Grantor Trusts, Powers of Appointment, and Adverse Party Consent

Avoiding pitfalls, especially for incomplete gift trusts

Table of Contents

1. Where We Left Off

2. IRC Section 674(b)(3), in General

3. Adverse Party Consent

4. Key Takeaways

Where We Left Off

The theme of the past few grantor trust articles has been situations where grantor trust status can be inadvertently created, notwithstanding the intent to create a non-grantor trust. The cornerstone of our analysis has been IRC Section 674, under which powers created in the trust itself can serve as traps for those intended to create a non-grantor trust. This power generally creates a grantor trust where the grantor, grantor’s spouse (by attribution to the grantor and perhaps if not adverse), or a nonadverse party hold a power of disposition over a beneficial interest in a trust without the consent of an adverse party.

In the last article, we discussed how discretionary powers to distribute corpus and/or income are treated separately under the various exceptions to IRC Section 674(a). These exceptions don’t always conveniently fit into certain transfer tax exceptions, under which the presence of an ascertainable standard can prevent a grantor from having a general power of appointment. Instead, these powers are analyzed from the perspective of whether the grantor might hold a 674(a) power directly or by attribution (from a trustee under Rev. Rul. 95-58 or a spouse under IRC Section 672(e)). The only ascertainable standard exception that applies to the grantor directly is the power to distribute corpus, and not income, which falls under an exception in IRC Section 674(6)(5)(A) and is subject to other requirements.

Of course, we would be remiss if we did not discuss powers of appointment and distinguish those from a trustee’s discretionary distribution powers. Nonetheless the two often overlap for tax purposes, and the application of these powers to grantor trusts is no exception. In fact, a common planning structure which relies on non-grantor trust status is the incomplete gift non-grantor trust, or “ING” trust. This trust is typically funded with an incomplete gift, as a result of the grantor’s retention of dominion or control in the form of a testamentary power of appointment as condoned by the following excerpt from Treas. Reg. Section 25.2511-2(b):

For example, if a donor transfers property to another in trust to pay the income to the donor or accumulate it in the discretion of the trustee, and the donor retains a testamentary power to appoint the remainder among his descendants, no portion of the transfer is a completed gift. On the other hand, if the donor had not retained the testamentary power of appointment, but instead provided that the remainder should go to X or his heirs, the entire transfer would be a completed gift.

As we will see, this definition fits conveniently (or perhaps inconveniently, depending on the context) into IRC Section 674(b)(3). Before exploring this from the grantor trust perspective, however, it is important to cite an issue that even I have been wrong or incomplete in discussing. Under CCA 201208026, notwithstanding the example from Treas. Reg. Section 25.2511-2(b) above (which is conveniently omitted from the CCA itself), the Service concluded that a retained testamentary power by the grantor only creates an incomplete gift of the remainder of the trust. It does not (in the eyes of the Service, at least in this determination) create an incomplete gift of the beneficial term interests of the trust. This itself is an issue worth examining, as it perhaps means that a grantor must retain some power over the current income (and corpus) of the trust that satisfies an exception to IRC Section 674(a), but that nonetheless prevents grantor trust status. A common workaround is the requirement of the consent of an adverse party, but even then one must be sure that the adverse party’s consent applies to the entire trust and not just to a portion, or just to the income or corpus separately as we will discuss below.

One must also question whether the guidance of this CCA somehow ties into the grantor trust distinction between corpus and income? As noted in the last article, the corpus is usually equated with the remainder in the context of the grantor trust rules – at least in a traditional situation where all income of the trust is distributed. Where income can be accumulated for future distribution to current or remainder beneficiaries, this analysis gets murky under the grantor trust rules. The CCA noted that the testamentary power of appointment was to “appoint so much of [the property transferred by the donors] as would still be in the Trust at his or her death.” But, it did not clarify whether this power extended to income generated by that property. This is an extremely important fact that will come into play below.

Notwithstanding this unsettled issue of incomplete gifts and testamentary powers, how would a grantor’s retained testamentary power affect grantor trust status? Could a testamentary power to appoint, even if only exercisable at death, cause a grantor to be taxed on trust income during life? To find out, we must look to IRC Section 674(b)(3).

IRC Section 674(b)(3), in General