Grantor Trusts and Substitution Powers, Part 2

Voting Stock

Table of Contents

1. Where We Left Off

2. Voting Stock and Retained Interests

3. Substitution Powers Over Voting Stock

4. Key Takeaways for Practitioners

Where We Left Off

To recap, in the article introducing substitution powers, we explored how retained interests by the grantor can lead to two forms of deemed ownership. On one hand, especially if you are intentionally creating a grantor trust, certain retained interests or powers can cause income tax ownership under the grantor trust rules. This is usually a good outcome. But this good outcome cannot be observed in a bubble, as it must be weighed against the possibility that certain powers or interests retained by a grantor can create deemed estate tax ownership if such powers are held at death, or released for less than full and adequate consideration within three years of death, under IRC Sections 2036 or 2038 (as modified by 2035(d)). This could be a bad outcome, especially for assets that have substantially appreciated since being transferred to the grantor trust.

Rev. Rul. 2008-22 generally stands for the proposition that a substitution power retained by the grantor, by itself, will not lead to gross estate inclusion under IRC Sections 2036 or 2038 so long as certain requirements are met. (For purposes of this article, we will call a substitution power meeting these requirements a “qualifying substitution power.”) We will explore those specific requirements in a later article to put a bow on this “series within a series” on substitution powers. In short, these requirements are generally stated as follows within the Ruling itself:

A grantor's retained power, exercisable in a nonfiduciary capacity, to acquire property held in trust by substituting property of equivalent value will not, by itself, cause the value of the trust corpus to be includible in the grantor's gross estate under § 2036 or 2038, provided the trustee has a fiduciary obligation (under local law or the trust instrument) to ensure the grantor's compliance with the terms of this power by satisfying itself that the properties acquired and substituted by the grantor are in fact of equivalent value, and further provided that the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries.

What if, however, we are exercising or releasing the power? Even with these guardrails, could the exercise or release itself create an issue? There is a certain bridge we have to cross to address these issues, in the form of asset-specific inquiries. Two specific types of assets come into play. One – life insurance – will be addressed in a separate article. The second, however, is the focus of today’s article – voting stock.

Voting Stock and Retained Interests

When we speak of IRC Section 2036, most of the focus is usually on 2036(a) – examining a grantor’s retained rights or powers over trust assets in general. However, there is another Code Section, IRC 2036(b), that often receives short shrift in this context. Briefly, 2036(b)(1) causes gross estate inclusion under 2036(a)(1) for shares of “stock of a controlled corporation” if, at death, the decedent had retained “the right to vote (directly or indirectly)” such shares.

While this article itself is not intended to be a primer on 2036(b), it is important to note that this retention of voting rights is treated as a retained right to the “enjoyment” of such voting stock under IRC Section 2036(a)(1). This test can be contrasted with IRC Section 2036(a)(2), which examines the right to designate persons who will enjoy the property “either alone or in conjunction with another person.” One may read this to believe that the right to vote stock is more in line with the power of a trustee, as opposed to the power of a beneficiary, but 2036(b) essentially treats a decedent as beneficiary (instead of trustee) where this applies. Why is this important? It is easy to read this to believe, perhaps, that if the decedent retains the right with another person to vote the corporate stock, that this perhaps avoids the reach of 2036(b) since a retained right exercisable with another person only expressly falls within 2036(a)(2). But, 2036(b)(1) modifies this overall framework by examining both direct and indirect retained voting rights.

Which raises the question – what is a controlled corporation? Does it have to be an actual state-law corporation, or does it instead look at the tax status of the entity in question? While income tax principles don’t often bleed over into estate tax by reference, 2036(b)(2) looks to the decedent’s retention of voting rights not just by direct ownership (presumably as modified by the grantor trust rules), but also by attribution under IRC Section 318. In short, IRC Section 318 can attribute ownership of C corporation stock (and by reference under the S corporation rules, S corporation stock) between related parties for certain purposes.

Accordingly, we can read this as focusing on the income tax status of the “controlled corporation” instead of the state-law status. Since entities that are by default taxed as partnerships, such as state-law partnerships and LLCs with more than one member, can check the box to be taxed as an association (invoking C corporation taxation) or can further make an S corporation election, 2036(b) can extend to such entities when classifying which forms of equity interest might be treated as “corporate” voting stock.

This is not the end of the road, however, as 2036(b)(2) imposes a 20% or greater threshold for total retained voting power (by the decedent) for this Code Section to apply. One can read this to assume that if the trust in question and decedent, in the aggregate, hold less than 20% of the voting power in a corporation that 2036(b)(1) would not apply (since the voting power of the decedent wouldn’t pass the ownership threshold for a “controlled” corporation – an express prerequisite). But remember that pesky Code Section – IRC Section 318 – cited above? It must also be applied across all related parties with respect to both the decedent and the trust. Application of 318 is equal parts art and science, and can quickly twist even the advanced practitioner in knots when tracing the various levels of attribution and constructive ownership therein. For that reason, we will leave this subject for now with the basic idea that you should simply be an issue-spotter for 318 attribution.

But what does all of this have to do with substitution powers? Let’s explore the intersection.