Tag: IRC

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.

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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.

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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 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. 

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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. 

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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