Originally published in the BNA Tax Management Estates, Gifts & Trusts Journal
A beneficiary grantor trust — an irrevocable trust
treated as owned by the beneficiary for income tax purposes but not
for estate tax purposes — can be a very useful tool. For
example, your client owns a business that is expanding. Her mother
creates a beneficiary grantor trust, making a $5,000 gift. The
trust forms a limited liability company (LLC). The LLC makes a deal
with the business — the LLC builds the building, and the
business will rent the building from the LLC. The LLC takes the
lease to a lender and obtains financing for the purchase of land
and construction of the building.
Over time, the LLC uses the rental income to pay down the mortgage,
acquiring equity in the building. When the mortgage is retired, the
trust continues receiving rental income and gaining equity. The
annual income taxes the beneficiary pays reduces the
beneficiary's estate. Eventually the beneficiary might get to
the point where her other assets are depleted, so that her estate
is reduced to the estate tax applicable exclusion amount. She can
then live off the trust comfortably, without having a conflict
between having plenty of retirement income and avoiding estate tax,
because her primary source of income — the trust
— is outside of the estate tax system.
The above is just one application of this technique. Regardless of
the technique, the structure generally follows a pattern. The
beneficiary needs to be granted a withdrawal right, which makes the
beneficiary the initial owner for income tax purposes. The
withdrawal right lapses, but the lapse must be the lesser of $5,000
or 5% of the trust, and the typical arrangement uses a gift of no
more than $5,000 to establish the trust1. After the
lapse, the beneficiary must have benefits or direct or indirect
control of the trust, using a power that would make the beneficiary
the deemed owner if the beneficiary had been the grantor, which
power cannot be one that makes the settlor the deemed owner.
The latest ruling on beneficiary grantor trusts is PLR 201039010.
The beneficiary had the power to withdraw each gift, but the amount
that can be withdrawn by the primary beneficiary in any one
calendar year was limited to the maximum amount as to which the
power of withdrawal can lapse without the lapse constituting the
release of a general power of appointment under
§§2041(b)(2) and 2514(e). The independent trustee had
absolute discretion to distribute part or all of the net income as
the trustee deemed appropriate to any one or more of the
beneficiaries, in amounts and proportions as the trustee
determines. The IRS ruled that the trust will be taxable to the
beneficiary and will qualify to hold stock in an S corporation if
all gifts will be subject to the initial withdrawal power.
PLR 201039010 did not address whether the trust's assets would
be included in the beneficiary's estate. What if there is a
pattern of the independent trustee making distributions each year,
once the beneficiary can no longer afford to pay the trust's
taxes? For some indirect guidance, consider Rev. Rul. 2004-64. The
ruling held that, if the trustee has discretion to reimburse the
grantor of a grantor trust for the grantor's income tax
liability with respect to trust income, the existence of that
discretion, by itself (whether or not exercised), will not cause
the value of the trust's assets to be includible in the
grantor's gross estate. However, Situation 3 of the revenue
ruling included some important caveats. The revenue ruling assumed
no understanding, express or implied, between the grantor and the
trustee regarding the trustee's exercise of discretion. It also
said that inclusion might apply if the discretion to make
distributions is combined with other facts, including, without
limitation, an understanding or pre-existing arrangement between
the grantor and the trustee regarding the trustee's exercise of
this discretion, a power retained by the grantor to remove the
trustee and name the grantor as successor trustee, or applicable
local law subjecting the trust assets to the claims of the
grantor's creditors. Thus, a pattern of distributions might
show such an understanding or pre-existing arrangement.
How safe is the PLR 201039010 fact pattern for income tax purposes?
That fact pattern, as well as any other beneficiary grantor trust
not structured as PLR 200949012,2 does not literally
follow the language of §678(a)(2). PLR 201039010 is consistent
with the IRS's prior letter rulings governing beneficiary
grantor trusts, so the IRS position is unlikely to change. However,
if the IRS were to change its position, it could assert that the
beneficiary is not the deemed owner after the withdrawal right
lapses and therefore trust no longer qualified to hold stock in the
S corporation. If the trust holds stock in an S corporation, as in
PLR 201039010, the trustee should consider electing to treat the
trust as an electing small business trust (ESBT).3 ESBT
income taxation is unfavorable, 4but the grantor trust
rules trump ESBT taxation during the beneficiary's
life.5 When the beneficiary dies, ordinarily the trust
would be subject to regular income taxation for the first two years
after the death of the beneficiary (as the deemed owner for income
tax purposes);6 however, if the ESBT election is already
in place, ESBT income taxation would kick in upon the
beneficiary's death.
PLR 201039010 might also have been the precursor to a sale from the
beneficiary to the trust. Such a sale would not be subject to
income tax, since the seller would be the deemed owner of the trust
for income tax purposes.7 Again, however, if the client
does not obtain a private letter ruling, the client is risking that
the IRS might change its §678(a)(2) position and tax the sale.
Therefore, in planning such a transaction, one should advise the
client of the costs and benefits of obtaining a private letter
ruling and let the client decide.
Footnotes
1.Generally, the beneficiary should have no withdrawal rights in any other trust that lapse in the same year as the year of the lapse.
2.The structure provided in PLR 200949012 is very sound from a §678 perspective, but note that the ruling did not say that the assets would not be included in the beneficiary's estate for estate tax purposes. I have significant estate tax concerns with the structure of PLR 200949012, but a full discussion of why a favorable estate tax ruling was not obtained is beyond the scope of this article.
3.§§1361(c)(2)(A)(v), 1361(e).
4.§641(c).
5.Regs. §1.641(c)-1(c).
6.§1361(c)(2)(A)(ii).
7.Rev. Rul. 85-13, 85-1 C.B. 184.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.