Over the past decade, the intentionally defective grantor trust has been used to exclude assets from the estate of the grantor while allowing the income tax liability of the trust to be taxed to the grantor. Using this strategy, the grantor sells assets to the trust to effectuate an estate "freeze" and transfers all future appreciation to younger generations. The grantor can also leverage the amount of assets removed from his estate on a tax-favorable basis by paying the income taxes for the trust without having the payment of the trust's taxes (inuring to the benefit of the trust beneficiaries) being considered a gift.

Would it be possible for a grantor to create a trust that would be taxable to a person other than the grantor? If so, what would be the advantage of doing so? One benefit would be that the trust could accumulate income while having a third person (usually a child or grandchild who is in a lower income tax bracket) pay the income tax on the trust's accumulated income. This effectively allows the trust assets to grow tax-free. It also permits the beneficiary to sell assets to the trust without recognition of gain, creating the possibility of using the trust as an estate planning tool for the beneficiary. Finally, if properly designed and administered under the laws of a state recognizing the validity of Domestic Asset Protection Trusts ("DAPTs"), the beneficiary defective trust would also offer asset and divorce protection for the beneficiary.

Trusts that are defective with respect to their beneficiaries are a relatively new development. Many attorneys doing this type of advanced planning have speculated as to whether the Internal Revenue Service would treat a "lapse" related to a withdrawal power granted to the beneficiary as a "release" for purposes of Internal Revenue Code Section 678. PLR 20094012 gives us some insight into the IRS' thoughts on this issue.

Under IRC § 678, a beneficiary who is not the actual grantor nonetheless is treated as the trust's owner for income tax purposes when the beneficiary holds the unilateral right to withdraw the property from the trust. The trust is treated as "substantially owned" by the beneficiary, so the grantor trust rule of IRC § 671 attributes the income, deductions, and credits of the trust to the beneficiary.

The beneficiary's power of withdrawal not only causes the beneficiary to be treated as the trust's owner for income tax purposes, but it also causes the beneficiary to be treated as holding a general power of appointment within the meaning of Internal Revenue Code §§ 2041 and 2514. This means that the property over which the beneficiary holds the general power will be included in the beneficiary's gross estate. The law provides that if a beneficiary releases or exercises the power, the beneficiary will be treated as making a gift (to the extent the power is exercised in favor of someone other than the beneficiary) and/or treated as a transfer for estate tax purposes. Hence, from an estate tax perspective, such a beneficiary seems no better off than the grantor who creates a self-settled trust: in each case, entitlement to income or a power of control causes estate tax inclusion.

But IRC §§ 2514(e) and 2041(b)(2) provide that if the power of withdrawal lapses, it is not a gift (or a transfer for estate tax purposes) except to the extent the power lapses in excess of the greater of $5,000 or 5% of the value of the property over which the power is exercisable in a given calendar year. Over time, the beneficiary gradually will lose the power of withdrawal by reason of the "five and five" lapse, except to the extent additional property is transferred to the trust which is subject to the withdrawal power. The question is whether that lapse causes the beneficiary to lose the status as the trust's owner — that is, does the trust stop being a defective trust with respect to the beneficiary?

IRC § 678(a)(2) provides that the beneficiary remains the owner where the power to withdraw is "partially released or otherwise modified" by the beneficiary and the trust would be a grantor trust if the beneficiary had been the true grantor (e.g., the beneficiary is eligible to receive trust distributions from the trustee). Several Private Letter Rulings indicate that the IRS may view a complete lapse as a partial release. However, these rulings cannot be easily reconciled with the language of IRC § 678 or its regulations. How is a complete lapse of a withdrawal power the equivalent of a partial release or other modification of such power? Is a lapse also a release? IRC §§ 2514(e) and 2041(b)(2) provide that a lapse is a release for purposes of those sections only to the extent the lapse exceeds the five and five level mentioned above. This begs the question of whether a lapse is a release for purposes of IRC § 678. PLR 200949012 suggests there is a way, even if a lapse is treated as a partial release, that the trust could remain "defective" for income tax purposes with respect to its beneficiary.

The PLR indicates that the beneficiary was granted a unilateral right to withdraw all contributions made to the trust (a) for any reason and (b) a right to withdraw trust corpus for the beneficiary's health, education, maintenance and support (HEMS). A unilateral power to withdraw the property for any reason is a general power of appointment but a power to withdraw under HEMS is not, due to the exception of IRC § 2514(c)(1).

In the subject PLR, the IRS notes that, in the beneficiary defective trust, the withdrawal power subject to the HEMS standard that will not lapse and the unilateral power to withdraw for any reason lapses each calendar year in an amount equal to the greater of $5,000 or five percent of the value of the trust. Even if the power to withdraw for any reason fully lapses, the beneficiary still retains the power to make withdrawals for HEMS. As such, the IRS concludes the beneficiary will be treated as the owner of the trust for federal income tax purposes before and after the lapse of the beneficiary's power of withdrawal for any reason.

PLR 200949012 sets forth what appears to be one way to allow a parent to create a trust for a child or grandchild in a manner making the trust a grantor trust with respect to such child or grandchild, even after the power to withdraw all property without restriction lapses. This will permit a beneficiary defective trust to grow free of income tax and without causing the beneficiary to be deemed to be making a gift by paying the income tax on the income taxed to him or her under IRC § 678. If the trust is created in a state which recognizes Domestic Asset Protection Trusts, the beneficiary may also be afforded divorce and asset protection and the trust would be excluded from the beneficiary's estate for estate tax purposes (after complete lapse of the withdrawal power) because the beneficiary's rights to distribution of income or principal from the beneficiary defective grantor trust are limited to an ascertainable standard.

The American Academy of Estate Planning Attorneys, of which our law firm is a member, has developed an ever simpler form of beneficiary defective trust that can provide divorce protection for beneficiaries. We call the trust a "Family Access Trust" because the beneficiary has access to the trust assets, yet while the assets remain in the trust they remain protected from a divorcing spouse of the child or grandchild. The child or grandchild can serve as trustee of the Family Access Trust and invest the trust assets in any manner desired by the child or grandchild – he or she can purchase real estate; stocks, mutual funds or other types of securities, or if so inclined, gold, oil and gas royalties, or other types of inflation hedging investments.

Estate Tax Update

There is nothing definitive out of Congress as of yet, although there have been some efforts to reinstate the estate and gift tax law as it existed in 2009. Congress will need to act soon if it wants to avoid a challenge concerning the constitutionality of reinstating the tax retroactive to January 1. We will keep you updated as to further developments.