor trust status. Such might be the case if, for example, the trust owns S corporation stock and has not made a valid ESBT or QSST election. Another example might be if there is an outstanding installment obligation payable to the grantor as a result of a sale to the trust in reliance on Rev. Rul. 85-13. There may be ways to trace contributions and protect from these outcomes in a situation where a non-grantor contributes property, but being certain about the scope of the substitution power may be the safer play.
Key Takeaways
It is frequent to encounter language in a trust acknowledging the state-law reality that the “settlor” or the “grantor” of the trust includes not just the persons signing the trust in this figurehead capacity, but also third persons who contribute property to the trust. However, this language may not always be present, and may not always prevent the issues highlighted herein regarding the scope of a substitution power. Remember that the application of the grantor trust rules to a contributor requires that contributor, or their spouse, to retain certain rights or powers. Where a trust is drafted to assign these rights or powers to a “settlor” or “grantor” as a figurehead role, it may be difficult to claim grantor trust status for a non-grantor contributor – even if other terms of the trust provide that they assume this capacity by their contribution. And, in fact, this can lead to taxation of beneficiaries through the use of Crummey withdrawal rights for example.
Speaking of, one must also be cautious about the potential for a contributor to become a beneficiary or even a trustee at some point. This could be good news for income tax purposes if the intent is to create a grantor trust in a situation where the contributor is not within the scope of a substitution power, but the powers necessary to get there could have an adverse effect on the contributor from an estate tax, and/or creditor protection, perspective. Substitution powers (and scope thereof) aside, it is important to analyze this possibility for any third party wishing to contribute to a trust before such contribution is made.
Which brings us to perhaps an overly-simplified prescription – the drafting of a substitution power to include any donor, to the extent of their contributions. As with any tool, this comes with its own warnings not to assume this is the desired outcome. In an unpublished 2021 opinion of the 4th Circuit, Wellin v. Farace, an estate planning attorney was sued for malpractice for an alleged failure to advise a client about the income tax consequences of grantor trust status. We will discuss this case in a separate article, but for the time being it stands as a caution towards the use of grantor trusts – even if seemingly-ubiquitous – especially for transfers for which grantor trust status cannot easily be terminated. This possibility further increases the importance of proper drafting when it comes to a substitution power, such that any contributor can control whether or not grantor trust status applies.