Grantor’s power to substitute trust property didn’t trigger inclusion in estate – Rev Rul 2008-22, 2008-16 IRB 796
Mike Habib, EA
myIRSTaxRelief.com A new revenue ruling concludes that the corpus of an irrevocable trust that a grantor created during life is not includible in his gross estate under Code Sec. 2036 or Code Sec. 2038 on account of the grantor having retained the power, exercisable in a nonfiduciary capacity, to acquire property held by the trust by substituting other property of equivalent value.
Observation: This ruling is good news for anyone who wants to set up a defective grantor trust – a trust intentionally structured so that the grantor, rather than the trust or its beneficiaries, will be taxed on the trust’s income without the trust being included in the grantor’s estate. Under Code Sec. 675(4), a grantor’s power to substitute property causes trust income to be taxed to the grantor and is commonly used to create a defective grantor trust. The new ruling gives this technique a big boost by making it clear that such a power of substitution won’t cause inclusion in the grantors’ estate.
Background. Under Code Sec. 2036, a decedent’s gross estate includes transfers under which he retained the possession or enjoyment of, or the right to the income from, the transferred property. The decedent need not have a legally enforceable right, but there must be an agreement, either expressed or implied, that the decedent will retain the benefit. Under Code Sec. 2038 , a decedent’s gross estate includes a lifetime transfer if the enjoyment of the transferred property was subject at his death to any change through the exercise by him of a power to alter, amend, revoke or terminate. This includes any power affecting the time or manner of enjoyment of property or its income. Inclusion is not required under Code Sec. 2036 or Code Sec. 2038 if the transfer was a bona fide sale for full and adequate consideration.
Facts. In Year 1, Danny, a U.S. citizen, established and funded an irrevocable inter vivos trust (Trust) for the benefit of his descendants. Danny is barred from serving as Trustee. Danny has the power, exercisable at any time, to acquire any property held in Trust by substituting other property of equivalent value. The power is exercisable by Danny in a nonfiduciary capacity, without the approval or consent of any person acting in a fiduciary capacity. To exercise the power of substitution, he must certify in writing that the substituted property and the trust property for which it is substituted are of equivalent value.
Under local law, Trustee has a fiduciary obligation to ensure that the properties being exchanged are of equivalent value. If a trust has two or more beneficiaries, under local law, the trustee must act impartially in investing and managing the trust assets, taking into account any differing interests of the beneficiaries. Further, under local law and without restriction in the trust instrument, Trustee has the discretionary power to acquire, invest, reinvest, exchange, sell, convey, control, divide, partition, and manage the trust property in accordance with the standards provided by law.
Danny dies in Year 2.
Inclusion not required. IRS noted that, under the posited facts, the trust instrument expressly prohibits Danny from serving as trustee and states that his power to substitute assets of equivalent value is held in a nonfiduciary capacity. IRS thus noted that Danny is not subject to the rigorous standards attendant to a power held in a fiduciary capacity. However, the ruling went on to observe that the assets Danny transfers into the trust must be equivalent in value to the ones he receives in exchange. In addition, Trustee has a fiduciary obligation to ensure that the assets exchanged are of equivalent value. As a result, Danny cannot exercise the power to substitute assets in a manner that will reduce the value of the trust corpus or increase his net worth. Further, in view of Trustee’s ability to reinvest the assets and his duty of impartiality regarding the trust beneficiaries, Trustee must prevent any shifting of benefits between or among the beneficiaries that could otherwise result from a substitution of property by Danny. Under these circumstances, the ruling concluded that Danny’s retained power will not cause the value of the trust corpus to be included in his gross estate under Code Sec. 2036 or Code Sec. 2038.