Grantor Trusts and Charitable Powers

Breaking down the nuances and exceptions

Table of Contents

1. Where We Left Off

2. Powers to Allocate Among Charitable Beneficiaries

3. Power to Add Trust Beneficiaries

4. Added Versus Existing Charitable Beneficiaries

5. Key Points for Practitioners

Author Note: I cover many advanced topics in this newsletter, but even this topic strained the limits of my ability to synthesize and simplify. It leaves open questions, while also perhaps ignoring some other technical guidance that I have not yet read. I have focused my attention on the Code and Treasury Regulations here, but I anticipate that there could be some gaps in this analysis that could be filled in at a later date in one or more separate articles.

Where We Left Off

In the previous grantor trust article, we discussed how recent income tax changes under the OBBBA have enhanced certain benefits that are available to nongrantor trusts. These include an increased SALT deduction cap, enhanced gain exclusions for qualified small business stock (QSBS), and higher phase-in limits for the deduction for qualified business income (QBI) under IRC Sections 199A(b)(3)(B) and 199A(d)(3)(A). However, even when there is an intent to create a nongrantor trust this status can be unintentionally invoked. The Service may have an even greater incentive moving forward to challenge the grantor trust status of some trusts given the enhanced benefits (especially QSBS gain exclusions) available to nongrantor trusts.

So, it is more important than ever not only to know how to opt-in to the grantor trust regime, but also how to opt out – whether at the time of trust funding, or at some later date.

A prior article also discussed how the charitable deduction, and changes thereto, may affect grantor trusts differently than nongrantor trusts due to the differences between IRC Section 170 versus IRC Section 642(c). In keeping with this theme, we will explore some of the issues relating to charitable powers within a trust that may or may not cause the trust to be treated as a grantor trust.

As you may recall from the last grantor trust article, IRC Section 674 sets forth the general proposition that powers of disposition held by the grantor (directly or perhaps by spousal attribution), or a nonadverse party, can invoke grantor trust status to the extent they can be exercised to affect beneficial enjoyment of the income or corpus of the trust. There are four key categories of exceptions to this general rule – (1) powers requiring the consent of an adverse party, (2) powers described in IRC Section 674(b) that can be exercised by anybody, (3) certain powers described in IRC Section 674(c) to the extent they are exercisable by an independent trustee, and (4) powers to distribute according to an ascertainable standard under IRC Section 674(d) to the extent they are solely exercisable by anyone other than the grantor or a spouse living with the grantor.

Within three of these four exceptions, we find an important power that is often carved out as an “exception to the exception” in the form of a power to add beneficiaries. Such a power, if held by any person in conjunction with certain “exception” powers described in IRC Sections 674(b)(5), (c), or (d) causes the default rule of IRC Section 674(a) to apply. This may cause a trust to be a grantor trust, unless the adverse party exception to 674(a) is met. Such a power may come into play as we explore the role that charitable beneficiaries play in a trust.

Powers to Allocate Among Charitable Beneficiaries

Does a trustee’s power to distribute income or principal to specific charitable beneficiaries by identification, or by class, result in a grantor trust? Or might this serve as an exception to the default rule of IRC Section 674(a), since retained charitable powers perhaps do not create as much of an abusive “control” issue as retained powers to allocate among non-charitable beneficiaries?