After covering Section 675 of the Internal Revenue Code, or IRC, in our previous article, let’s go into the next section that clients want to learn more about: IRC Section 674.
What is a Grantor Trust?
Before we begin, let’s start with a simple understanding of what a grantor trust is before going into how financial processes such as IRC can apply to it. Every grantor trust begins with a grantor, defined as any person who either creates a trust, i.e. the settlor, or directly or indirectly makes an excessive property transfer to a trust. A grantor is, therefore, the person with administrative powers to make a gratuitous transfer of their trust property, whether it is the grantor’s estate, trust assets, items of income, or capital gains from an investment.
Hence, a grantor trust is a trust where the grantor has control over the trust to the extent that they will be recognized as the owner/taxpayer of all or any part of the trust for possible federal income tax purposes. That way, they are directly taxed on the income and any other tax attributes belonging to the trust as if it did not exist. The IRS disregards the trust for federal income tax purposes and treats the grantor/primary taxpayer as the deemed owner of the trust assets and trust property included.
What Grantor Trusts Are Used For
Grantor trusts have mainly been used for estate and gift planning purposes to avoid an income tax, gift tax, or estate tax, as well as to best reg trust assets according to the grantor’s wishes. These trusts are sometimes called Intentionally Defective Grantor Trusts (IDGT).
See below for some of the grantor trust methods used by estate planners to reduce and minimize taxes:
- In the case of a revocable grantor trust, probate can be avoided;
- However, an irrevocable trust cannot be changed unless given consent from the beneficiaries involved. The purpose is to reduce or eliminate taxes after the grantor passes, though some, including gift tax if a gift exceeds $15,000;
- As a “leveraging” tool to grow the impact of giving to designated donees such as using a Grantor Retained Annuity Trust (GRAT);
- As a protection structure for trust assets, providing adequate security for particular business interests such as possible creditors or claimants (if the circumstances involve business succession planning).
Funding The Grantor Trust – Who is the Grantor?
Essentially, a trust’s grantor is that trust’s settlor (or ‘notional settlor’). They are defined as any person who either creates a trust, i.e., the settlor, or directly or indirectly will make a gratuitous transfer of a trust property or items of income (grantor’s estate, capital gains, etc.) to a trust and is regarded as the primary funder.
Provisions Triggering Grantor Trust Status
The rules within the Internal Revenue Code’s Subchapter J, Subpart E govern when the trust income is taxable under a grantor trust status to the grantor or another person who is deemed to be the substantial owner of the trust (and, therefore, the primary taxpayer). This rule was designed primarily for federal income tax purposes instead of the trust itself or its beneficiary. Thus, they are granted administrative powers over the trust when the said grantor trust status is recognized and finalized by the IRS.
These provisions for grantor trust status are also contained in IRC 671-679:
- IRC 671 – Sets forth the overall principle that if the grantor is recognized as the owner of the trust, then they must include the trust’s income when calculating their taxable income and income tax;
- IRC 672 – Sets forth the definitions and rules when applying the grantor trust provisions to a subordinate party;
- IRC 673 – 678 sets out the rules to decide when the trust’s existence can be ignored for federal income tax purposes, including if a grantor can reacquire corpus if they substitute the trust corpus with property or asset of similar value, adequate interest, and adequate security;
- IRC 679 – sets out the rules to determine when a foreign trust will be regarded under grantor trust status with or without income tax applied.
IRC Section 674 – Power to Control Beneficial Enjoyment
Now that we understand the general provisions for a grantor trust and what may trigger a status, let’s look more closely at what Section 674 can do for you.
IRC Section 674 General Rule
IRC §674(a) puts forward the general rule for power to control beneficial enjoyment that the grantor will be recognized as the owner of any trust portion concerning the corpus or income’s beneficial enjoyment. Therefore, they are liable to a power of disposition used by either the grantor or a nonadverse party (or, in unique cases, both) without any adverse party’s consent or approval.
Exceptions for Certain Powers
This particular section of the Internal Revenue Code allows certain powers not only for the grantor but for a subordinate party and or the items of interest within a trust, such as beneficiaries, the will, income, and corpus:
Power to Apply Income to Support of a Dependent
Any power to distribute trust income to support a beneficiary the grantor has been deemed or deems themselves legally obligated to support does not automatically trigger the trust as a grantor trust unless it is used for other beneficial interest purposes. This exception applies even if the grantor or the grantor’s spouse holds this power. Support for a beneficiary that may not be included includes premiums and gifts over $15,000, which can be subject to a gift tax. However, the grantor may be exempt from income tax under IRC 677(b).
Power Affecting Beneficial Enjoyment Only After Occurrence of Event
A grantor won’t be recognized as the owner of any portion of the trust established by a such power to affect the trust’s beneficial enjoyment if that power is not exercisable for an extended period of time. Such a period of time should be long enough that, had the postponed power been a reversionary interest stipulated in IRC 673, it would not have triggered grantor trust status (most common periods used are by taxable year). Therefore, control over beneficial enjoyment will not trigger a grantor trust status if the grantor can’t exert it for a period of time. If the power had become a reversionary interest at any point, the trust should have a value of less than 5%. If this happens and to decide if this criterion was met, it is mandatory to determine the prevailing and adequate interest rate and check the applicable IRS Tables under the treasury regulations for confirmation. However, after the expiration of a stated time has occurred, and the power instantly becomes exercisable, the grantor will be recognized as the owner only if they have not relinquished the power earlier.
Power Exercisable Only by Will
A grantor shall not be recognized as a trust’s owner based on a power to alter beneficial interest and enjoyment if they possess a power exercisable only by a will. The only exception is for a power of appointment to accumulated income of the trust by the will if the trust allows the grantor or a nonadverse party to provide mandatory or discretionary accumulation of trust income.
Power to Allocate Among Charitable Beneficiaries
A grantor shall not be recognized as the owner of any portion belonging to a trust if they have the power to decide the beneficial enjoyment of the trust income or trust corpus when the income or corpus is irrevocably payable for a philanthropic purpose by one or more charitable beneficiaries as defined in IRC §170(c).
Power to Distribute Corpus
A grantor shall not be recognized as the owner of a trust based on if they have the power to distribute corpus to beneficiaries of the trust. In contrast, the grantor’s power to dispense the corpus has been subjected to a reasonably definite standard outlined in the trust instrument.
Powers of Distribution Primarily Affecting Only One Beneficiary
The principal and income must be paid to the said beneficiary (or such beneficiary’s estate and any estate tax attached) or to appointees designated by the beneficiary.
Powers of Distribution Affecting More Than One Beneficiary
The principal and income are distributed to such beneficiaries following their respective shares.
Power to Withhold Income Temporarily
A grantor shall not be recognized as the owner of any portion belonging to a trust if they have the power to distribute or apply the trust income to any present beneficiary or to accumulate the trust income if the accrued income and income tax must be paid eventually to one of the following individuals:
- The beneficiary whom the income was withheld from;
- The beneficiary’s estate and any estate tax attached;
- The beneficiary’s designatees;
- The present income beneficiaries are within one or multiple shares fixed by the trust instrument.
Power to Withhold Income During Disability of a Beneficiary
The grantor shall not be recognized as the trust’s owner merely because they (or a nonadverse party) hold power to distribute income and accumulate and reg income before adding it to a principal during a period of time in which the income beneficiary possesses a legal disability. Furthermore, any income withheld during such periods does not need to be ultimately payable to the income beneficiary or to their estate and any estate tax attached. It may be payable to whomever the trust declares as the recipient of the trust principal.
Power to Allocate Between Corpus and Income
IRC §674(c) catalogs powers that shall not trigger a grantor trust status if they are to or are being held by an independent trustee, who may be given relatively broad powers over beneficial interest and enjoyment without triggering the grantor to be treated as owner.
Some examples are as listed:
- Power to divide and provide income amongst particular income beneficiaries;
- Power to build accumulated income without needing to pay the income to a beneficiary whom it was withheld from at any time;
- Power to invade corpus for particular beneficiaries (including persons who aren’t income beneficiaries).
Exception for Certain Powers of Independent Trustees
An independent trustee can be given broad powers over beneficial enjoyment without triggering owner recognition towards the grantor unless they cannot due to nonfiduciary capacity. Examples are:
- Power over diving and sharing income amongst particular income beneficiaries;
Power to Allocate Income If Limited by a Standard
The grantor rules mustn’t be applied to a power solely exercisable (without the consent of any adverse party) by a trustee or trustees who are not the grantor or their spouse (who must still be living with the said grantor. Power to distribute, accumulate, or apportion income for or to one or more beneficiaries, or from, within, or to a class of beneficiaries (even if the conditions of Subsection (b), paragraphs (6) or (7) are satisfied), is restricted by a reasonably definite and external standard that is presented by the trust instrument. However, a power cannot fall within the powers described above if any person uses it to add to two or more beneficiaries or a class of beneficiaries to receive the corpus or income. One exception would be where such an action is to provide for after the adoption or birth of children.
Commonly Used Exceptions by Practitioners
The above powers and exemptions are pursuant to understanding the benefits and setbacks IRC 674 can provide for individuals surrounding a trust. However, exceptions can affect how much an individual within a specific role can receive their distribution, whether because of limitations due to income tax purposes, the number of roles involved, or if a role is deemed a nonadverse party possesses nonfiduciary capacity within the trust.
The trustee’s power to make distributions are restricted because of an understandable and absolute standard like health, maintenance, support, or education (HEMS) (IRC Section 674(b)(5)(A));
There is only one current beneficiary belonging to a trust, and the principal and income must be paid to the said beneficiary (or such beneficiary’s estate and any estate tax attached to it) or to any appointees that the beneficiary has decided (IRC Section 674(b)(6));
Pro Rata Shares
The trust possesses two or more beneficiaries, but the principal and income have been distributed to those said beneficiaries based on their relevant shares (IRC Section 674(b)(5)(B));
No Real Control
The grantor nor the grantor’s spouse do not serve as the trust trustee, and less than one-half of trustees are subordinate or related to the grantor (IRC Section 674(c));
Careful consideration should be taken by advisors and estate planners when drafting the trust deed for clients when it comes to rules for any portion of the trust. The central point of this article isn’t just an analysis of typical powers around a grantor trust status. Still, it is also a careful exploration of the identity of the trustees. For instance, if the grantor’s spouse has the co-trustee role, the trust will trigger and become a grantor trust unless an adverse party is a co-trustee. While grantor trust status has many taxable advantages and grants the power of appointment, under the latest tax regime, taxpayers may increasingly prefer to have non-grantor trusts. Careful planning is critical in preventing inadvertent and potentially harmful income tax consequences.