To build upon our previous discussions on foreign grantor trusts, today’s topic concerns Section 677 of the Internal Revenue Code (IRC). Specifically, this section of the IRC discusses a foreign trust’s grantor’s ability to receive income from the trust. This topic is essential for anyone who owns assets in foreign trusts and is moving to the U.S. or facing a liquidity event. Furthermore, this topic is also necessary for those who wish to take steps to avoid having their trust activate a grantor trust status.
What is IRC Section 677? Simply put, any rev. rul under it states that a grantor of a trust shall be recognized and treated in the role of the owner of any portion of a trust with an income that is distributed towards the grantor or their spouse, held, or has been accumulated for future distribution towards the grantor or their spouse. This also will apply to the payment of life insurance policies on the life of the grantor or their spouse.
Income for Benefit of Grantor
The grantor shall be recognized and treated as the owner if the income from the trust is or may, at the grantor’s discretion (or a nonadverse party), be:
- Accumulated for future distribution towards the grantor or their spouse;
- Distributed to the grantor or their spouse; or
- Applied towards the life insurance payment on the life of the grantor or their spouse.
IRC Section 677 – General Rule
This section of the Internal Revenue Code and all rev. rul provides that the grantor of a trust will be granted ownership and taxation upon any portion of the trust whose income is at the discretion of the grantor, their spouse, or any nonadverse person without the consent or approval of an adverse party, either:
- Accumulated for future distribution towards the grantor or their spouse
- Distributed to the grantor or towards the grantor’s spouse
- Applied to pay premiums on life insurance policies for the grantor or their spouse
- Applied or distributed in order to support or put towards maintenance of beneficiaries whom the grantor or their spouse is legally obligated to support or maintain
Definitions Relevant to Section 677
Various definitions relevant to this section of the code are basic yet essential to explain.
What is Income?
For the purposes of this subpart, under any rev. rul under Internal Revenue Code 677, income refers to taxable income (and not fiduciary accounting income), such as ordinary income or capital gains income.
Who is a Spouse?
For the purposes of this subpart, a person is considered the spouse of a grantor solely during the period of the marriage to the grantor. Therefore, if the grantor and the spouse divorce, the grantor would cease to be taxed as the trust’s owner for income distributions or accumulations that benefit the former spouse.
Who is an Adverse Party?
For the purposes of this subpart, an adverse party can be defined as someone who holds a substantial beneficial interest in the trust and would be negatively affected by the exercise (or lack of exercise) of the power the person possesses concerning the trust.
What is a Grantor Trust?
According to the IRS, grantor trust status is activated when the grantor retains control over the trust’s income and assets.
What Grantor Trusts Are Used For
There are various reasons for an individual to set up a grantor trust, but the five most common reasons are:
- Asset protection and wealth preservation;
- Credit protection;
- Avoiding probate;
- Reduce or eliminate estate taxes and gift tax; and
- To gain any possible tax benefits or tax deferral benefits.
Who is the Grantor?
Also known as the owner, settlor, or trustor, it is a general rule that this person contributes property (such as real estate or estate planning), other funds, or even a trust instrument such as life insurance to the trust. According to the grantor trust reg, the property and the grantor’s funds become part of the trust corpus (in other words, the trust assets). It is crucial to note that a trust can have more than one grantor. If more than one taxpayer had funded a grantor trust, they will each be treated as a grantor in proportion to the cash or property’s value they transferred to the trust, according to the terms of the trust.
The grantor is someone who retains the power to direct or control the trust’s income or assets, including estate planning under the trust. This is crucial to understand, especially when dealing with a foreign trust and the income tax treatment surrounding this trust instrument. Pulling from one of our previous articles, the grantor can also be any taxpayer who creates a trust and either directly or indirectly contributes a gratuitous transfer of property towards a trust. If someone creates or funds a trust on behalf of another, they are treated as the trust’s grantors.
Income for Benefit of Grantor
The grantor shall be treated as owner if the income from their trust is or may, at the discretion of the grantor, be:
- Distributed towards the grantor or to the grantor’s spouse, not in a fiduciary manner;
- Accumulated for future distribution towards the grantor or their spouse; or
- Applied towards the insurance policies’ payment on the life of the grantor or their spouse.
Under Section 677, the grantor shall be recognized and treated in the role of the owner of any portion of a trust if they retain interest. And, without the approval/consent of an adverse party, the grantor can be enabled to have their income from the portion of the trust distributed to themselves at some time, either actually or constructively. The grantor shall also be treated as the owner if they have granted or retained any interest which might be distributed to the spouse (whether actually or constructively). Again, this action can be done without the approval or consent of an adverse party to enable their spouse to have the income from the portion at any time, even if it is not within the grantor’s lifetime. In this case, constructive distribution includes payment on behalf of the grantor or their spouse to another in obedience to their direction and payment of premiums upon life insurance policies on the grantor’s life or their spouse’s life.
Discharge of Legal Obligation of Grantor or His Spouse
The grantor shall be recognized and treated as owner of the trust if that trust income is or able to be applied towards the discharge of a legal obligation belonging to the grantor or the grantor’s spouse.
Exception for Certain Discretionary Rights Affecting Income
A grantor should not be recognized or treated as the owner of a trust when a discretionary right can only impact the income’s beneficial enjoyment of a trust that is received after a period of time during which the grantor would not be recognized or treated as an owner if the power were a reversionary interest.
Accumulation of Income
The grantor shall be recognized and treated as owner of a trust if any income has been accumulated for future distribution towards the grantor or their spouse without the consent of an adverse party. The grantor will be taxed in the current year, even if they must wait for an extended amount before accessing the accumulated income. Suppose that income is accumulated as a tax liability for future distribution towards the grantor or their spouse during any taxable year. In that case, the grantor shall be considered the owner for that taxable year.
Income Distributed to or on Behalf of the Grantor or Grantor’s Spouse
Section 677 applies when the grantor or their spouse is entitled to or can demand trust income. Further, it also applies when a nonadverse trustee has the discretion to distribute trust income to either the grantor or their spouse without the consent of an adverse party. Therefore, even the mere possibility that the grantor or their spouse will receive income is sufficient to trigger the application of Section 677. For income tax purposes, the grantor shall be taxed on all income that could be distributed, even if it is not distributed.
Income Accumulated for Future Distribution to Grantor or Grantor’s Spouse
According to the grantor trust reg, a grantor is recognized and treated as owner of a trust whose income is or may be at the discretion of the grantor, their spouse, or a nonadverse party, currently accumulated for future distribution towards the grantor or their spouse, even without an adverse party’s consent. Therefore, this income would be taxable to the grantor in this scenario.
Deferred Right to Distribution or Accumulations
Section 677 does not result in a grantor being taxed on a trust’s income when a discretionary power to apply the income of the trust for the grantor or their spouse’s benefit may occur only after a period of time that would not cause the grantor to be treated as an owner if the discretionary power were what is called a reversionary interest.
Income Applied to Pay Premiums on Life Insurance Policies on the Life of the Grantor or Grantor’s Spouse
For income tax purposes, the grantor is taxed on any taxable income (and not fiduciary income) used to pay premiums on life insurance policies on the life of the grantor or their spouse.
Income Applied or Distributed in Satisfaction of the Grantor’s or Grantor’s Spouse’s Legal
For possible income tax purposes, the income of a trust is not taxable to the grantor merely because trust income may be distributed or applied for the support or maintenance of a trust beneficiary whom the grantor or their spouse is legally obligated to support or maintain. The discretion of another person or the grantor acting as trustee must be applied in this scenario.
Obligation of Support for a Trust Beneficiary
With the statement above, however, any trust income distributed or used to satisfy the grantor’s or their spouse’s legal obligation of support for beneficiaries will cause the grantor to be taxed on such income.
Divestiture of Powers Triggering Section 677
Suppose the grantor and/or their spouse have any interest in a trust that triggers the grantor trust status. In that case, they may be able to evade the application of Section 677 if they divest themselves of every interest that could cause the grantor to be taxed under Section 677.
Taxable Portion Under Section 677
A grantor with only an income interest in the trust is taxed on ordinary items of income, and a grantor with only an interest in the trust’s principal is taxed on capital gains items.
Estate, Gift, and Generation Skipping Transfer Tax Implications of Section 677
The three most common transfer taxes under this section of the code (gift tax, estate tax, and generation skipping tax) under IRC 677 usually depend on the existing status of a person involved with the trust. For instance, the federal estate tax can be applied to the transfer of property or other kinds of items of income upon or following death. The gift tax also applies to transfers made only if a person is still living. Additionally, the generation skipping transfer tax is a supplemental tax on a transfer of a trust property or other items of income that skips a generation. However, intention and power under this section of the code over that transfer may impact if one of these taxes is imposed for your case. For example, a gift tax can only be imposed if complete dominion, including interest, over the gift, as the gift will be recognized as a trust property, thus triggering the gift tax.
How is an Irrevocable Grantor Trust Taxed?
An irrevocable trust can trigger grantor trust status if the trust fulfills any one of the following requirements as set out in Internal Revenue Code § 673-679:
- The Grantor Maintains A Reversionary Interest
- If a grantor holds a ‘reversionary interest’ within a trust greater than 5% of the trust income or principal, the trust may trigger the grantor trust status in terms of IRC § 673m.
- The Grantor Has The Power To Control Beneficial Enjoyment
- If a grantor can control the ‘beneficial enjoyment’ of trust assets or income, the trust may trigger the grantor trust status in terms of IRC § 674.
- The Grantor Maintains Administrative Control
- If the grantor can maintain administrative control over their trust that is able to be exercised for their own benefit, the trust may trigger the grantor trust status in IRC § 675.
- The Grantor Maintains Revocation Powers
- If the trust allows the grantor to revoke any portion of the trust, followed by reclaiming or taking back the trust assets, the trust may trigger the grantor trust status in terms of IRC § 676.
- The Trust Distributes Income To The Grantor
- If the trust distributes any income towards the grantor, the trust can, in terms of IRC § 677(a), trigger the grantor trust status.
Is an ILIT a Grantor Trust?
An ILIT, also known at length as an irrevocable life insurance trust, is an optional irrevocable trust that contains provisions designed to facilitate the ownership over one or more life insurance policies. In other words, an ILIT is a trust designed primarily to hold life insurance. Because it is irrevocable, the grantor cannot change or terminate it. It is important to note that in this scenario, the ILIT is both the owner and beneficiary of the life insurance policy and that it insures the grantor’s life. But to answer the question in this section, an ILIT is not necessarily a grantor trust. For a trust to trigger grantor trust status, specific provisions or powers that can lead the grantor of the trust to be recognized and treated as the owner over the trust’s assets under reg have to be in place. An ILIT is also subject under Grantor Trust Rule §677(a)(3) if the income of the trust may be applied towards the premium payments on policies that insure the grantor’s life (or the grantor’s spouse’s life). Again, for income tax purposes, the grantor will need to report all income of the ILIT towards the grantor’s income tax return. That way, the ILIT will use the grantor’s Social Security number as its primary tax identification number. This grantor trust option is usually referred to as an Intentionally Defective Grantor Trust (IDGT”).
What Makes an Insurance Trust a Grantor Trust?
The grantor will be treated as the trust’s owner if its income is, or in the owner’s direction, distributed to the owner or the grantor’s spouse. It will also accumulate for any future distribution to the grantor or their spouse or to be applied to payment of insurance policies on either the life of the grantor or their spouse.
Can a Non-Grantor Trust Own Life Insurance?
Yes, for instance, through private placement life insurance or PPLI. PPLI provides the ability for a foreign non-grantor trust to make investments into assets deemed to generate U.S.-sourced income and avoid U.S. taxation to the non-grantor trust.
An increasingly utilized technique to either eliminate or reduce U.S. income taxation towards U.S.-sourced income-generating assets to the foreign non-grantor trust is all for the trust to be making those investments inside a U.S. tax-compliant PPLI contract.
Inside a PPLI transaction, the insurance company will become the underlying beneficial owner over the assets in exchange for a policy whose value is tied to the asset’s value as held by the insurance company. Therefore, the trust would have ownership over a U.S. tax-compliant life insurance policy that includes a tax deferral on the build-up of cash value. It will not own the income tax-generating U.S.-sourced income assets, as those assets would be considered to be owned by the insurance company.
If the U.S.-sourced income-generating assets are held until the insured’s death within a PPLI policy, the death benefit is tax-free by the trust. In effect, having the U.S.-sourced income-generating assets that are held along with the policy should permit all the growth within the assets to escape U.S. income taxation while also being held and then sold at the insured’s death as they are changed into a death benefit.
However, once the current taxable year’s distribution exceeds the trust’s distributable net income, it is treated under reg as being paid from prior years’ undistributed income (also known as an accumulation distribution). This throwback to an accumulated distribution is taxed at the highest income tax rate that would have been applied if the income had been distributed to the beneficiaries in the year it was received. To make matters worse, any accumulated long-term capital gain loses its favorable character and is taxed at the higher ordinary income tax rate for a higher total tax liability. Further, the beneficiaries are also subject to a non-deductible interest charge on the accumulation distribution based on how long the trust retained it.