• Intentionally Defective Grantor Trusts
  • October 7, 2004 | Author: Katherine M. Reynolds
  • Law Firm: Michael Best & Friedrich LLP - Manitowoc Office
  • Rarely do we promote legal work that is defective, but the intentionally defective grantor trust presents a great opportunity for making tax free gifts. Until recently, there was some doubt about certain tax effects of such a trust, but the IRS issued a ruling in July 2004 confirming favorable tax treatment.

    Background. A "grantor trust" is a trust in which the grantor must include all items of trust income, deductions and credits as part of grantor's individual taxable income, as if the grantor had received the items directly. Even if the trust distributes income to beneficiaries other than the grantor, if it is a grantor trust, the grantor pays the tax on the trust's income.

    The grantor trust rules identify various powers which, if contained in the trust document, will result in the income being taxed to the grantor. In general, if the trust document provides (1) certain administrative powers over the trust under which the grantor can or does benefit, or (2) the grantor or a nonadverse party with certain powers over the beneficial interests under the trust, or (3) the grantor or a nonadverse party with the power to distribute income to or for the benefit of the grantor or the grantor's spouse, then the income of the trust is taxed to the grantor.

    Ordinarily, when a trust is created for other beneficiaries, the grantor tries to avoid being taxed on the trust's income. Nevertheless, there are situations in which it is very desirable for a trust to be a grantor trust. This is accomplished by intentionally drafting the trust to come within the grantor trust rules, thus being an "intentionally defective grantor trust."

    Revenue Ruling 2004-64. The extra benefit of an intentionally defective grantor trust occurs when the grantor pays all of the tax on the trust's income, effectively giving the trust beneficiaries all of the trust income free of tax. There has been some concern that the IRS would treat the payment of that tax by the grantor as an additional gift to the trust or its beneficiaries. In Revenue Ruling 2004-64, the IRS conceded that the payment of income tax by the grantor is not treated as a gift. The ruling involved a trust for the benefit of the grantor's descendants. The trust was structured to be a grantor trust, but otherwise the trust would not be included in the grantor's estate. Thus, the creation of the trust removed the trust assets from the grantor's estate, and the grantor continues to provide additional benefits to the beneficiaries each year, free of gift tax, in the form of the grantor's payment of the taxes on the trust's income.

    Occasionally, the tax benefit of an intentionally defective grantor trust can become burdensome to the grantor. If the trust's investments thrive, the trust can generate significant income, placing a heavy tax cost on the grantor. To help defray that expense, some intentionally defective grantor trusts give the trustee discretion to make distributions to the grantor to cover tax liability. Revenue Ruling 2004-64 specifically acknowledged that such a trust provision by itself would have no adverse tax consequences. On the other hand, if the trust requires that the trustee make distributions back to the grantor to pay the taxes on the trust's income, the Revenue Ruling provides that the trust will be included in the grantor's estate for estate tax purposes. This portion of the ruling applies prospectively only; it does not apply to any intentionally defective grantor trust created before October 4, 2004.

    Summary. This revenue ruling clarifies aspects of the use of intentionally defective grantor trusts for gift and estate tax purposes. There is now more certainty in their use to accomplish the transfer of wealth from one generation to the next at the lowest gift, estate and income tax cost. This revenue ruling also underscores the importance of properly drafted fiduciary powers. These trusts require a clear understanding of the grantor trust rules as well as the estate and gift tax laws.