When she learns she will be taxed on the trust’s income she will not be a happy camper.
Two common planning scenarios could land you in a malpractice trap if you don’t know this rule.
SCENARIO 1: Don Kilroy is a veteran and wants to protect some real property and other income generating assets for future Medicaid and VA benefit planning. The best strategy seems to be a non-grantor trust (to avoid VA scrutiny . . . and maybe even your state’s Medicaid scrutiny), but also to insure estate inclusion to obtain stepped-up basis. The trustee will be given discretionary authority to make distributions of income and principal among Dad’s descendants. Don names his son as sole trustee.
SCENARIO 2: Ma Barker’s last will and testament leaves most of her assets to a testamentary trust for the benefit of her descendants. The trustee (one of Ma’s daughters) has discretion to sprinkle income and assets among Ma’s descendants until the youngest living at her death has attained age 25.
ONE BIG PROBLEM: In both scenarios the sole trustee is one of the children of the settlor/testator. Further, the trustee’s discretion is unlimited.
RESULT: Both trusts will be treated as owned by the trustee for income tax purposes. In effect, the trusts will be grantor trusts with respect to the trusts. This is not a good thing.
REMEDY: Either name co-trustees who must act jointly with respect to distributions, subject distributions to an ascertainable (HEMS) standard, or require the trustee to obtain some other party’s approval for a distribution.
WHAT THE . . . . ?
Look at IRC section 678.[i]
This section is the only grantor trust provision under which a person other than the grantor or a transferor to the trust could be the deemed owner of all or a portion of the trust for tax purposes. Note that each of IRC sections 673 through 677 begin “The grantor shall be treated . . .” and IRC section 678(a) commences with “[a] person other than the grantor shall . . .”).
IRC section 678 is poorly drafted and is the source of confusion. From the face of the statute, it appears that a person with “power exercisable solely by himself to vest the corpus or the income therefrom in himself” will be the deemed tax owner.[ii]
AN EXCEPTION TO IRC SECTION 678
However, IRC § 678(b) applies an exception:
Subsection (a) shall not apply with respect to a power over income, as originally granted or thereafter modified, if the grantor of the trust or a transferor (to whom section 679 applies) is otherwise treated as the owner under the provisions of this subpart other than this section.
In other words, is this statute to be read that if the grantor and the other person are both treated as the owner of trust income, the rules of IRC §§ 674 through 677 trump application of IRC § 678(a) to the third party? For example, if grantor has retained an income interest IRC § 678(a) might not apply . . . or so it might seem. On the other hand, a third person with some power over corpus would, in fact, be treated as tax owner notwithstanding that grantor also has powers over corpus because IRC 678(b) would not apply . . . or so it might seem. The statute actually is “something else.”[iii]
DECIPHERING THE TERM ‘INCOME’ UNDER IRC SECTION 678
The apparently correct reading of the section should be that if the grantor has retained any power over corpus or income under IRC sections 674 through 677, the power will trump application of IRC section 678(a) to the third party. The key to answering the riddle is in the definition of “income.”
In the context of IRC section 678, “income” likely refers to “taxable income” as opposed to “trust accounting income.” The former includes both income allocable to corpus (i.e., gains on sale or exchange of capital assets) and to trust accounting income (i.e., ordinary income); the latter includes ordinary income. If you have attended a TrustChimp Trust Summit this has been pounded into you.
Treas. Reg. section 1.671-2(b) specifies that for purposes of the grantor trust rules the term “income” refers to income for tax purposes and not trust accounting purposes and that if trust accounting income is being referenced the term “ordinary income” would be used. IRC section 678(b) uses the unmodified term “income” which refers to taxable income pursuant to the regulation. Accordingly, if a grantor and a third person are both deemed the owner of income allocable to either corpus or accounting income, then under IC § 678(b) the grantor would be treated as the owner (i.e., IRC sections 674 through 677 trump IRC section 678(a)).
IRC section 643(b) (which does not apply to grantor trusts) specifies that the term “income” refers to “income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law” (i.e., trust accounting income under a state’s principal and income act) for the purposes of Subparts B, C, and D of Part I of Subchapter J. The grantor trust rules are in Subpart E, clearly omitted from the IRC section 643(b) reference. Combined with the reference under Treas. Reg. section 1.671-2(b) discussed above, the meaning of “income” under IRC section 678(b) takes on some clarity.
DUCKING THE IRC SECTION 678 BULLET
Particularly in the context of veterans’ benefits planning, designing a trust to avoid application of the grantor trust rules to the grantor may be a sound strategy if a goal is to avoid trust tax attributes appearing on the grantor’s tax return. In connection with that strategy many may want to provide access to trust assets by allowing the trustee or some other person to make distributions to one or more individuals or a class of individuals.
As you now know, care should be taken to avoid application of IRC section 678(a) to an individual with the sole authority to order distributions to a class that includes herself. For example, a trust granting a trustee the authority to make distributions to descendants of the grantor “within the sole discretion of the trustee” will trigger application of the grantor trust rules to the trustee if the trustee is a descendant of the grantor.
There are two ways to address the issue.
- Perhaps the easiest method is to subject the decision-maker’s authority to the approval of another person, perhaps a sibling or some other trust beneficiary.[iv] This approach not only avoids IRC section 678(a) issues, but may provide an added layer of security to trust assets by fettering an otherwise broad power residing in a single individual.
- A second approach is to subject the decision-maker’s authority to an ascertainable or “health, education, maintenance and support” standard. But be careful here. The trustee may seem to be subject to an ascertainable standard, but it may be illusory if language provides that the determination is solely within the power of the trustee (“whose determination shall be conclusive for all purposes and blah, blah, blah”). In this case, the trustee’s authority is not really subject to any standard and we’re back to IRC section 678(a).
Crummey powers and inter vivos powers of appointment could also trigger this section with respect to a trust if the grantor has not retained powers under IRC sections 673-677 that would cause grantor trust status with respect to the grantor (even if the beneficiary is unable to exercise the Crummey power due to minority or disability).[v] But will save that little gem for another discussion.
[i] Because this is not a law review article and is a post to my website, I can violate standards of citation if I want to. Take that.
[ii] IRC § 678(a)(1).
[iii] IRC § 678 reminds me of the motto of the State of North Carolina: Esse quam videri (“To be, rather than to seem”). The motto is a literal translation of a phrase from a sentence in Cicero’s On Friendship (De Amicitia, chapter 26). The complete sentence in Latin is: Virtute enim ipsa non tam multi praediti esse quam videri volunt, which means something along the lines of “Fewer persons actually possess virtue than those who would seem to possess it.” I still believe it could apply to IRC § 678, but I digress.
[iv] Example: “The Trustee may elect within her sole discretion to make distributions of principal or income to any of grantor’s descendants subject to the advance written approval of a proposed distribution or distributions by one of grantor’s descendants not then serving as Trustee.”
[v] See, e.g., Rev. Rul. 81-6, 1981-1 C.B. 385. If you enjoy self-testing, go through the ruling and determine why the trust in question was not a grantor trust with respect to parent. The Service does not tell the reader that (which would have made the ruling much clearer). Or you can take my word for it.