“Keep your friends close and your enemies closer”

Michael Corleone (The Godfather Part II)

Sound Familiar?

Greta Grantor wants to put her home into a trust to protect it from estate recovery in case she ever goes into a nursing home and onto Medicaid. At the same time she and her daughter agree that a time could come to sell the home and reinvest in an in-town condo. Grantor trust status is a paramount goal in order to preserve the tax free sale of the home, but Greta is very concerned about state Medicaid rules that could include any asset over which she has too much retained control.

Sam Settlor wants to move some assets to trust in order to qualify for VA benefits, yet he wants to insure that those assets receive stepped-up basis upon his death. Because the VA will likely question the existence of a grantor trust that generates tax activity that will show up on his Form 1040, avoiding grantor trust status is important. In spite of this concern he would still like to have some control over trust distributions and who may eventually inherit.

The answers for Greta and Sam might involve the intelligent use of people called adverse and nonadverse parties. Grantor trust status is achieved by the grantor retaining certain benefits or control mechanisms over trust assets (in this article these are called “Grantor Powers”). In many cases, however, a Grantor Power can be given to (or shared with) a nonadverse party without jeopardizing grantor trust status. On the other hand, a Grantor Power will not cause grantor trust status if it requires the cooperation of an adverse party, or if it can be blocked by an adverse party.

Who’s On Adverse?

An adverse party is someone with a beneficial interest in the trust that will be positively or negatively affected by the exercise or non-exercise of a certain power. For example, if Anthony has been given an income interest in a trust but Greta Grantor has retained a power to appoint the income interest, Anthony will be adverse with respect to that retained power of appointment. If Greta Grantor exercises her power to appoint the income of the trust, Anthony Adverse will be the loser.

The rules are simply based on an understanding of human nature and the propensity of an individual to act in his or her best interests during the course of navigating life’s many decisions. An adverse party is less likely to be subject to the influence of the grantor because she will be primarily motivated to take or withhold action to preserve her trust benefits. On the other hand, a nonadverse party is free of those motivations (“he doesn’t have any skin in the [trust] game,” so to speak, and is more likely to act on grantor’s behest). In fact, if trust design calls for the use of a nonadverse party the grantor will look around for someone who is not a beneficiary and who will likely return the grantor’s phone calls (if not do exactly what the grantor wants done).

Internal Revenue Code (“Code”) section 672 and the regulations thereunder recognize this very human tendency. Unfortunately, nothing is as simple as it may seem.

 A Deeper Look

Code section 672(a) defines an adverse party as “any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or non-exercise of the power which he possesses respecting the trust.” Subsection (b) simply defines non-adverse party as anyone who is not adverse.

As usual, the regulations flush it out a bit, and that is where things become more interesting. If an individual is not a beneficiary, she will not be an adverse party.[1] On the other hand, it does not always follow that a trust beneficiary will be adverse. The regulations spell out a couple of examples.

Example

An individual can be adverse with respect to a portion of a trust only. Say a trust provides an income interest of three equal shares to Anthony, Betty and Charlie. Greta Grantor, however, has reserved a right to appoint the income interest to the North Carolina Zoological Park with the consent of Anthony. This is a Grantor Power because Code section 674(a) provides that a grantor will be the deemed owner of any portion of a trust over which he has retained a power to affect the beneficial enjoyment thereof, without the consent of any adverse party.

If you are paying attention, you must be thinking, “Wait, Anthony is adverse so how can this be a grantor trust?” You are half right (er . . . one-third right). Anthony is adverse with respect to Greta’s retained power of appointment, but only with respect to one-third (1/3) of the income of the trust. Anthony is nonadverse with respect to the other two-thirds of the income. In this particular case, the trust would be a grantor trust with respect to two-thirds of the income and a non-grantor trust with respect to a third.[2] After all, Anthony’s interests are not at all affected by the appointment of what would have been Betty and Charlie’s shares. He is, however, keenly interested in his one-third of the income.

In that case, two-thirds of the items of income, deduction or credit allocable to trust income under the terms of the trust agreement or the North Carolina Uniform Principal and Income Act will be deemed to be Greta’s and will appear in some form or fashion on her Form 1040. The trust will need to report the tax attributes allocable to one-third (1/3) of the trust corpus on its own Form 1041.

Yet another riveting example

A trust provides an ordinary income interest to Adella Adverse with a power in Adella to appoint the trust principal to Sam Settlor either during Adella’s life or upon Adella’s death with a testamentary power of appointment.  Under the trust agreement (and, in the event the trust agreement had been silent, under the state principal and income act) any capital gains are to be added to trust principal. These powers, too, are potential Grantor Powers. Code section 677 provides that a grantor will be the deemed owner of any portion of a trust with respect to which the income may be distributed to grantor or held or accumulated for future distribution to grantor without the approval or consent of an adverse party.

In this particular case, Adella’s power is adverse to Sam to the extent that Adella can appoint the corpus during her life (after all, Adella’s income will be wiped out if she appoints the principal to Sam). In that case the ordinary trust income will not be reportable on Sam’s Form 1040 because the ordinary income can be controlled by Adella Adverse. Rather, the income will be reportable on the trust’s Form 1041. Had Adella been a nonadverse party her discretionary authority to distribute principal to Sam, Code section 677 would have required ordinary income to be reported on Sam’s Form 1040.

But wait . . . Adella’s power to appoint corpus to Sam upon Adella’s death will result in capital gains making an appearance on Sam’s Form 1040 because IRC section 677 says that any taxable income (capital gains is taxable income, after all) that could be accumulated for later distribution to grantor results in grantor trust status with respect to that trust portion. In this case, Adella (presumably) couldn’t care less what happens to trust income after her death which renders her nonadverse with respect to Sam and that specific trust portion. In this case, a nonadverse party (Adella) has the Grantor Power to accumulate income for potential later distribution to the grantor (Sam).[3]

A Potential Trap

The Regulations flatly state “[t]he interest of a remainderman is adverse to the exercise of any power over corpus of a trust, but not to the exercise of a power over any income interest preceding his remainder.”[4] This exposes a common planning trap.

The Code and Regulations say that a testamentary power of appointment does not in and of itself create a grantor trust. If, however, income is accumulated “in the discretion of the grantor or a nonadverse party, or both, without the approval or consent of any adverse party”[5] for later testamentary distribution by the grantor, then a grantor trust will be the result.

Because capital gains is most often not distributed, but rather added to corpus under the terms of the trust or the state principal and income act, it follows (one would think) that a retained testamentary power of appointment will create a grantor trust with respect to trust principal because income is being added to corpus for later disposition under grantor’s will.[6] But not so fast.

Many attorneys think they have locked in grantor trust with respect to principal (let’s say they want to insure favorable capital gains treatment under Code section 121) by simply adding a testamentary power of appointment (realizing that capital gains are being added to principal and thus satisfying the regulation). Here is the catch: The same attorneys may also add a provision in the trust distributions terms that principal may not be distributed to grantor, but may be distributed to some class of other beneficiaries within the discretion of the trustee or some other parties. These sorts of provisions are added to allow some mechanism to strip principal out of the trust without creating potential Medicaid availability issues for the grantor.[7]

If the consenting trustee or other consenting parties are from the pool of trust remainder beneficiaries, those consenting parties will be adverse. Because these adverse parties have control over distributions of principal, it follows that any accumulated capital gains added to corpus will be distributed via grantor’s will only with the tacit consent or approval of adverse parties. These consenting parties may simply elect to distribute the entire trust prior to grantor’s death.

In this particular case, if grantor trust status with respect to trust principal is important, look for some provision other than a testamentary power of appointment if any party has the ability to distribute corpus prior to the grantor’s death in a manner that could benefit herself. Possible solutions might involve subjecting discretionary distributions of trust principal to the discretion of a nonadverse party or allowing grantor or a nonadverse party to add or delete remainder beneficiaries (both of which are Grantor Powers under Code section 674(a)).

For example: Greta Grantor retains a testamentary power of appointment over trust corpus. Under the trust instrument and local law capital gains are added to principal. Greta’s son Anthony Adverse, the trustee and one of the named remainder beneficiaries, has the discretionary authority to distribute principal to or among Greta’s issue. Greta’s testamentary power of appointment is not a Grantor Power because an adverse party can at any time prevent the accumulation of income for later testamentary distribution simply by ordering a distribution of principal.

OK, Another Example: The facts are as above, except that trust principal may not be distributed during Greta’s life. Greta’s testamentary power renders the trust a grantor trust with respect to all items of income, deduction and credit allocable to corpus (i.e., capital gains) because income is being accumulated for later testamentary distribution by Greta.[8]

On the other hand, for some reason Greta does not trust herself with a testamentary power in her later years. The trust contains a “default” provision that on Greta’s death the remainder will be distributed per stirpes among Greta’s issue. But she also trusts her sister Nancy Nonadverse to respond to changing circumstances, so she provides that Nancy may order discretionary distributions of principal among Greta’s issue at any time. Nancy’s power is a Grantor Power under Code section 674(a) and is held by a nonadverse party, thus rendering the trust grantor trust with respect to all items of income, deduction and credit allocable to corpus.

Isn’t This Marvelous?

By wisely identifying available potentially adverse and nonadverse parties in the grantor’s universe, and by carefully designing trust provisions to meet grantor’s needs, a drafting attorney can control the tax status of the trust. This remarkable accomplishment will insure hero status in the client’s eyes and could very well be the stuff of later legal legend. ________________________________________________________________

[1]  Treas. Reg. § 1.672(b)-1 (the regulation reads in its entirety: “A ‘nonadverse party’ is any person who is not an adverse party.” Certainly this must put it in the running for the shortest tax regulation.)

[2]  See Treas. Reg. § 1.672(a)-1(b).

[3] See Treas. Reg. § Treas. Reg. 1.672(a)-1(c).

[4] Treas. Reg. § 1.672(a)-1(d).

[5]  Treas. Reg. § 1.674(b)-1(b)(3).

[6]  Id.

[7]  42 U.S.C. § 1396p(d)(3)(B).

[8]  Id.