Grantor Trusts: Income Taxation Under Subpart E (Portfolio 819)

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Tax Management Portfolio No. 819, Grantor Trusts: Income Taxation Under Subpart E, examines the taxation of grantors and third parties deemed to own the assets of a trust under §§671–679.

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Tax Management Portfolio No. 819, Grantor Trusts: Income Taxation Under Subpart E, examines the taxation of grantors and third parties deemed to own the assets of a trust under §§671–679. The planning and drafting of trusts requires a clear understanding of the grantor trust rules in order to ensure that the grantor, trust, and beneficiaries are taxed in the desired fashion.
A grantor trust is any trust which, under §§671–677 and §679, is taxed as if owned in whole or in part by the trust's creator. A Mallinckrodt trust (sometimes called a “section 678 trust”) is a trust that, under §678, is taxed as if owned in whole or in part by someone other than the grantor. A grantor or third person is required to include in his or her personal income tax computations those items of income, deduction, and credit allocable to any portion of a trust that such grantor or third person is deemed to own under the grantor trust rules.
The grantor trust rules generally delineate those powers and interests that are sufficient to shift the incidence of income taxation from the trust and its beneficiaries to the grantor or third party who holds certain powers or interests in the trust. This portfolio explores which powers over and interests in a trust that a grantor may retain or third party may hold, whether individually or as a trustee, without being deemed to own the trust. It also examines what powers a trustee (other than the grantor) may hold without causing the trust to be taxed as a grantor trust. This examination includes consideration of the rules relating to reversionary interests, the power to control beneficial enjoyment, administrative powers (including the power to borrow trust assets), the power to revoke, and the use of trust income for the benefit of the grantor. The portfolio also discusses the special rules that apply to foreign trusts with U.S. beneficiaries.
The grantor trust rules may also be used intentionally to shift the incidence of taxation away from the trust and its beneficiaries and to the grantor or other specific third person. Such intentional grantor trusts provide special planning opportunities, which this portfolio also explores.
Portions of this portfolio are taken from Zaritsky, Lane and Danforth, Federal Income Taxation of Estates and Trusts (3d ed. 2001).
This portfolio may be cited as Danforth and Zaritsky, 819 T.M., Grantor Trusts: Income Taxation Under Subpart E.


Robert T. Danforth

Robert T. Danforth; B.A., Washington University (1980); J.D. with High Honors, Duke University (1986); Order of the Coif; Article Editor, Duke Law Journal (1985–1986); Law Clerk, Judge Stephanie K. Seymour, United States Court of Appeals for the 10th Circuit (1986–1987); Adjunct Assistant Professor, University of Tulsa College of Law, 1986; Associate, Arnold & Porter, Washington, D.C. (1987–1991); Associate (1992–1996) and Of Counsel (1997), McGuireWoods LLP, Charlottesville and Tysons Corner, Virginia; Lecturer, University of Virginia School of Law (1995–1997); Assistant Professor of Law (1997–2002); Associate Professor of Law (2002–2006); Professor of Law (2006–present); Associate Dean for Academic Affairs (2007–present), Washington and Lee University School of Law; Academic Fellow, American College of Trust and Estate Counsel; member, Tax Management Advisory Board on Estates, Gifts and Trusts; author of 823 T.M., Taxation of Jointly Owned Property; co-author of T.M., Transfer Tax Payment and Apportionment (with J. Pennell); co-author of Federal Income Taxation of Estates and Trusts (3d ed. 2001) (with H. Zaritsky and N. Lane); co-author of Federal Income Taxation of Trusts and Estates (3d ed. 2008) (with M. Ascher).

Howard M. Zaritsky

Howard M. Zaritsky; B.A., Emory University (1970); J.D., Stetson University College of Law (1973); LL.M. (Taxation) Georgetown University Law Center (1976); member, Virginia and Florida Bars; lecturer at most major tax and estate planning institutes, including the University of Miami Heckerling Institute on Estate Planning (where he is a member of the advisory committee); author of Tax Planning for Family Wealth Transfers (4th ed. 2002); and co-author of Structuring Estate Freezes (2d ed. 1997) (with R. Aucutt); Federal Income Taxation of Estates and Trusts (3d ed. 2001) (with N. Lane and R. Danforth); Structuring Buy-Sell Agreements (2d ed. 2000) (with F. Aghdami and M. Mancini); Tax Planning With Life Insurance (2d ed. 2008) (with S. Leimberg); and Generation-Skipping Transfer Tax (2d ed. 2001) (with C. Harrington and L. Plaine); author of T.M., Revocable Inter Vivos Trusts; 854 T.M., U.S. Taxation of Foreign Estates, Trusts, and Beneficiaries; Tax Reporter for Probate Practice Reporter; Fellow in the American College of Trust and Estate Counsel and the American College of Tax Counsel.

Table of Contents

Portfolio Description


Technical Advisors


Detailed Analysis

I. Introduction

II. History

III. Section 671: Trust Income, Deductions, and Credits Attributable to Grantors and Others as Substantial Owners

Introductory Material

A. Interaction with General Principles

1. Assignment of Income

2. Transfer-Leasebacks

3. Discharge of Legal Obligations

4. Nonexempt Employee Deferred Compensation Plans

B. Charitable Split-Interest Trusts

C. General Consequences of Grantor Trust Status

D. Identifying the Grantor, Indirect Transfers, and Reciprocal Trusts

1. Transfers Before August 10, 1999

2. Transfers on or After August 10, 1999

a. General Rule

b. "Gratuitous Transfer" Defined

c. Investment Trusts, Etc.

d. Corporation or Partnership as Grantor

e. Trust-to-Trust Transfers

3. Involuntary Grantors

E. Definition of "Portion"

1. Ownership of Ordinary Income or Principal Portions

2. Ownership of a Fractional or Pecuniary Share

3. Ownership of Income and Principal Attributable to a Specific Trust Asset

F. Taxable Year

G. Reporting Requirements

1. General Reporting Requirements

2. Certain Domestic Revocable Trusts

3. Other Grantor Trusts

H. Gift Tax Implications of Grantor Trusts

I. Termination of Grantor Trust Status

1. Background

2. Termination of Grantor Trust Status During Grantor's Lifetime

3. Termination of Grantor Trust Status at Grantor's Death

a. Why Gain Should Not Be Recognized

(1) Background

(2) No Gain Under Rev. Rul. 85-13

(3) Basis of Trust Assets

b. Possible IRS Contrary Views

IV. Section 672: Definitions and Rules

Introductory Material

A. "Adverse Party," "Nonadverse Party," "Related or Subordinate Party"

1. "Adverse Party" and "Nonadverse Party"

a. Beneficial Interest Component

b. Substantiality Component

c. Adverse Character Component

2. "Related or Subordinate Party"

B. Grantor Powers Subject to Conditions Precedent

C. Powers Held by the Grantor's Spouse

D. Special Rule Where Grantor Is a Foreign Person

1. Grantor Trust Rules Applied to Determine Who Is the Grantor

2. Trusts Created by Certain Foreign Corporations

3. Certain Revocable Trusts

4. Irrevocable Trusts Benefiting Only the Grantor or the Grantor's Spouse

5. Compensatory Trusts

6. Effective Date Protection (Certain Trusts in Existence on September 19, 1995)

7. Recharacterization of Certain Gifts

8. Recharacterizing Beneficiary as Grantor of Inbound Trust

V. Section 673: Reversionary Interests

Introductory Material

A. Background

B. Section 673: Post-March 1, 1986, Rules

C. Section 673: Pre-March 2, 1986, Rules

D. Transfers to Certain Charitable Trusts Before April 22, 1969

E. Taxation of Reversionary Trusts

VI. Section 674: Power to Control Beneficial Enjoyment

Introductory Material

A. Power of Disposition Over Beneficial Enjoyment

B. Adverse and Nonadverse Parties

C. Powers That May Be Exercised by Anyone

1. Power to Apply Income to Support of a Dependent

2. Deferred Power Affecting Beneficial Enjoyment

3. Power Exercisable Solely by Will

4. Power to Allocate Among Charitable Beneficiaries

5. Power to Distribute Corpus

a. Power Limited by a Reasonably Definite Standard

b. Power to Advance Principal

c. Power to Add Beneficiaries

6. Power to Withhold Income Temporarily

7. Power to Withhold Income During Disability of a Beneficiary

8. Power to Allocate Between Corpus and Income

D. Powers Exercisable by Certain Independent Trustees

E. Power to Allocate Income Limited by a Standard

F. Power to Remove and Replace Trustees

VII. Section 675: Administrative Powers

Introductory Material

A. Power to Deal for Less Than Adequate and Full Consideration

B. Borrowing Trust Assets

1. Power to Borrow Without Adequate Interest and Security

2. Actual Grantor Borrowing from the Trust

3. Taxable Portion and Timing of Repayment

C. Administrative Powers Exercised in a Nonfiduciary Capacity

1. Powers Exercisable in a Fiduciary Capacity

2. Powers over Certain Stocks and Securities

3. Power to Reacquire Trust Assets

VIII. Section 676: Power to Revoke

IX. Section 677: Income for Benefit of the Grantor

Introductory Material

A. Income Payable to or Accumulated for the Grantor or the Grantor's Spouse

1. Taxable Portion

2. Actual or Constructive Benefit

3. Discharge of Legal Obligations

4. Spousal Attribution

B. Payment of Life Insurance Premiums

C. Deferred Right to Distributions or Accumulations

D. Divestiture of Tainted Powers

E. Discharge of the Grantor's Support Obligation

X. Section 678: Persons Other Than Grantor Treated as Substantial Owners

XI. Section 679: Foreign Trusts with One or More U.S. Beneficiaries

Introductory Material

A. Generally

B. The Transferor Must Be a "U.S. Person"

1. Foreign Transferors Who Become U.S. Persons

2. Transfers of Community Property

3. Expatriating U.S. Transferors

C. Required Transfer

1. Generally

2. The Testamentary Transfer Exception

3. Transfers for Fair Market Value

a. Transfers Before February 7, 1995

b. Transfers After February 6, 1995

(1) Generally

(2) Transfers for Partial Consideration

(3) Debt Obligations, Generally

(4) Qualified Debt Obligations

(a) Changing the Terms

(b) Principal Payment

4. Transfers to Charitable or Employee Benefit Trusts

5. Direct vs. Indirect Transfers

a. Transfers from Grantor Trusts

b. Indirect Transfers Through Intermediaries

c. Constructive Transfer by Assumption or Satisfaction of Trust's Debt

d. Constructive Transfer by Guarantee of Trust's Debt

e. Transfers to Entities Owned by a Foreign Trust

6. Outbound Trust Migration as a Deemed Transfer

D. The Trust Must Be a "Foreign Trust"

E. The Trust Must Have a U.S. Beneficiary

1. Scope of Inquiry

2. Discretionary Beneficiaries

3. Beneficiaries Who Could Become U.S. Persons

4. Indirect U.S. Beneficiaries

5. Annual Determination and the Five-Year Rule

6. Effect of Acquiring a U.S. Beneficiary

7. Drafting for § 679

8. Conflict Between § § 679 and 678

9. Deemed Transfer on Grantor's Immigration

F. Outbound Migrations of Domestic Trusts

G. Amount of Trust Income Taxable to Grantor Under § 679

XII. Intentional Grantor Trusts

A. Introduction

B. Section 674 Power to Alter Beneficial Enjoyment

1. General Rule

2. Exceptions, and Exceptions to the Exceptions

a. Power to Distribute Corpus Under Reasonably Definite Standard

b. Power to Distribute Corpus Charged Against Proportionate Share

c. Power to Withhold Income Temporarily Subject to Payment to Beneficiary's Estate

d. Power to Withhold Income Temporarily Subject to Beneficiary's Power to Appoint

e. Power to Withhold Income Temporarily Subject to Distribution with Corpus

f. Power to Withhold Income During Disability

g. Sprinkling Power Held by Independent Trustees

h. Power to Allocate Income Limited by Reasonably Definite Standard

i. Exceptions to the Exceptions

C. Nonfiduciary Power to Substitute Assets

1. Section 675(4)(C) Generally

2. Nonfiduciary Nature of the Power

3. May Third Party Hold This Power?

a. Statutory Language

b. Regulations

c. Does "Reacquire" Equal "Acquire"?

d. Why Only a Nonadverse Party?

4. What Is "Equivalent" Value?

5. Income Taxation of the Exercise of a Power of Substitution

6. Estate Taxes

a. Retained Substitution Power - Rev. Rul. 2008-22

(1) Facts

(2) IRS Analysis

(3) IRS Conclusion

(4) Planning Implications

(a) Terms of Trust

(b) Selection of Trustee

(c) Life Insurance

(d) Closely Held Voting Stock

b. Third-Party Substitution Power

D. Amounts Distributed to or Accumulated for Grantor's Spouse

E. Amounts That May Be Used to Pay Premiums on Insurance on the Life of the Grantor or Grantor's Spouse

1. Broad Statutory Language

2. Revenue Ruling 66-313

3. Other Early Precedents

4. Other IRS Pronouncements

a. PLR 6406221750A

b. Early 1980s Private Rulings

c. No Rulings Position

d. PLR 8839008

e. NDSA 20062701F

f. Evaluating the Pronouncements

5. Conclusion

F. Toggling Grantor Trust Powers

1. Turning the Grantor Trust Status Off

a. Effective Date of Taxability

b. Should the Trustee Have the Power to Turn Off Grantor Trust Status?

c. Third Party Should Have Power to Turn Off Grantor Trust Status

d. Powers That May Be Turned On and Off

2. Restarting Grantor Trust Status

a. Who Can Hold Power to Restart Grantor Trust Status?

b. Modifying the Trust

c. Naming a Foreign Trustee

3. IRS Scrutiny of Toggling - Notice 2007-73

a. First Variation

b. Second Variation

c. Effective Date

d. Analysis

4. Tax Consequences of Toggling

G. Section 2511(c)

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Sample Intentional Grantor Trust

Worksheet 2 Sample Clause Negating Grantor Trust Powers

Worksheet 3 Checklist of Grantor Trust Rules

Worksheet 4 Five Percent Reversionary Interest Charts