In our 8th installment of the grantor trust series, Peter Harper, our managing director and CEO, explains IRC Section 678 and the circumstances in which someone other than the grantor can be the owner of the trust.
This vlog is for anyone that owns assets in a foreign trust who has a US beneficiary.
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IRC Section 678 – Quick Guide Blog
What is IRC Section 678?
Section 678 was added to the grantor trust provisions by the IRS as a result of the decision in Mallinckrodt v. Commissioner by the United States Court of Appeals for the Eighth Circuit. In that case, the grantor created a trust for the benefit of a beneficiary and the beneficiary’s family. The trust instrument provided that the trustees were to distribute trust income generated from the trust assets to the beneficiary upon his request. The Eighth Circuit held that, because the beneficiary could essentially direct the timing and amount of distribution of income from the trust, the beneficiary had the equivalent of ownership of the trust income for income tax purposes and the taxpayer should include these distributions including capital gains in his taxable income as it does not constitute a non-grantor trust.
The most common form of a Mallinckrodt power is a general power of appointment over the trust income or corpus that enables the holder to appoint it to himself or herself during the holder’s lifetime.
A Mallinckrodt power also exists if a beneficiary has a demand or Crummey power as to a limited portion of the additions to the trust.
A Mallinckrodt power renders a third person taxable under §678(a) only if the power is exercisable by the third person alone. If the exercise of the power requires the consent of any other person, whether or not adverse, §678(a) does not apply.
Example: Beneficiary B is one of three trustees who must act by majority vote to make distributions to the beneficiaries. Absent an actual distribution, B is not taxed on the trust income. Section 678(a) does not apply.
What makes a Section 678 trust stand out from the other grantor trust provisions is that under this tax law provision a person or taxpayer other than the grantor/decedent or a transferor to the trust could be the deemed owner of all or a portion of the trust assets for income tax purposes by the IRS and any distributions – interest, capital gain etc will be taxable income.
The general rule of a Section 678 trust is that a person or taxpayer other than the grantor shall be treated as the owner of any portion of a grantor trust’s assets with respect to which:
- such person or taxpayer has a power exercisable solely by himself (power of appointment) to vest the trust corpus/trust assets or the income therefrom in himself, or
- such person or taxpayer has previously partially released or otherwise modified such a power of appointment and after the release or modification retains such control as would, within the principles of sections 671 to 677, inclusive, subject a grantor of a trust to treatment as the owner of the trust assets.
Any trust regarded as a grantor trust in terms of Section 678 is also sometimes referred to as a “beneficiary‐deemed owner trusts” (“BDOTs”). The beneficiary is regarded as the grantor of the trust.
There are certain tax benefits when a beneficiary is regarded as the grantor of the trust. One of these income tax benefits relates to life insurance rules.
A beneficiary can sell a life insurance policy insuring themselves to a BDOT without triggering the transfer for value rule.
An Exception to IRC Section 678 Grantor trust
Exception Where Grantor is Taxable
There is however an exception in tax law to the grantor trust provision which stipulates that if the grantor/decedent or transferor (which IRC 679 applies to – foreign grantor trusts) are treated as the owner of trust income, the grantor trust rules of IRC §§ 674 through 677 trump application of IRC § 678(a) to the third party taxpayer.
A plain reading of subsection (b) implies that, if a third person holds a withdrawal power over the trust principal (power of appointment), Section 678(b) would not apply, and therefore the person with the withdrawal power would be taxed as owner of the trust and the trust assets. The key reconciling this seeming inconsistency between Section 678(b) treatment of a withdrawal power over income and a power over principal seems to be in the definition of the word “income”
Obligations of Support
Section 678(c) provides another exception in relation to grantor trust status, where a third person, in his or her capacity as trustee or co-trustee, will not be treated as the owner of the trust assets if he or she has the power merely to apply the income of the trust, including capital gains to the support or maintenance of a person whom such third person is obligated to support or maintain, except to the extent that such income is so applied. Therefore there is no withdrawal power to vest in himself and no taxable income due to Grantor trust status not being applicable. The support obligation is in terms of asset protection for the beneficiaries.
In cases where the amounts so applied or distributed are paid out of trust corpus or out of other than income of the taxable year, such amounts shall be considered to be an amount paid or credited within the meaning of paragraph (2) of section 661(a) and shall be taxed to the holder of the power under section 662.
This grantor trust status exception, however, does not apply if the third person holding the withdrawal power can exercise the power by himself or herself in any capacity other than that of a trustee or co-trustee.
Effect of Renunciation or Disclaimer
Subsection (a) grantor trust status shall not apply with respect to a grantor trust power which has been renounced or disclaimed within a reasonable time after the holder of the power first became aware of its existence.
It is important to understand what constitutes a “reasonable time” and how the IRS will interpret the same to determine grantor trust status.
A valid disclaimer is a matter for determination by state law, since neither Code Section 678 nor the regulations provide any guidelines as to what will constitute a valid disclaimer for these purposes while Sections 2518(a) and 2046 provide substantial guidance with respect to what constitutes “qualified disclaimer” for federal gift tax and estate tax purposes. The IRS has been quite vague on this regarding to it’s application for income tax purposes.
It is realistic to believe that if one meets the §2518(a) statutory standard and disclaims the trust assets within nine months of the date of its transfer or, if the third person is a minor, within nine months of attaining age 21, the disclaimer will be timely for income tax purposes.
Generally the estate and gift tax effect of general powers of appointment (and lapses) are unaffected by a powerholder’s incapacity. IRC §678(a) is similar – see Rev. Rul. 81-6, holding that a minor beneficiary with a withdrawal right (Crummey power) is deemed the substantial owner for §678 purposes even if local law requires a court appointed guardian and none has ever been appointed.
The IRS has taken the position that a trust beneficiary who disclaims the trust income remains taxable on the trust income (capital gain, interest, etc.) realized prior to the disclaimer.
The disclaimer of a Code Section 678 power did not allow the disclaimant to avoid income taxation on the income earned by the trust on the trust assets prior to the disclaimer for income tax purposes.
Section 678(e) of the Code refers to section 1361(d) as the provision under which a beneficiary of a trust is treated as the owner of the portion of the trust assets which consists of stock in an electing small business corporation.
Section 1.671-4(b) of the Income Tax Regulations provides that in the case of a trust, when the same individual is both grantor and trustee, and that individual is treated as owner for the taxable year of all of the assets of the trust by the application of section 676, a Form 1041 should not be filed with the IRS for tax return purposes. Instead, all items of income, deduction, and credit from the trust should be reported on the individual’s Form 1040 in accordance with its instructions provided by the IRS for taxable income on his tax return.
Section 1361(a)(1) of the Internal Revenue Code provides that the term “S corporation” means, with respect to any taxable year, a small business corporation for which an election under section 1362(a) is in effect.
Deciphering the Term ‘Income’ Under Internal Revenue Code Section 678
In the context of the Internal Revenue Code section 678, “income” likely refers to “taxable income” such as capital gains disclosed in your tax return, as opposed to “trust accounting income’ for grantor trust purposes.
Treas. Reg. section 1.671-2(b) specifies that for purposes of the grantor trust rules the term “income” refers to income for income tax purposes and not trust accounting purposes and that if trust accounting income is being referenced the term “ordinary income” would be used. IRC section 678(b) uses the unmodified term “income” which refers to taxable income pursuant to the regulation. Accordingly, in terms of the grantor trust rules, if a grantor and a third person are both deemed the owner of income allocable to either trust corpus or accounting income, then under IRC § 678(b) the grantor would be treated as the owner (i.e., IRC sections 674 through 677 trump IRC section 678(a)).
IRC section 643(b) (which does not apply to grantor trusts) specifies that the term “income” refers to “income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law” (i.e., trust accounting income under a state’s principal and income act) for the purposes of Subparts B, C, and D of Part I of Subchapter J (Irrevocable trust). The grantor trust rules are in Subpart E, clearly omitted from the IRC section 643(b) reference.
Ducking the IRC Section 678 Bullet
Designing a trust to derive tax benefits and to avoid application of the grantor trust rules to the grantor may be a sound strategy if a goal is to avoid trust tax attributes appearing on the grantor’s tax return. In connection with that strategy many may want to provide access to trust assets by allowing the trustee or some other person with withdrawal power to make distributions to one or more individuals or a class of individuals, while still providing asset protection.
Please be careful when trying to argue exemption from the grantor trust rules for such trusts. Avoiding grantor trust rules should be dealt with the same as that sticker on a box of breakables being transported. Handle with care! The IRS will not be lenient when you try to argue non-grantor trust classification and could trigger some unforeseen gift or estate tax implications for such trusts.
By way of an example, a trust granting a trustee withdrawal power to make distributions to descendants of the grantor “within the sole discretion of the trustee” will trigger application of the grantor trust rules to the trustee if the trustee is a descendant of the grantor/descendant.
There are however ways to address this grantor trust provisions. The easiest exemption method is to add an additional restriction on the trustee’s withdrawal power (fiduciary power) to make a decision by requiring approval from another person. This could then be regarded as a non-grantor trust and still provide asset protection.
Two Common Planning Scenarios Could Land You in a Malpractice Trap if You Don’t Know This Rule
Trap 1: Fourie Du Preez is retired and for estate planning purposes wants to protect some real property and other income generating assets for future use. A non-grantor trust could be a solution to estate planning to ensure estate inclusion to obtain a stepped-up basis on trust property. The trustee in their fiduciary capacity will be given discretionary authority to make distributions of income and principal among Fourie Du Preez’s descendants, and appoints his son, Arno as sole trustee of the non-grantor trust.
Trap 2: Fourie Du Preez’s last will and testament leaves most of his assets to a testamentary trust and the trust property is for the benefit of his descendants. The trustee, his son Arno has discretion to distribute income of the trust and trust property among his descendants until the youngest living at the decedent’s death has attained age 21.
Issue : In both scenarios the sole trustee is one of the children of the settlor/testator/decedent. Further, the trustee’s discretion is unlimited. Both trusts will therefore be treated as owned by the trustee for income tax purposes and not classified as a non-grantor trust, which makes the estate planning irrelevant.