Proposed Changes to the Grantor Trust Rules Reflect a “Caddyshack-like” Approach to Problem Solving
October 8, 2021
As seen in Steven Leimberg’s Estate Planning Newsletter
Fans of the 1980 film Caddyshack will recall that Bushwood Country Club had a serious problem: A gopher was ravaging the golf course, creating havoc on their well-manicured grounds. Instead of calling local pest control (which would seem to have been a simple, direct, and almost certainly more effective, solution), Assistant Greenskeeper, Carl Spackler (Bill Murray), was assigned to “kill all the gophers” – which he ultimately tried to do by detonating plastic explosives throughout the course. Not surprisingly, the movie ends with a shot of the gopher emerging unharmed from the ruins of the smoldering landscape.
Similarly, today’s Congress is also faced with a serious problem: A long-standing loophole in the Internal Revenue Code that has, for many years, been used by wealthy taxpayers to transfer substantial wealth to their children and grandchildren without ever being subjected to the Federal estate and gift tax. Instead of opting for a simple, direct, and almost certainly more effective, solution, Congress appears poised to take a page from Spackler’s book and has put forth a proposal that would blow up whole sections of the tax code and destroy the use of trusts as an estate planning tool in their effort to curtail specific abuses that could easily be targeted through far less destructive means.
What Problem is Congress Attempting to Address?
Before diving into an explanation of the “abuse” that Congress is trying to address, a bit of a history lesson is in order. Back in the 1950’s, when the top income tax rate was 91%, some high-bracket taxpayers saw an opportunity to shift income by dividing their investment assets among dozens (and in some cases, hundreds, or even thousands) of newly-established trusts that could claim to be separate taxpayers (each with their own set of lower brackets). Because the creators of these trusts were often not yet ready to part with control of the assets contributed, many of the trusts used for this purpose included provisions that allowed the grantor to retain certain rights and powers over the trust’s assets. To combat this practice, the Internal Revenue Code of 1954 included a set of rules under which a trust would be ignored for income tax purposes in cases where the grantor retained certain powers. These rules became known as the “grantor trust rules,” which are today found in Sections 671-678 of the Internal Revenue Code (the “Code”). While many of the retained powers that cause a trust to be ignored for Federal income tax purposes under the grantor trust rules are also retained powers that would cause the trust to be included in the grantor’s estate for estate tax purposes, there are certain retained powers that will cause a trust that is not includable in the grantor’s estate to nevertheless be ignored for income tax purposes. As explained below, this asymmetry is the source of the current problem.
The Tax Reform Act of 1986 further discouraged people from creating multiple trusts that could serve as separate taxpayers by compacting the tax brackets that apply to trusts so narrowly that even without the grantor trust rules there would be no economic benefit associated with dividing one’s investment assets among hundreds or thousands of new taxpaying trusts. Today, where trusts currently pay tax at the highest marginal rate (37%) on all income over $13,050, the cost of creating and administering a separate trust is likely well above the $1,682.50 in annual savings that might result from a run through the trust’s lower brackets. At this point, the grantor trust rules – at least those that went beyond the scope of powers that would also cause estate tax inclusion – could have (and some would say, should have) been repealed. But they weren’t.
Although the grantor trust rules were originally intended to disadvantage the taxpayer by eliminating one’s ability to spread investment income across multiple sets of lower brackets without having completely given the investment assets away, clever estate planning attorneys soon found a number of ways to turn the tables and use the asymmetry between the grantor trust rules and the estate and gift tax rules to their clients’ benefit. First and foremost, they realized that rules which force a parent (the trust grantor) to pay the tax on income that will ultimately pass to his or her children (the trust beneficiaries) provide an opportunity to transfer additional wealth (i.e., the amount of the tax) without that transfer being subjected to gift tax. Moreover: A trust that is ignored for income tax purposes is free to enter into a loan and/or a purchase of assets (or, better yet, both – a purchase of assets in exchange for the trust’s issuance of a promissory note) without the economic impact of those transactions being subjected to income tax (because the grantor is treated as having entered into those transactions with himself or herself). Accordingly, creating irrevocable trusts that are respected for estate and gift tax purposes but ignored for income tax purposes quickly became a staple of effective estate planning and wealth transfer. On its own, this might seem like little more than an opportunity to nibble around the margins of the estate and gift tax, but combined with other factors like valuation discounts and the below-market assumed interest rates that are set by the Internal Revenue Service (“IRS”) each month, “intentionally defective grantor trusts” have been used to help facilitate the transfer of substantial amounts of wealth to younger generations without being subjected to gift or estate tax. This is the problem that Congress is attempting to solve.
The Easy and Practical Solution
The Congressional equivalent of calling local pest control to solve Bushwood’s gopher problem would be a simple repeal of those provisions within the grantor trust rules that do not also result in estate tax inclusion. By realigning the retained powers that cause a trust to be ignored for income tax purposes with the retained powers that cause a trust to be ignored for estate and gift tax purposes, Congress could quickly and easily stop taxpayers from exploiting any disparity between the two tax regimes. Any irrevocable trust that is outside of the grantor’s taxable estate would have to pay its own income tax going forward (at today’s heavily-compacted brackets), and all transactions (like loans or sales) between a grantor and his or her (now non-grantor) irrevocable trust would be subject to income tax because the grantor and the trust would be considered two separate taxpayers. While such a change would hardly be welcomed by wealthy taxpayers or by an estate planning community that has long thrived on designing complex strategies that would no longer be available, this solution would surgically target the problem, and it could be implemented without generating unnecessary fallout that ultimately compromises the structural integrity of the Code. Unfortunately, this is not the approach that Congress is currently poised to take.
What Congress is Planning Instead
In lieu of a clear and straight-forward solution, the House Ways and Means committee released draft tax legislation on September 12, 2021 that includes (among many other things) the addition of two new Code sections: Section 2901 and Section 1062.
New Section 2901 would include the following provisions:
- Any trust property that is held in a grantor trust would now (by definition) be included in the gross estate of the grantor – even if such property would not otherwise have been included under the estate tax provisions of the Code.
- Any distribution of property from a grantor trust to a beneficiary of that trust (other than the grantor or the grantor’s spouse) would now be considered a taxable gift from the grantor to the beneficiary at the time of the distribution – even if the grantor’s original gift to the trust qualified as a completed gift and had already been subjected to gift tax (or use of gifting exemption).
- If grantor trust status is terminated during the life of the grantor, such termination would now be considered a taxable gift from the grantor to the trust beneficiaries at the time of termination.
These changes would apply to any trusts created after the date of enactment, and to the portion of any pre-enactment trust that is attributable to contributions made after the date of enactment.
New Section 1062 would include the following provision:
- Any transfer of property between a grantor trust and its grantor would now be fully recognized and subjected to income tax where applicable. This would effectively override the characterization in the grantor trust rules under which grantor trusts are treated as disregarded entities for income tax purposes.
“Au Revoir, Gopher”
So, does the proposed legislation solve the problem that Congress is attempting to address? One could say that it does…but one could also say that blowing up the golf course prevented the gopher from continuing to destroy it. The proposed new sections of the Code would introduce radical changes by reference (rather than by directly amending the sections of the Code that they wish to modify), introduce additional complexity and ambiguity by creating deliberate inconsistency among varying sections of the Code, and they would produce a tax environment that fosters substantial disparity between similarly situated taxpayers without any coherent policy rationale for doing so. The damage that this new legislation would do to the structural integrity of the Code is considerable. Here’s why:
Some of the Grantor Trust Rules are Ambiguous
The biggest problem with the approach proposed by Congress is that there is notable ambiguity surrounding what is and is not a grantor trust. Up to this point, that ambiguity has been of little consequence because (a) most irrevocable trusts contain express language indicating whether or not they were designed to be grantor trusts (effectively opting in or out); (b) it’s much easier to opt in than to opt out of the grantor trust rules (and this is what most trusts have wanted to do anyway); and (c) the IRS hasn’t had much incentive to challenge whether trusts that have chosen to opt out have really done so effectively. If this new legislation passes, however, no taxpayer will want their newly-created trust to be classified as a grantor trust – but the way to avoid this characterization is not necessarily clear.
For example: Section 677(a)(3) of the Code explicitly states that a trust shall be considered owned by the grantor if “income” from the trust may be “applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor’s spouse”. One might think, based on the clear, express wording of the statute, that one could avoid grantor trust status by explicitly stating in the trust agreement that only “trust principal,” and not “trust income” may be used to pay premiums. But the IRS has suggested that the word “income” doesn’t just mean current income, it also includes any income from prior years that had been accrued and added to principal. Given the severe adverse consequences that would stem from being classified as a grantor trust under new Section 2901, it is critical that this question be clearly resolved. If the IRS interpretation is upheld, then the only way to avoid grantor trust status might be for a trust agreement to prohibit the trustee from using any trust assets at all to pay life insurance premiums. (This would still leave unresolved the question of whether a grantor could pay life insurance premiums directly to the insurance carrier in support of a policy that is owned by a grantor trust where the trustee is prohibited under the terms of the agreement from paying those premiums himself or herself. This should work because, under this approach, it would seem clear that no trust “income” – past or present – was used make those payments, but it begs the question of what policy objective would be served by forcing people to go this route.)
There are also differing opinions about the interplay between Section 678(a) and Section 678(b) of the Code. Many practitioners believe that Section 678(a) causes a beneficiary who previously allowed a Crummey withdrawal power to lapse to be treated as the ‘grantor’ of the trust for grantor trust purposes, while Section 678(b) potentially overrides that treatment in cases where the original grantor would otherwise be treated as the ‘grantor’ for grantor trust purposes…but only “with respect to a power over income.” As neither the term “income” nor what it means to have a “power over income” have been clearly defined, there has been much debate about what these provisions mean and when they apply. If different parties are to be treated as the ‘grantor’ with respect to different portions of an undivided trust, keeping track of who is deemed to own what (where percentages change anytime there is a contribution or distribution of trust property) would be a logistical nightmare!
Before Congress makes being a grantor trust or not being a grantor trust the determining factor for whether the grantor of that trust will be subjected to severe adverse gift and estate tax consequences, they must first ensure that the grantor trust rules (and particularly the applicable definitions) are clear and unambiguous.
Making Significant Changes Indirectly by Reference is No Way to Amend the Tax Code
The Code already includes an entire Chapter (Sections 2001 through 2058) that defines the scope of one’s taxable estate. Included within this section are several provisions that cause assets which had previously been given away to be dragged back into the estate because the decedent had retained too much control over them. If Congress wants to expand the list of retained powers that cause estate tax inclusion of previously gifted assets, these additional powers should be specifically enumerated in the same place where all of the other retained powers that cause estate tax inclusion are located. It defies logic why Congress would try to amend the estate tax rules by adding a brand new section to an entirely different Chapter of the Code which says that taxpayers need to refer to (and interpret) yet a third (unrelated) Subchapter of the Code in order to understand the way in which the estate tax rules are to be applied.
Similarly, the gift tax rules (Sections 2501 through 2524) currently make a distinction between “complete gifts” and “incomplete gifts”. Gifts that are complete are subject to gift tax when made, and (except in rare circumstances) there is no further gift tax consequence to the transferor thereafter because he or she is deemed to have completely parted with dominion and control over the asset transferred. Gifts that are incomplete (because the transferor has not completely parted with dominion and control) are not subject to gift tax when made, but are instead subjected to gift tax when the transferor’s control is terminated and the gift becomes complete. Section 2901 would blur this otherwise clear distinction by creating a whole new category of gifts that (like complete gifts) are subject to gift tax when made, but (like incomplete gifts) re-trigger a new gift tax (with credit given for the value initially transferred) when the grantor’s retained power is terminated. This would be a major change to the entire process for determining when a gift tax is imposed and (as with the estate tax changes) it is hard to understand why Congress would try to amend the gift tax rules by adding a brand new section to an entirely different Chapter of the Code which says that taxpayers need to refer to (and interpret) yet a third (unrelated) Subchapter of the Code in order to understand the way in which the gift tax rules are to be applied.
The fact that the grantor trust rules that Congress is attempting to incorporate by reference are ambiguous, with several sections that lack clear guidance, makes this shorthand approach to tax legislation even more ill-advised.
Sections 2901 and 1062 are Inconsistent with other Sections of the Code
While it may not seem obvious to people who aren’t either tax attorneys or accountants, there is a great deal of logic to the layout of the Code, and many of its provisions are interrelated. Tax treatment is often determined through application of broad principles: What does it mean to “own” something, and what are the tax consequences associated with ownership? What types of expenses are “personal expenses” and what types are “business expenses”? What is the difference between a deductible “expense” and a non-deductible “capital investment”? Many times, in the practice of tax law people determine how to treat a situation where there is no direct controlling authority by looking to see how similar situations are treated. The system breaks down, however, when we start enacting rules that treat something one way for one purpose, and an entirely different way for a different purpose – especially if there is no defined policy reason for the distinction.
The grantor trust rules clearly provide that a grantor trust is a disregarded entity and treated as if it were the grantor. New Section 1062 would contradict this treatment by saying that a grantor trust will not be disregarded in the context of a transfer of property between a grantor trust and its grantor. Presumably the purpose for this carve out is to cause a taxable recognition of gain on any sale or exchange between a grantor and a grantor trust. But what if the grantor trust is the one with the gain? Does the trust now pay its own tax on that gain (because the taxable income resulted from a sale of property to the grantor)? Or is the carve out just for the recognition of the gain, and not for the payment of the tax? Ordinarily one might look to see how analogous situations are handled in other parts of the Code, but there are no analogous situations because the provision that generated the question was created out of whole cloth and not based on any overriding principle or rationale.
More specifically: Section 675(4)(C) provides that a trust shall be considered a grantor trust if the grantor has the “power to reacquire the trust corpus by substituting other property of an equivalent value”. This power, which is sometimes referred to as a “swap power,” relates to a fair market value exchange of assets between the grantor and the trust. If proposed Section 2901 is enacted, it will cause a paradox where Section 675(4)(C) says that having the power causes the trust to be considered a grantor trust, but Section 2901 says that exercising the power causes the trust to not be considered a grantor trust (at least for that purpose).
Finally: While Section 2901 isn’t necessarily in direct conflict with the sections of the Code that provide for Grantor Retained Annuity Trusts (GRATs), or Qualified Personal Residence Trusts (QPRTs), or Charitable Lead Annuity Trusts (CLATs, at least the deductible kind that generate an income tax charitable deduction), it effectively overrides those sections because it eliminates any benefit that a taxpayer might hope to realize by utilizing one of these planning vehicles. This would leave us with a number of obsolete tax provisions that are still technically in effect, but practically useless. If Congress really wants to eliminate these planning vehicles, they should have to do it directly rather than killing them off indirectly.
Similarly Situated Taxpayers Will be Treated Differently
Under the existing grantor trust rules, if the trustee of an irrevocable trust has the ability to loan trust assets to the grantor without requiring the grantor to pledge “adequate security” for the loan, then the trust will be considered a grantor trust. Accordingly, under the proposed legislation, the mere presence of that ability would cause all of the assets in that trust to be included in the grantor’s estate, which would subject them to estate tax. It’s unclear why Congress would feel that this treatment is fair or warranted. If a parent makes an outright gift to a child, that child has the ability to loan the gifted assets back to the donor parent without requiring any security at all, and there are no adverse estate or gift tax consequences that would stem from this. Why should the result be different just because the gift was made to an irrevocable trust for the benefit of the child rather than directly to the child himself or herself?
A similar situation arises in connection with the grantor trust rule which states that if the trustee has the power to use trust income to pay life insurance premiums on the life of the grantor (and, as noted earlier, there are differing views on what is meant by the term “income”), this will cause the trust to be considered a grantor trust, which under the proposed legislation will cause all of the trust assets (including the death benefit on the insurance policy) to be included in the grantor’s estate, which will subject them to estate tax. The proposed legislation exempts trusts that are already in place at the time of enactment, but that will be of little consolation to existing irrevocable life insurance trusts where the policies they hold still have premiums due (because making new contributions to a trust that would otherwise be grandfathered causes the trust to no longer be grandfathered). Contrast that treatment with a parent who makes an outright gift to a child, and then the child uses income from the gifted asset to pay life insurance premiums on a policy that insures the life of the donor parent. In that case, there is no estate tax inclusion of either the gifted asset or the death benefit on the life insurance policy.
While some might suggest that a distinguishing factor in the above examples is whether or not the recipient of the gift is the one who has the discretion to loan money back to the donor without adequate security, or to use future income to pay life insurance premiums, that isn’t necessarily the case. What if, instead of making an outright gift to the child, the parent placed the gifted asset in a manager-managed limited liability company (managed by the parent’s sibling, who might otherwise have named as trustee if a trust had been used), and then makes a gift of 99% of the LLC to the child? In that scenario, the manager (who, again, is the same person that would otherwise have been serving as trustee) would have the ability to either (a) loan LLC assets back to the parent without requiring adequate security, or (b) use LLC income to pay life insurance premiums on the life of the parent – and neither of these things would cause the inclusion of any of the LLC’s property in the parent’s estate.
Which brings us full circle to the question of what Congress is trying to accomplish with the proposed legislation. Is the goal to stop taxpayers from abusing the asymmetry between the grantor trust rules and the estate tax rules, or is the goal to vandalize the tax code and destroy the use of trusts as an effective estate planning tool? Returning to the Caddyshack analogy: Are we trying to eliminate the gophers, or are we trying to turn the golf course into a landscape of smoldering ruins? If the answer is the former, then there is an easy way to do that: Put away the dynamite, pick up the scalpel, and get to work.