Introduction
Grantor trusts are groovy. They have so many potential benefits that they are the cornerstone of many, maybe even most estate plans. Grantor trusts let you transaction business with your trust without triggering gain for income tax purposes. Rev. Rul. 85-13. So, you can sell your family business or rental real estate to the trust and pay not capital gains tax. Why would you want to do that? Because the trust, if structured and operated to be outside of your estate, can grow those assets outside of your estate meaning no estate tax. There are many nuances, implications and considerations with using grantor trusts, but that is not our topic for here. One of the tax consequences of a grantor trust is that you as the person setting up the trust (called the “settlor, “trustor” or “grantor”) report on your personal income tax return. That means you get to pay the income tax on income earned by the trust and perhaps remaining inside the trust. This one little oddity can be one of the most powerful forces in estate planning over time. Over the years your paying income tax on trust income makes the trust grow outside of your estate as if it were income tax free. That can result in powerful compounding. Your paying income tax over all those years on income you do not get reduces your estate for estate tax purposes. That can be a good thing from an estate tax planning perspective.
I Do not Love This Arrangement!
So, after many years of paying income tax on income you’re not getting, and your kid who is the beneficairy of the trust and all your largesse still forgetting your birthday, you grow less enthused about this tax benefit when you die. What might you do to defray that tax burden that is no longer giving you smiles? Several ideas to discuss with your planning team (CPA, wealth adviser, insurance consultant, estate planning attorney) are briefly explained below. This is really complex stuff and has potentially huge and adverse implications to your planning or even to your current bill to the IRS. So, proceed really cautiously. Very carefully review the consequences, and in particular potential tax or legal issues of any action you are considering and especially the loss of the benefits of your trust being a grantor trust, before doing anything. Losing the grantor trust benefits could be a whopping mistake depending on the growth of your estate, future tax law changes (less predictable than weather forecasts) and so on. If after that analysis you want to proceed, then review all the options your advisor team can think of. The ideas below might help them get started on this. Many of the options below may not be available to you, or even if available may have negative repercussions. So this is really a brainstorming checklist for you to chew over with your advisers.
First, Evaluate What The Real Issue Is
Before taking any action make certain to honestly fess up to your advisers about what your real concerns are. Do you really have a financial issue as a result of paying income tax on trust income? Or perhaps you did not really understand the planning implications or forgot them. In that case better understanding the benefits of the plan may help. Is the tax issue you face one temporary or regular concern? That may affect how you advisers evaluate possible steps to take. Finally, are you frustrated with paying taxes or with the beneficiaries who are getting all trust assets? If the latter, then a very different course of action may be advisable.
Use the Acronyms: Exercise a DAPT, hybrid-DAPT or SPAT power. Some trusts are created with additional mechanisms to provide a means to provide access or benefit to trust assets to the settlor from the trust. A Domestic Asset Protection Trust (“DAPT”) provides that the settlor themselves are a beneficiary of the trust. If that is a case then a distribution may be made to the settlor (you) to thereby assist the settlor in defraying the tax costs from bearing the tax burden on trust income. Exercise caution however in trigging this benefit. First, review the trust instrument to determine what if any restrictions may exist on your right to distributions as a beneficiary of the trust. Some DAPTs intentionally prohibit the settlor from receiving any benefit for 10 years (or ten years plus one day) after funding or formation to endeavor to avoid the ability of the bankruptcy laws to reach the trust. Other restrictions might include a minimum net worth, or divorce prerequisite. So be certain that it is permissible before such a distribution is made. Also, the trust must be based in (have situs in) state that recognizes such trusts or the entire plan may bust. A hybrid-DAPT creates a mechanism by which you as the settlor can be added as a beneficiary. Again, be certain that the trust has situs in an asset protection jurisdiction that permits such trusts before that mechanism is triggered (e.g. AK, DE, NV, SD). Also, consider the liability exposure and increased tax risk trigging that option may entail (especially if your home state does not recognize such trusts). Finally, some trusts include a special power of appointment wherein a person in a non-fiduciary capacity may exercise a limited or special power of appointment to direct the trustee to pay money to the settlor. That is why they are called Special Power of Appointment Trusts (“SPATs”). The SPAT is a new creature with perhaps no law directly saying they work so be careful. Any of these mechanisms if they exist may provide you the cash flow necessary to meet the tax costs you are incurring on trust income and which you are uncomfortable with.
Get Paid: Are you as the settlor providing services to entities owned in the trust? In some cases, a family business may have been gifted and/or sold to the trust. If so, that business should pay you arm’s length compensation for any services you provide to the trust. If that was not being done, starting fair and documented payments for those services at a fair market price may help solve some of the cash flow pressure the income tax costs has you feeling.
Pay Down Notes: If you sold assets to the trust for a note making a principal payment on the note might provide some measure of relief from the income tax cost you are feeling.
Sell: Sell illiquid assets to the trust for cash. If you have non-liquid assets (real estate investments, private equity in a startup phase) those can be sold to the trust for cash that is held in the trust. If this makes you more liquid, you can use some of that new liquidity to address the income tax costs.
Borrow from the Trustee: The trustee may be able to loan cash to you even if you are the settlor who created the trust. This may be feasible under the general loan powers a trustee has. If this is done, however, the trustee must balance the needs of other beneficiaries of the trust and the investment allocation of the trust. If you are not a beneficiary of the trust the trustee may only be able to make a loan to you that constitutes a reasonable investment of the trust. If that is the case then the trustee may want to demonstrate due diligence, arm’s length collateral and loan terms, and consider other factors.
Get a Loan Directed by a Powerholder: The trustee may have a special loan provision that gives a person, called a powerholder, the right to loan you as the settlor trust money without adequate consideration. So that person can mandate the trustee to loan funds to you. Some trusts include an express loan provision that provides a person in a non-fiduciary capacity the power to loan funds to the grantor. Often that provision expressly provides that the loan may be made without adequate security. One point of such a provision has been that the existence of that loan power itself can serve to characterize the trust as a grantor trust. Increasingly, loan provisions like that have been intentionally added to trusts not only to support grantor trust characterization but to facilitate funding tax and other cash needs you might have, like the burden of paying trust income taxes. If this later provision is used be sure to charge adequate interest to reduce the risk of the IRS arguing that a no or low interest loan demonstrates a retained right you had in trust assets thereby causing estate inclusion.
Swap: Substitution of assets in the trust for personal assets you are holding in your own name (or in a revocable trust you have, but you might distribute those from the revocable trust into your name first). Many grantor trusts include a swap or substitution power that permits the settlor to exchange non-liquid personal assets for liquid assets in the trust. That swap, similar to the sale discussed above, may permit you to access liquidity to use to pay income taxes. But if this is done be certain that appropriate steps are taken to corroborate that the assets are of equivalent value. That might require a qualified appraisal. The transaction might be structured to include a defined valuation adjustment mechanism, e.g., like a Wandry clause, to adjust if there is later a determination that the values believed at the time of the swap were not correct (that is complicated and too much for this article but your advisers can explain if this is worth considering). Consideration should also be given to reporting such a swap as a non-gift transaction on your gift tax return. Also, if this approach is used with regularity, or even too frequently, some commentators might worry that it suggests an implied agreement to access trust assets. Similar ancillary considerations might be relevant to the sale discussed above and other options.
Distributions to Spouse: Consider whether distributions can be made to your spouse, if your spouse is a beneficiary of the trust (e.g. in a spousal lifetime access trust or irrevocable life insurance trust). But this must be done carefully and clearly within the guidelines of what distribution rights the spouse has under the trust instrument. For example, if the trust only permits distributions to your spouse to maintain his or her standard of living distributions should not be made beyond that level. That type of restriction may prevent you from accessing what you feel you need.
Turn off Grantor Trust Status: Consider whether grantor trust status can be turned off. If that is feasible (not always so simple) then you won’t be liable for the income tax on trust income after that date. Some trusts provide an express power to a named person terminate certain powers that characterize the trust as a grantor trust for income tax purposes. It may also be possible for the people holding those powers to renounce them, thereby collectively ending grantor trust status and your tax burden.
Conclusion
The income tax you pay on a grantor trust you created is a powerful planning tool, but like with all good things, it can sometimes be too much. If there are ways you can access liquidity from the trust to help with the tax cost, that approach may mollify the concern you have. You might be able to have the tax status of the trust changed, but your advisers may be comfortable turning that back on in the future. Also, losing grantor trust status might trigger income tax gains on the transformation of the trust’s status. Finally, losing grantor trust status may be more negative of a consequence then you are comfortable with. What this all means is that you should be meeting with your adviser team at least annually keeping on top of the administration of the trust and all the ramifications. Staying current on issues may give you more time to plan to address them, and permit better operation of the trust so it continues to meet your goals. Most of these trusts and the plans that they are part of are pretty complicated and involve a lot of money.