The Grantor Trust Rules and their Implications May 19, 2009

1. The Grantor Trust Rules and their ImplicationsMay 19, 2009 Presented by: Philip A. Di Giorgio, Esq. & Louis W. Pierro, Esq.

2. Introduction • While all men (and women) may indeed be created equal, all trusts are not created equal, at least for tax purposes

3. Introduction to Grantor Trusts • The income, deductions and credits of some trusts are attributable to grantors • These trusts are known as “Grantor Trusts” (IRC § 671)

4. Motivations for Grantor Trusts • Disparity between tax rates for trusts and individuals • Example: 2009 the top tax rate of 35% is applicable to married couples filing jointly with taxable income of $372,950 or more whereas, in 2009 the top income tax rate of 35% kicks in for trusts with taxable income of $11,150 or more! • Permit the assets of a trust to grow tax free for the benefit of the beneficiaries with the income tax instead being borne by the grantor • Desire to avoid the recognition of taxable gains in transactions between the grantor and a grantor trust

5. Income Tax Filing Requirements • Any taxable income; or • Gross income of $600 or more In general, the trustee of a grantor trust must obtain an EIN for the trust and file an I.R.S. Form 1041 for a trust if the trust has either of the following:

6. Income Tax Filing Requirements • In some cases the trustee of a grantor trust may not need to obtain an EIN number or file a tax return (See Treas. Reg. 1.671-4 for a description of optional filing methods for grantor trusts.)

7. 7 Statutory Triggers for Grantor Status • Reversionary Interest in Excess of 5% • Power to Control Beneficial Enjoyment • Certain Administrative Powers • Power to Revoke • Income for Benefit of Grantor • Person other than Grantor Treated as Substantial Owner • Foreign Trusts Having One or More U.S. Beneficiaries (IRC § 673 thru 679)

8. Basic Categories of Grantor Trusts • Revocable Living Trusts (RLT’s) • Irrevocable Trusts Included in the Grantor’s Estate for Estate Tax Purposes • Intentionally Defective Grantor Trusts (IDGTs) Excluded from the Gross Estate

9. Revocable Trusts (RLTs) • Having a Revocable Trust is like having an alter ego RLT

10. Revocable Trusts (RLTs) • All revocable trusts are classified as grantor trusts • The income, deductions and credits of a grantor trust are attributable to the grantor • Sale of residence by RLT will require grantor to report a capital gain, but grantor will be entitled to claim IRC § 121 exclusion from capital gain • Decedent’s estate may elect to have RLT treated as part of the estate for a limited period of time following decedent’s death

11. Irrevocable Trusts • Common factors which will cause a Trust to be included in a Grantor’s estate for estate tax purposes • Grantor retains the right to possess or enjoy transferred property for life • Grantor retains right to income from transferred property for life • Grantor retains the right to designate who will possess or enjoy the transferred property • Grantor retains the right to alter, revoke or amend the trust

12. Irrevocable Trusts • Grantor retains a reversionary interest in excess of 5% of the value of the transferred property as of the date of death • Grantor deemed to have general power of appointment over trust assets • Grantor has retained an incident of ownership over an insurance policy transferred to a trust • Grantor transfers or otherwise relinquishes any of the aforementioned powers within three years of death

13. Examples of Irrevocable Trusts Included in Gross Estate • Grantor Retained Annuity Trusts (GRAT’s) • Qualified Personal Residence Trusts (QPRT’s) • Charitable Lead Annuity Trusts (CLATS) • Irrevocable Medicaid Trusts with Retained Income Trusts

14. Treatment of GRATs • GRAT treated as a grantor trust as to income because GRAT payments must be made from trust income • GRAT treated as a grantor trust as to principal if grantor retains testamentary power to appoint accumulated capital gains • Retention by grantor of reversionary interest having value in excess of 5% of GRAT at time of transfer makes trust a grantor trust as to principal

15. Treatment of GRATs • If GRAT is treated as grantor trust, then there will be no recognition of gain in regard to transfers between the grantor and the GRAT • If grantor does not survive trust term, the assets of the GRAT will be included in the grantor’s estate • The method of calculating the portion of the GRAT included in grantor’s estate is set forth under Treas. Reg. 20.2036-1(c)(2)

16. Treatment of QPRTs • All income of a QPRT must be paid to the grantor • All QPRTs are grantor trusts as to income • QPRT in which the grantor has retained a testamentary power of appointment over principal or a reversionary interest in excess of 5% of QPRT, will be a grantor trust as to principal • In the event that the grantor does not survive the trust term, the assets of the QPRT will be included in the grantor’s estate

17. Treatment of CLATs • Grantor of CLAT may only claim income tax deduction for assets transferred to CLAT if trust is a grantor trust • If CLAT is a grantor trust; income of CLAT is attributed to grantor • CLAT may be included in grantor’s estate if grantor does not survive trust term and transfer is deemed not to be a completed gift, or if grantor retains too much control over charitable beneficiary

18. Treatment of Medicaid Trust • Trust with retained income in grantor is grantor trust as to income • Medicaid trusts can become grantor trusts as to principal by giving grantor a testamentary special power of appointment (SPOA) over corpus • Retained SPOA has convenient side effect of making transfers to such trusts incomplete gifts for gift tax purposes • Such a trust is included in grantor’s estate

19. Intentionally Defective Grantor Trusts • Grantor Trusts Excluded from the Gross Estate - commonly known as IDGTs • Trusts designed as IDGTs include: • Irrevocable Life Insurance Trusts (ILIT’s) • Dynasty or Generation Skipping Transfer Tax (GST) Trusts

20. IDGT No Recognition of Asset Gain • In general, assets transferred to a grantor trust retain the character and tax basis for income tax purposes, as they had in the hands of the grantor just prior to the transfer • A notable exception to this rule is the case of Rothsteinv. United States, 735 F. 2d 704 (2d Cir. 1984) • However, the IRS indicated it will not follow Rothstein in Rev. Rule. 85-13, 1985-1 CB

21. What does this mean for taxpayers? • Taxpayers may generally rely on Revenue Rulings published in the Internal Revenue Bulletin • In addition some commentators have indicated that IRS decision not to follow the Rothstein case in IRS Rev. Rul. 85-13 will be applied by the IRS even in the second circuit where the Rothstein case was decided

22. Irrevocable Life Insurance Trusts • ILITs are one of the most common Intentionally Defective Grantor Trusts in use • Transfer existing life insurance policy to ILIT or gifting cash to enable the trustee to pay premiums on new policy • Goal - assets excluded from grantor’s estate

23. ILIT as Grantor Trust • Retention by grantor of a power to substitute property of equivalent value for trust property may trigger grantor trust status • Power to substitute held by grantor in a fiduciary capacity will not cause estate tax inclusion but will not trigger grantor trust status • In a recent ruling IRS held power to substitute retained by grantor in a non-fiduciary capacity, would not cause inclusion in grantor’s estate • Withdrawal power would ordinarily make beneficiary a grantor, as to the portion of the trust over which power is held • Beneficiary will not be treated as grantor, if trust is already being treated as grantor trust as to grantor

24. Exchanging or Transferring a Policy • If the goal is simply to retire an insurance policy which has outlived its usefulness in exchange for a policy of similar value which is more in tune with the current needs of the trust an IRC § 1035 exchange may be appropriate • If insurance policy has accumulated significant cash value, the trustee must seriously consider the transfer for value rule which could require recognition of income by the grantor upon the sale of the policy • In order to avoid transfer for value rule, consider sale of policy to a grantor trust

25. Dynasty Trusts (GST) • Commonly used for generation skipping transfer tax planning • Transfers of assets by gift or sale to a GST trust are like transfers to a GRAT in that both techniques are referred to as an “Estate Freeze” • Success of GRAT tied to ability of GRAT assets to out perform IRC § 7520 rate • Success of sale to GST trust depends on ability of trust assets to out perform the applicable federal rate in effect at the time of transfer

26. Dynasty Trusts (GST) • As is the case with GRATs, if a GST trust, is designed as a “grantor trust” for income tax purposes, a sale by the grantor to that trust will not be recognized for tax purposes • Unlike the GRAT a transfer to a GST trust designed as an IDGT can be used as an effective generation skipping transfer tax planning tool • In contrast to GRAT, if grantor dies during term of note issued by GST trust, only the balance of note & any accrued interest will be included in grantor’s estate • Unlike the GRAT or the QPRT, it is hoped the GST trust will last for generations

27. Tax Basis of Transferred Assets • Assets transferred gratuitously to a grantor trust have the same tax basis in the hands of the trustee immediately after the transfer as they did in the hands of the grantor immediately before the transfer.

28. Relieving Income Tax Burden • Release of grantor trust power by the grantor can cause adverse tax consequences when the trust holds assets subject to debt in excess of basis • A disinterested party, such as a trust protector, can be granted the power to toggle off the grantor trust provisions without triggering adverse tax consequences • One safe (though expensive) way to toggle grantor trust provisions back on once they have been toggled off, or add them where they previously did not exist, would be through a trust reformation • A disinterested trustee could be given the discretion to reimburse the grantor from trust assets for the amount of income tax attributable to the grantor from the trust

29. Tax Consequences of Termination • Release of Grantor Trust Powers During the Grantor’s Lifetime: Grantor will be required to recognize gain to the extent that the balance of any debt deemed to be assumed by the trust exceeds the grantor’s adjusted basis in the trust at the time the trust ceased to be a grantor trust

30. Termination Due to Death • Grantor trust ceases to be a grantor trust upon the death of the grantor • The tax consequences of the death of the grantor while a note issued by a GST trust or other IDGT is still outstanding are less universally agreed upon • Some commentators believe that the basis of the trust assets upon the death of the grantor will be the same as the trust’s adjusted basis in the assets just prior to the death of the grantor

31. Termination Due to Death • Other commentators believe that trust assets should acquire a step up in basis upon the death of the grantor • Given the uncertainty of the potential capital gains which may be triggered by the grantor’s death, the best approach may be to make every effort to ensure that the note is paid off prior to the date of death

32. Conclusion The grantor trust is a powerful estate planning tool which offers practical and beneficial solutions to a wide variety of planning objectives

33. Questions? 20 Corporate Woods Blvd., Albany, NY 12211 Phone: 518-459-2100 l Toll Free: 866-951-PLAN l Fax: 518-459-2200 www.PierroLaw.com