Tag: grantor trust

Generational Skip Trust

Posted on by Peter Harper

Generational Skip Trust

With previous discussions of estate planning and grantor trust, let’s examine another common practice within financial planning: generation-skipping trust.

What is a Generation-Skipping Trust?

A generation-skipping trust is a trust where the settlor or grantor of the trust transfers assets to recipients who are two or more generations younger than them. Therefore, the settlor can bypass a generation when leaving assets to their heirs and eliminate one round of estate tax.

How a Generation-Skipping Trust Works

A generation-skipping trust allows the grantor to leave an inheritance (either in the form of money or assets) to his grandchild, great-niece, great-nephew, or any other natural person who is at least 37.5 years younger than the grantor. The trust’s beneficiaries cannot, however, be the spouse or ex-spouse of the grantor.

The trust created will also be regarded as irrevocable, meaning that the trust cannot be changed or revoked. The fact that the trust will be irrevocable does not mean that the grantor relinquishes all of their power and can still insert provisions that allow them to determine how the assets are distributed and how the estate is invested.

The tax on generation-skipping trusts is also separate from estate and gift tax. 

No regulations prevent the grantor’s children (the skip person) from participating in the income earned on the assets held in the trust as long as the original assets are not distributed. 

Who Needs a Generation-Skipping Trust?

A generational skipping trust may only be suitable for some. It should be noted that it should last the lifetime federal GST exemption of $12.06 million per individual (this increases to $24.12 million for a couple). If this is possible, the grantor may be subject to GST and estate taxes.

As the skipped generation will only be able to benefit from the income earned and generated from the trust assets, it may not be suitable for smaller estates where the assets need to pass directly to the next generation (children/spouses).  

Who Gets the Income from a Generation-Skipping Trust?

The income generated and earned from assets held in the trust can be paid to the children/spouse of the grantor as long as the assets are not physically distributed to them. The income will be taxed accordingly; however, the assets will be kept separate from their own estate.

Passing Assets to Grandchildren Through a Generation-Skipping Trust

A grandparent can ensure that assets and inheritance can be passed to grandchildren by forming a generation-skipping trust during the grantor’s lifetime or by transferring the assets directly to the grandchildren in the grandparent’s wills. 

Asena advisors. We protect Wealth.
Contact

How to Create a Generation-Skipping Trust

Creating a generation-skipping trust is complicated, and the exact details of the trust will depend on the specific goals of the grantor. Two transferring strategies are available to grantors, and these are as follows:

Generation-Skipping Transfers:

Assets are placed in a trust using the GST exemption. The trust can then pay any income earned from the assets in the trust to the skip person and/or skipped generation (children/spouses), while the remaining assets in the trust pass outside of the grantor’s estate to future generations after the death of your child/spouse.

Direct Generation Skip

The grantor will bypass their own children and give the assets qualifying for the GST exemption amount directly to your grandchildren or place them in a trust for their benefit or the benefit of future generations.

Generation-Skipping Trusts & Taxes

Much like other financial trusts, a generation-skipping trust will often have taxes attached to it. Who, what, and how are listed as:

Who Has to Pay Estate Taxes?

Estate taxes are owed on any estate exceeding the federal estate tax exemption of $12.06 million. This lifetime exemption changes annually to adjust for inflation (it should be noted that should Congress not intervene, the exemption amount will revert to a $5 million baseline, adjusted for inflation, in 2026). In some states, the estate tax exemption is the same as the federal exemption; in others, this may be less than $1 million.

Gift Tax

An individual is allowed to give gifts during their lifetime without paying taxes as long as the value of the gifts does not exceed your lifetime exclusion which is the same as your estate tax exemption.

There is an annual gift exclusion of $15,000.00. However, should you grant a gift worth more than the annual exclusion, your lifetime exclusion decreases by the excess value of the gift.

Generation-Skipping Transfer Tax

The GST tax applies when someone gives direct gifts of money or other assets to someone at least 37.5 years younger than them. A flat tax rate of 40% on the transfer value exceeds the GST exemption, and GST tax can also be referred to as GSTT or simply as a transfer tax.

Benefits of Generation Skipping Trusts

The following three most common benefits are:

  • GST is a great planning tool for larger estates as you can ensure that your family legacy is maintained for at least two generations. It enables your own children to benefit and ensures that your grandchildren will also be supported.
  • GST allows the grantor to skip a round of federal estate taxes, as the federal estate taxes will only be assessed when the property is distributed to the beneficiaries of the trust. Should the assets be passed to the children of the grantor, the family legacy would have been subjected to tax twice.
  • GST assets are not included in your child’s estate, which effectively protects their estate. They can also retain complete control of their own trust during their lifetime.

Drawbacks of Generation-Skipping Trusts

When considering a GST, the following drawbacks need to be considered:

  • GST was established to ensure that families cannot escape federal estate taxes over multiple generations. If the estate’s value exceeds the GST tax exemption, it will be subject to both GST and estate taxes at a rate of 40%.
  • Trusts may be powerful estate planning tools that allow families to minimize their estate’s exposure to probate. However, there is a very high administrative burden of running a trust. As trusts require a lot of thought, resources, and energy, it is best to work with an estate planning professional to assist with setting up a trust that will best suit your family’s needs.
  • With a large enough estate, your children may still benefit from the profits generated from the assets held in trust. Suppose there is a need to support your children financially. In that case, an evaluation needs to be done to ascertain that the income produced by the GST will be substantial enough to cover their expenses and lifestyle.

Can a Generation-Skipping Trust be Broken or Dissolved?

It may be possible to dissolve a generation-skipping trust as the trust is an irrevocable trust. This means the trust cannot be broken, modified, revoked, or dissolved; however, it may be possible to modify or terminate the trust judicially, depending on the State.

Can a Generation-Skipping Trust be Contested?

A GST can be contested; however, this cannot purely be done on the basis that an individual or family member does not agree to the terms. It will need to be proven that the trust is not legally valid for the contention to be valid. Here are some valid reasons for a GST to be contested:

Mental Incapacity

The grantor needs to be ‘sound of mind’ when the trust is created, meaning the grantor needs mental awareness of what they are doing. The trust can be invalid if it is possible to prove that they were not.

Undue Influence

If a third party coerced the grantor to create the trust or name a specific beneficiary/fiduciary, the validity of the trust can be challenged. The level of pressure the grantor faces must be so severe that their own free will must be overwhelmed.

Fraud or Forgery

If a trust document was obtained through fraud, it could be contested and thrown out. This can occur when the grantor is tricked into signing the trust when they are under the impression that they are signing another document.

Asena Advisors focuses on strategic advice that sets us apart from most wealth management businesses. We protect wealth.
Contact

Who can Contest a Generation-Skipping Trust? 

A trust litigation attorney can be approached to contest the GST. The aggrieved party will submit a motion or oral application to a High Court.

Do I Need A Trust Litigation Attorney To Contest A Generation Skipping Trust?

Some states, such as California, do not require a trust litigation attorney to contest the validity of a GST. However, it would be most beneficial for the person challenging the trust to employ one. Other states do require a Trust litigation attorney to be appointed by the aggrieved party or family members to submit a motion or oral application to a High Court.

Is a GST Trust Revocable or Irrevocable?

A GST is an irrevocable trust; however, the grantor can still make decisions regarding the investments made in the trust and the distributions made from the trust.

Protect against the Generation-Skipping Transfer Tax

In order to protect against the GST Tax, it is crucial to consider the most tax-efficient planning tools. As the lifetime exemption applies to an individual, it is possible to put an estate plan in place which may allow each spouse to apply for their GST tax exemption either during their lifetime or at the time of their death when the trust is created.

Common Transfer Strategies for You to Discuss with Your Tax and Legal Advisors

Bring up options for GST as an irrevocable trust to your tax or legal advisor, as they will best recommend options that are unique to your case and circumstances. The same can be done for tools to protect against the GST tax discussed above.

How to Use a Lifetime Exemption from GST

Lifetime exemption from GST can be used during the grantor’s lifetime or at the time of their death when the assets are inherited outright by the next generation or transferred into the trust. During the lifetime of the grantor, all applicable transfers of wealth made are automatically applied to the lifetime GST exemption unless elected otherwise. Also taken into consideration is that it’s also possible to employ the annual gift tax exclusion to ensure that not too much of the GST exemption is used up during the course of the grantor’s lifetime. For transfers at death, the exemption may be allocated as directed in the will of the grantor or as directed by the executors if not explicitly mentioned in their wills.

 

Speak with an Asena consultant to learn more about your generational skip trust case.

–Jean-Dré Tombisa

–Peter Harper

IRC 677

Posted on by Peter Harper


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. 

IRC 677

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.

Asena advisors. We protect Wealth.
Contact

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.
Constructive Distribution

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.

Asena Advisors focuses on strategic advice that sets us apart from most wealth management businesses. We protect wealth.
Contact

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.

 

Speak with one of our specialists to learn more about IRC 677 and how it can help your case.

Arin Vahanian

Peter Harper

IRC 674

Posted on by Peter Harper

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.

Asena advisors. We protect Wealth.
Contact

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 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).
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.

Asena Advisors focuses on strategic advice that sets us apart from most wealth management businesses. We protect wealth.
Contact

 

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. 

Hems

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));  

Single Beneficiary

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));

Identity of Trustees

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.

Think that IRC 674 may be for you? Speak with one of our consultants to learn how to proceed forward.

Shaun Eastman

Peter Harper

IRC 675

Posted on by Peter Harper

IRC 675

Following our previous articles on grantor trusts, we will cover the first of the three main IRCs: Section 675.

What is an IRC Section 675?

IRC 675 of the Internal Revenue Code, or IRC, involves, under treasury guidelines, the administrative powers of a foreign grantor trust. To be more precise, it states that the grantor of any foreign trust shall be treated as the owner of the foreign trust. This is only true if, under the instruments’ terms of the trust, that specific administrative control can be exercised primarily for the benefit of the grantor instead of the benefit of the beneficiaries. 

Additionally, suppose the owner of the foreign trust has the power to amend the administrative provisions of the trust instrument, which would result in him, her, or they becoming the trust owner. If that were to happen, the grantor would be treated as the owner of the trust. 

Now that we know the basic understanding of what IRC 675 is, let’s explain its various powers, such as what may cause a foreign trust to become a grantor trust, who the owner of a grantor trust is, and how to toggle grantor trust status. 

Sec. 675’s Administrative Powers

The administrative powers under IRC 675 include several different authorities related to administrative duties; notable examples to take note of include voting powers and directing the investment of trust funds, borrowing funds, and the ability to deal with trust income and funds for less than adequate consideration, as well as not having sufficient interest or security. 

Asena advisors. We protect Wealth.
Contact

General Powers of Administration

When we refer to a general power of administration, this will commonly include the following: 

  • The power to vote or direct voting of a trust’s stock or other securities, where holdings belonging to the grantor or the trust are significantly essential from the viewpoint of voting control. 
  • The power to control the funds’ investment by directing or vetoing proposed any trust investment or reinvestment. Of course, this is only to the extent that the funds consist of corporation stocks or securities, in which the grantor and trust’s holdings are significant from a voting control viewpoint.
  • The power to reacquire the trust corpus, also known as the sum of money or trust property set aside to produce income of the trust for beneficiaries by substituting other property of an equivalent value. 

To summarize our three points above, the perspective through which we need to assess whether a grantor has these powers has to do with controlling funds and assets within a trust. 

Borrowing of the Trust Funds

Another power a grantor can possess is the ability to borrow trust funds. For example, we should consider a scenario where the owner can directly or indirectly borrow the corpus or trust’s income and wouldn’t be expected to completely repay any loan, including any interest, before the beginning of the taxable year.

Power to Deal for Less than Adequate and Full Consideration

This particular power is exercisable by the grantor in a nonfiduciary capacity without the approval or consent of another party. It enables the grantor to purchase, exchange, or otherwise deal with or dispose of the corpus or the trust’s income for less than adequate consideration in money or its monetary worth. Specifically, it could allow a grantor to remove assets from the trust for a small amount of deliberation, thus resulting in the grantor being able to terminate that trust completely. 

Power to Borrow Without Adequate Interest or Security

This power enables the grantor to borrow the corpus or income, directly or indirectly, without sufficient interest or adequate interest or security except where a trustee, if under a general lending power, is authorized to create loans for any person without regard to said adequate interest or security.

What Are The Grantor Trust Powers?

To summarize the definitions and examples above, here are the most common and vital powers a grantor can have over a trust and its process:

  • To change or add the beneficiaries of the trust. 
  • To borrow from the trust or a portion of the trust without adequate security. 
  • To use income from the trust in order to pay life insurance premiums.
  • To change the trust’s composition by substituting assets of equal value.

What Causes Grantor Trust Status?

Now that we know several types of powers a grantor can have, let’s look into what causes a trust to be considered a grantor trust. There are various criteria, but among the most relevant are the following:

  • IRC § 673(a): the grantor maintains a reversionary interest, meaning that the grantor holds a ‘reversionary interest’ in a trust greater than 5% of the trust principal or income.
  • IRC § 674: the grantor can control the ‘beneficial enjoyment’ of trust income or assets.
  • IRC § 675: the grantor maintains administrative control over the trust that can be exercised for his benefit rather than for the trust’s beneficiaries.
  • IRC § 676: the trust allows the grantor (or a nonadverse party) to revoke any part belonging to a trust and reclaim or take back the trust’s assets later. 
  • IRC § 677(a): if the trust distributes income to the grantor, the trust may be regarded as a grantor trust.
    • The grantor will also 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 the grantor’s spouse, or to be applied to payment of insurance policies on either the life of the grantor or the grantor’s spouse.

Additionally, it’s crucial to note that a grantor trust is considered a disregarded entity by the IRS for federal income tax purposes. This will mean that the grantor’s income tax return will include any taxable income or deduction earned by that trust. For the taxpayer’s convenience, the IRS will allow a grantor trust to employ the grantor’s Social Security number (SSN) rather than having a separate tax ID number (TIN).

Also, when discussing what causes grantor trust status, a vital topic to always consider is what grantor trusts’ advantages and disadvantages are. The primary benefit of estate planning is the potential to preserve wealth while minimizing taxes for one’s beneficiaries. That way, beneficiaries will have a lowered tax rate and better prioritization of any estate tax inclusion that may be available. However, a major concern is an assumption that the grantor, as a taxpayer, will have the funds to pay income tax obligations on trust assets and possible interest for the income of the trust during their lifetime. These implications for income tax purposes may cause a grantor to toggle grantor trust status so that the trust is no longer treated as a grantor trust (discussed later in this article). Further, the gift tax is also a concern, so the taxpayer must consider gift tax considerations and tax consequences when creating the trust. 

Asena Advisors focuses on strategic advice that sets us apart from most wealth management businesses. We protect wealth.
Contact

Who Is Considered the Owner of a Grantor Trust?

The grantor, also known as the owner, settlor, or trustor, is typically the person who creates the trust and contributes property (such as real estate), other funds, or even trust instruments, such as life insurance, to that trust. The trust property and the owner’s funds become part of the trust corpus (in other words, the trust’s assets). 

Personal or familial trusts often have only one grantor, but can, along with business trusts, have two or more. For example, if more than one person had funded a grantor trust, each one will be treated as a grantor in proportion to the cash or property value they transferred to. 

Suppose a resident of a foreign country is treated as the owner of the trust under the grantor trust rules. In contrast, that specific trust has a domestic civilian or resident as a beneficiary. In that case, the beneficiary will be treated as the trust’s grantor to the extent that the beneficiary made gifts (directly or indirectly) to the foreign owner, irrespective of gift tax applying. 

Bear in mind that the grantor is the person who retains the power to control or direct the trust’s income or assets, and is allowed full discretionary protection as the grantor. It’s crucial to understand, especially when dealing with a foreign trust and the income tax consequences surrounding this instrument. Moreover, the owner can also be any person who creates a trust directly or indirectly and makes a gratuitous property transfer to a trust.

How Do I Toggle Grantor Trust Status?

One common question received when looking at IRC 675 is how to toggle a grantor trust status so that the trust will no longer be treated as a grantor trust.. 

Why would a grantor want to do this? Given that there are implications for income tax purposes of a foreign grantor trust, the grantor may deem it too burdensome to be liable for tax on the income attributable to the trust, year after year. Other common motives include keeping up with the tax rate that comes with their specific grantor trust, or for their own discretionary reasons. Therefore, to terminate the grantor trust status or toggle it off, the powers we explored above (which are often used to create the grantor trust status) must be released or terminated. 

How is this done? One possibility this can be accomplished is by transferring power to a specific trustee or a third party, such as a trust protector.

Similarly, to turn the grantor trust status back on after it has been released, the powers released previously must be brought back and given to the previous grantor. This can be done by amending the trust instrument. However, it’s important to remember that a grantor or trustee should never approach this toggling of status flippantly and that professional advice and assistance should be engaged when going down this path. 

New Responsibilities With Incorporation

If the grantor trust status terminates during the grantor’s lifetime, and the trust ceases to be a grantor trust, then the grantor is deemed to have transferred the assets to the trust at that time for federal income tax purposes. The question then becomes, does the grantor recognize a taxable transaction or a gain? Assume the trust has non-recourse liabilities to a third party secured by the trust’s assets. If that is true, the grantor will recognize the gain because the grantor will be deemed to have transferred the secured assets to the trust in exchange for a release of liability. In another scenario, the grantor may also recognize capital gain where the trust owes the debt to the grantor because the trust can be received the secured asset from the grantor in exchange for the promissory note to the grantor as of the date that the grantor trust status terminated. However, based on numerous court cases and tax law examples, there appears to be no gain recognized by either the trust or the grantor’s estate at the grantor’s death for income tax purposes. 

We will be discussing more on the responsibilities within incorporation in later articles, such as gift tax implications, estate tax inclusion, and creating an irrevocable trust, and where the trust deed is drafted to trigger a certain status intentionally (such as an IDGT, which is an irrevocable trust set up by the owner for this particular purpose).  

Speak with one of our consultants to see how IRC 675 can help your financial case.

Arin Vahanian

Peter Harper