My Favorite Presentation from Heckerling

I was fortunate enough to attend the 54th annual Heckerling Institute on Estate Planning in Orlando. Heckerling is known worldwide for being one of the most innovative and informative estate planning conferences put on. The topics are always relevant and timely, and there are always some new and innovative planning techniques and ideas presented. Additionally, the speaker line-up is a Who’s Who of the estate planning and tax world.

When I returned to my office after the conference, one of my co-workers asked me what my favorite presentation was. Trying to pick a favorite is a difficult task as every presentation is useful and informative. I am still digesting and trying to take in everything from the week, and in doing so, I would like to take some time to highlight my favorite presentation from the week, which just so happens to be the very first one, a presentation on grantor trusts. While the use of grantor trust comes up in many presentations in a variety of ways, Heckerling kicked off this year with a fundamentals session on all things grantor trusts.

The Life-Changing Magic of Grantor Trusts – Samuel A. Donaldson

Samuel A. Donaldson started this year’s conference with a fantastic presentation on grantor trusts which served as both a great review of the fundamentals of a grantor trust as well as an in-depth review of some of their planning applications. First, if you have never seen Mr. Donaldson speak, please do yourself a favor and attend one of his presentations. I have had the pleasure of seeing him speak on a variety of topics and consistently come away both entertained and enlightened. His three-hour presentation on grantor trust flew by, and he had the crowd laughing and engaged throughout, setting the stage for a great week.

Planning with grantor trusts has been around for quite some time, and the use of a grantor trust is nothing new to experienced estate planning professionals. Nevertheless, we are constantly finding new ways and new techniques to incorporate these grantor trusts into our planning.

Before we dive into the presentation, let us start with a brief explanation of what a grantor trust is. A grantor trust is a trust which is taxable to the grantor under Sections 671 through 679.1 The grantor is [usually] the person who contributed property to the trust. There can be multiple grantors. A trust can also be partially grantor whereby some assets are taxed to the grantor and some are not taxed under the trusts and estates tax regime. Additionally, under §678, the trust can be taxable to the beneficiary, a so called beneficiary defective trust. A grantor trust is not considered a separate taxpayer, but rather is taxable to the grantor. Thus the grantor (per the Code) pays tax on the grantor trust income as if the trust did not exist for income tax purposes. Any trust which is not a grantor trust is considered a separate taxpayer taxed under the trusts and estates tax regime and pays its own tax determined under that regime.

The History of Grantor Trusts

Donaldson began his presentation by walking through the history of the grantor trust provisions of the Code and the use of grantor trusts throughout such history. Prior to the grantor trust provisions, a common planning technique to reduce overall tax and receive a second run up through the tax brackets, which were much less compact in terms of dollar value than they are today, was to place assets in a revocable trust such that the trust now paid tax on the assets. The grantor still enjoyed the benefit and control of the assets but reduced his or her overall tax burden. The grantor trust provisions, §§671-679, began in 1924 and continued to be revised until 1969. The current grantor trust provisions have not been changed since 1969. Donaldson walked through the various tax brackets in effect during different periods of time and showing how grantor trusts could often be detrimental in the past due to the structure of the income tax brackets which were much different than what we have today.

Uses of Grantor Trusts

Next, Donaldson walked through some scenarios and uses where grantor trusts can be beneficial.

Same Taxpayer for Lower Aggregate Tax Liability

First, a grantor trust can serve to reduce the aggregate tax liability of the grantor and the trust combined. Since a non-grantor trust reaches the top tax bracket at only $12,951, it can be useful to have that income taxable to the grantor who may be in a lower tax bracket. Of course, this does not always work when the grantor is already in the top tax bracket. Donaldson presented several examples to show how the use of a grantor trust can significantly reduce the overall tax burden under the right set of facts. Below is one such example Donaldson presented:

Example: In 2019, the taxable income of G, an individual, is $100,100. Trust has gross income of $100,100 and no deductions or credits attributable to its assets. Assuming Trust is a separate taxable entity (non-grantor trust) and that G is not the owner of any portion of the Trust under the grantor trust provisions of the Internal Revenue Code, the total tax liability of G and Trust is $53,556.50.

Analysis Using Non-Grantor Trust

Analysis for G

Taxable Income:$100,100

2019 Tax Liability: $18,198.50

Analysis for Trust

Gross Income: $100,1000

Less Exemption: ($100)

Taxable Income: $100,000

2019 Tax Liability: $35,358

Aggregate 2019 Tax Liability: $53,556.50

Analysis Assuming Grantor Trust

Analysis for G

Taxable Income:$200,200

2019 Tax Liability: $45,380.50

Analysis for Trust

No income. All income imputed to G for 2019.

Aggregate 2019 Tax Liability: $45,380.50 (Also consider the savings by not having to file an additional 1041)

Note the above result for the grantor trust applies regardless of whether the Trust distributes income or principal to G or any other beneficiary.

Non-Taxable Sales to Trusts

The second primary use of a grantor trust is where the grantor intends to engage in transactions with the trust such as a sale to a grantor trust described below. In Revenue Ruling 85-13, 1985-1 C.B. 184, the IRS confirmed that transactions between a grantor trust and its grantor are disregarded for federal income tax purposes. This allows a grantor to transact with the grantor trust and not have to recognized gain on appreciated assets sold to the trust, not treat interest paid by the trust to the grantor as income, and otherwise deal with the trust in a host of other ways without any income tax consequences.

Easy S-Corporation Owner

A grantor trust also qualifies as an eligible shareholder of S corporation stock. This allows a grantor trust to hold S corporation stock without having to elect to be a Qualified Subchapter S Trust or an Electing Small Business Trust.

Gifting Opportunities

Another use of a grantor trust is to allow the grantor to make tax free gifts to the beneficiaries in the form of the payment of income tax on income earned by the trust. This allows the income to stay in the trust and not have to use part of such income to pay the tax. When you consider the potential compounding of income, this can be a powerful tool to grow trust assets without incurring an additional gift tax consequences.2

678 Trusts

Donaldson also discussed the use of the so-called Beneficiary Deemed Owned Trust (the “BDOT”) often referred to as simply a 678 Trust. A BDOT is a trust structured in a way the triggers grantor trust status to the beneficiary rather than the grantor pursuant to §678, and thus the beneficiary is treated as the owner of the trust assets for federal income tax purposes. This allows the beneficiary to transact with the 678 Trust in the same ways grantors can transact with a grantor trust, many of which discussed elsewhere in this article. Donaldson also discussed some additional uses of a 678 Trust including allowing the 678 Trust to be an eligible shareholder of S corporation stock and legally assigning income to a beneficiary by transferring income generating assets to a 678 Trust.

Where Grantor Trusts Don’t Work

Donaldson then flipped the script to discuss scenarios where a grantor trust is not so beneficial and a non-grantor trust may be preferred. Some of these uses focus on the ability of a non-grantor trusts to double the run up to threshold limitations for certain benefits available to taxpayer.When using more than one trust for this purpose, taxpayers should be aware of Reg. §1.643(f)-1 which states that two or more trusts which have substantially the same grantor(s) and substantially the same primary beneficiary or beneficiaries will be treated as a single trust for federal income tax proposes if a principal purpose of the establishing multiple trusts is the avoidance of federal income tax.

First, the use of a non-grantor trust may be beneficial to maximize the availability of the qualified business income deduction under §199A. In general, without getting into the details of a very complex area of the tax code, the thresholds for claiming the §199A deduction without having to get into details of whether there actually is a specified service trade or business as well as some additional limitations are $160,700 for unmarried taxpayers and $321,400 for joint filers for 2019.  Trusts and estates are subject to these same thresholds applicable to individuals. So transferring part of a business to a non-grantor trust may allow both the individual taxpayer and the non-grantor trust to qualify for the §199A deduction which might otherwise have been lost.

Second, the use of a non-grantor trust may allow the taxpayer to double dip on the state and local tax deduction. As part of the Tax Cut and Jobs Act, Congress placed a $10,000 cap on the state and local tax deduction available for federal income tax purposes. A non-grantor trust has it’s own $10,000 cap for this deduction. However, one must be mindful of the quick bracket ride for non-grantor trusts.

Another area where a grantor trust does not work is where the grantor is attempting to avoid state income tax. Typically, a grantor trust for federal tax purposes will also be a grantor trust for state tax purposes and thus subject to the trust to state income tax in the grantor’s home state. By having the trust be a non-grantor trust and having it situated in a state that does not impose a state income tax, the grantor may be able to avoid state income tax on assets held in the non-grantor trust. One such strategy to accomplish this result without having any gift tax consequences is an “incomplete non-grantor trust,” referred to as an “ING trust.” This is a popular planning strategy that we have used successfully in the past that can be a real homerun under the right scenario.

Powers that Cause Grantor Trust Status

Following his discussion for the uses of grantor trusts as well as scenarios where a grantor trust does not work, Donaldson presented a thorough presentation of the powers that cause grantor trust status under §§671-679. A full discussion of these powers and the nuances related to each one is beyond the scope of this article, but I will take some time to discuss a few such powers that are commonly used.

Power to Revoke

The first such power is the power to revoke the trust. A common planning technique to avoid probate is to establish and fund a revocable trust during life. These trusts generally provide that the grantor can amend or revoke the trust at any time. Pursuant to §676, the power to revoke causes grantor trust status.

Power to Substitute Assets

Another common power that causes grantor trust status is referred to as the swap power. The swap power is my personal choice for achieving grantor trust status and is probably the most widely used method of doing so, at least for irrevocable trusts. Pursuant to §675(4), where the grantor has “a power to reacquire the trust corpus by substituting other property of an equivalent value.” Pursuant to this power, the grantor has the right to swap assets providing the assets transferred to the trust and those received back from the trust are of equal value. Not only does this provide any easy way to cause grantor trust status without any adverse consequences, but it also provides some powerful basis step planning opportunities discussed below.

Donaldson discussed numerous other powers that cause grantor trust status. Donaldson also provided a thorough discussion of some potential adverse consequences of many of these powers including estate inclusion for estate tax purposes. Following this discussion, Donaldson provided the following chart which is a great summary of powers that cause grantor trust status and those that cause estate inclusion:

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Using the Swap Power

As noted above, not only is the swap power an easy way to trigger grantor trust status without any adverse tax consequences, but it also provides some great planning opportunities. The first such use is the near-death swap to achieve the §1014 stepped-up basis for income tax purposes for appreciated assets held in the trust. The general consensus is that assets held in a grantor trust do not received a stepped-up basis to fair market value on the grantor’s death. However, by creatively using the swap power, such assets can receive the stepped-up basis. Where there are appreciated assets in a grantor trust over which the grantor has a swap power, the grantor can use this swap power to transfer other assets to the grantor trust, usually cash or some other liquid assets with a near-equivalent basis and value, and take back the appreciated asset in return. The result is that the appreciated asset is now owned by the grantor and receives a stepped-up basis upon the grantor’s trust. Of course, there are several pitfalls to be wary of including valuation issues of assets transferred and those received since the swap must be for assets of equivalent value. Nevertheless, when these issues are properly navigated, using the swap power to obtain the stepped-up basis for appreciated assets held in a grantor trust is great weapon to wipe out built in gains on such assets.

On the flip side, the swap power can also be used to preserve loss when the grantor is near death. This is because §1014 not only provides a step up on cost basis of appreciated assets, but also a step down in basis for loss assets. If the grantor holds assets with a built-in loss, the grantor can swap such assets with grantor trust assets such that the grantor trust now holds the loss asset. At the grantor’s death, the loss asset is not subject to the §1014 step down since it is in the trust and not in the grantor’s estate.

The swap power can also be used to avoid the three-year transfer rule under §2035(a) whereby certain assets gifted within 3 years before the date of death remain taxable in the transferor’s estate. This could be a great way to get life insurance into a grantor trust at a lower value and allow the death benefit to pass to the trust without triggering estate inclusion. Additionally, the swap power can also be used to control cash flows based on swapping cash flowing assets in and out of the grantor trust.

Tax Reimbursement Clauses

As discussed earlier, one of the advantages of a grantor trust is that the grantor can make tax-free gifts to the beneficiaries through the payment of income tax. And the grantor can pay such taxes without any adverse tax consequences. Revenue Ruling 2004-64 makes this clear. But one concern clients generally have when discussing grantor trusts is what happens when they lack the money to pay such taxes. Many grantor trusts contain a so-called “tax reimbursement clause”. In Revenue Ruling 2004-64, the IRS held that where the trust instrument requires the trustee to reimburse the grantor, the grantor has effectively retained the right to use trust property to discharge the grantor’s obligation to pay federal income tax, meaning the full value of the trust assets must be included in the grantor’s gross estate under §2036(a)(1). However, where the payment is merely discretionary instead of mandatory, and assuming there is no express or implied understanding between the grantor and the trustee that the trustee will reimburse the grantor for the taxes, §2036 does not apply and the assets of the grantor trust are not included in the grantor’s gross estate as a result of the tax reimbursement clause.

Toggling Grantor Trust Status

Donaldson next discuss turning grantor status off, on, and toggling between the two. It has long been known that one could turn grantor status off by merely disclaiming the power that causes such grantor trust status to be triggered in first place. Note however that this may not work in all circumstances since certain powers held by a spouse may not be able to be disclaimed or toggled off. For instance, where there is a swap power which causes grantor trust status, the grantor can irrevocably disclaim this power and turn the grantor trust status off. But what about turning grantor trust status on, then off, and then on again. As Donaldson discussed, toggling between grantor trust and non-grantor trust status should be possible through §675(3) which states that a trust in which the grantor has taken out a loan that does not have adequate interest and adequate security will cause the trust to be a grantor trust for the year in question. So if the grantor borrows from the trust and has not repaid the amount borrowed before the start of the trust’s taxable year, the trust will be a grantor trust as long as the loan does not have both adequate interest and adequate security. If the grantor wants to turn off grantor status, the grantor simply needs to repay the loan.

Another option for toggling on and off is through decanting from a non-grantor trust to a grantor trust and vice versa. The IRS has blessed this method in Private Letter Ruling 200848017 where the trust decanting from a trust with no swap power to a trust with a swap power, and the resulting trust with the swap power was held to be a grantor trust.

Grantor Trust Techniques

Near the end of his presentation, Donaldson discussed a few common planning techniques whereby grantor trusts are used.

Installment Sale to Grantor Trust

The first such technique is the sale to a grantor trust for an installment note. This is known as an estate freeze technique whereby the grantor sales an asset with the potential for appreciation to a grantor trust in exchange for a promissory note. Since the sale is considered as a sale from the grantor to the grantor, it is not treated as a sale for tax purposes and thus there is no gain on the sale. Further, the interest payable on the note is not taxable to the grantor when received.  In addition to an estate freeze, this technique can preserve any discounts applicable to the asset sold such as the sale of a fractional interest of an asset wholly owned by the grantor.

Grantor Retained Annuity Trust (“GRAT”)

Donaldson also discussed the use of a grantor retained annuity trust “. A GRAT is a trust whereby the grantor transfers property the trust and takes back an annuity. The value of the annuity reduces or offsets the value of the gift to the trust. The annuity can be structured in a variety of ways and the gift tax consequences of the GRAT will be based on the value of assets transferred to the trust and the structure of the annuity which in turn determines the value of the annuity for offsetting purposes. One structure Donaldson spent a little extra time on is the so called “zeroed out” GRAT whereby the taxpayer structures the annuity which is paid back to the grantor to equal the value of the property transferred to the GRAT thereby avoiding a gift when the GRAT is formed. Note that anytime a GRAT is employed, the Generation Skipping Transfer Tax (“GSTT”) rules should be careful reviewed to avoid unintended consequences with regard to allocation of GSTT exemption.

Tax Reporting

One question that constantly comes up with grantor trusts is the proper method to report the income on assets held in a grantor trust. Donaldson briefly touched on this in closing. There is only one owner for tax purposes (i.e. one grantor), there are three methods available for tax reporting.

Where the grantor is the deemed owner of the entire trust, the trust must still report to the Service, and it generally has three options for doing so. Certain grantor, trusts, however, may only file a Form 1041 as described below. These include foreign trusts, qualified subchapter S trusts, and non-United States grantor trusts. Reg. §1.671-4(b)(6) – (7).

  • First, the trust may file a Form 1041, U.S. Income Tax Return for Estates and Trusts and show all the trust income as flowing through to the grantor.
  • Second, the grantor may provide the trustee with a Form W-9, Request for Taxpayer Identification Number and Certification. The trustee should then provide the Form W-9 to each payor to the trust showing the name and taxpayer identification number of the grantor.
  • The final method is for the trustee to provide all payors with the trust’s taxpayer identification number and then file Forms 1099 for all income items, listing the trust as payor and the grantor as payee.

Where there are multiple grantors, the reporting can be a bit more complicated. Under these circumstances, the trustee may only use the Form 1041 method or the Form 1099 method.

Closing

Donaldson closed right on time with the following quote (I may be paraphrasing a little) “Look at that right time, dang I’m good. You may not have thought I was good but I was good”. I think everyone in the audience would agree with Donaldson that he was indeed good, and who doesn’t appreciate getting entertained and let out right on time?

I hope this writing has been useful in highlighting some of the topics Donaldson discussed during his presentation. Trying to cover every item Donaldson discussed and provide some detail and insight as Donaldson did would be futile. Nevertheless, hopefully this summary has some helpful information regarding the fundamentals of grantor trusts as well as a view on some of their benefits, or lack thereof. And I’ll say this again, if you ever have the opportunity to see Donaldson speak or get your hands on some audio from one of his presentations, please do yourself a favor and take advantage.

Footnotes

  1. References to a § or a Section refer to a Section of the Internal Revenue Code.
  2. Revenue Ruling 2004-64.
  3. This chart was provided by Samuel A. Donaldson in the Heckerling materials. All credit for the chart and its contents is attributable to Samuel A. Donaldson.