Current federal tax law generally permits individuals to make aggregate lifetime contributions to inter vivos trusts in excess of $5 million per individual without any out-of-pocket tax cost. Although the identity of the trustees administering a trust has always been important, the considerable value of property in inter vivos trusts highlights the importance of retaining the ability to remove and appoint trustees to ensure that trusts are managed and administered in accordance with a grantor’s wishes. However, care must be exercised when a grantor retains a power to remove and replace trustees. The Internal Revenue Service has taken the position that a grantor’s retention of a power to remove a trustee and replace it with a related or subordinate party within the meaning of Section 672(c) of the Internal Revenue Code may cause the trust to be includible in the grantor’s estate for federal estate tax purposes because the trustee’s powers will be attributed to the grantor.
Removal Without Court Order
Grantors may want to retain a power to remove a trustee without cause and the need for judicial involvement. While a trustee’s actions may not rise to the level of a breach of fiduciary duty or other malfeasance that would permit a removal, a grantor may have good reason to want to remove the trustee. Examples include unanticipated conflicts; investment performance; trustee responsiveness; the movement of trust administration from a local office to a call center; personal relationships; fees and management costs; the merger of a corporate trustee with, or sale to, another institution or the movement of a trust officer, investment advisor or relationship manager from one institution to another. Most, if not all, of these reasons wouldn’t justify a removal of a trustee by a court.1
Also, obtaining removal of a trustee by a court can be both costly and time-consuming. In addition, if no one holds the power to remove the trustee, the trustee may demand an accounting or a release from beneficiaries before he’ll agree to resign. This situation can be problematic if there are minor or unborn beneficiaries who can’t release the trustee. Many also believe that a trustee who can only be removed for breach may become complacent and perform less than optimally.
According to the regulations under IRC Sections 2036 and 2038, the power to remove and/or replace trustees may result in the trust’s inclusion in a grantor’s estate.
If a decedent reserved the unrestricted power to remove or discharge a trustee at any time and appoint himself as trustee, the decedent is considered as having the powers of the trustee.2
The rationale is that the grantor has made a transfer, and because of the attribution of the trustee’s powers to the grantor, the grantor has retained “the right, either alone or in conjunction with any person to designate the persons who shall possess or enjoy the property or the income therefrom,”3 or that “the enjoyment thereof was subject at the date of his death to any change through the exercise of a power by the [grantor] … to alter, amend, revoke, or terminate.”4
In Revenue Ruling 77-182, a decedent was the grantor of an irrevocable trust in which a corporate trustee distributed trust income to the decedent’s children as the corporate trustee deemed proper in its sole discretion.5 The decedent had the power for life to appoint a successor corporate trustee if the original trustee resigned or was removed by judicial process.6 This ruling held that the value of the trust assets wasn’t includible under Section 2036, stating:
. . . [t]he decedent’s power to appoint a successor corporate trustee in the event of resignation or removal of the original trustee did not amount to a power to remove the original trustee that, in effect, would have endowed the decedent with the trustee’s discretionary control over trust income.7
There was no discussion of related or subordinate parties; however, given that the terms of the trust required the successor trustee to be a corporate fiduciary, it’s very likely that such trustee wouldn’t be related or subordinate to the decedent within the meaning of Section 672(c). Rev. Rul. 79-353 describes the holding of Rev. Rul. 77-182:
. . . the settlor’s reserved power was not a power to remove the trustee which would have been regarded as a retention of the trustee’s powers.8
This statement suggests that a replacement power is permissible, but a power to remove is more suspect. Rev. Rul. 79-353 involved a decedent who retained the power to remove the corporate trustee without cause and substitute another corporate trustee; as in Rev. Rul. 77-182, the trustee could distribute income and/or principal without limitation.9 In contrast to Rev. Rul. 77-182, Rev. Rul. 79-353 seemed to regard the removal power (or the removal power coupled with the replacement power) as the cause of inclusion in the grantor’s estate:
Thus, reservation by the settlor of the power to remove the trustee at will and appoint another trustee is equivalent to reservation of the trustee’s powers.10
Rev. Rul. 79-353 was widely criticized because it ignored a trustee’s fiduciary duties and overlooked the fact that such duties mean that a trustee isn’t necessarily subject to the grantor’s bidding. The Tax Court examined Rev. Rul. 79-353 in Estate of Wall v. Commissioner, which involved virtually identical facts.11 In Wall, the decedent created an irrevocable trust and retained the right to remove the corporate trustee and to replace that trustee with another corporate trustee.12 The court criticized Rev. Rul. 79-353 and held that neither Section 2036 nor 2038 applied to cause inclusion of the trust property in the grantor’s estate because the:
. . . retained power to substitute another independent corporate trustee for [the initial corporate trustee] is not the type of power which would affect the ‘enjoyment’ of the trust contemplated by [IRC Section] 2036(a)(2) or [IRC Sec-
Specifically, the court stated that the power to remove a corporate trustee and replace it with another isn’t an “ascertainable and enforceable power to affect the beneficial enjoyment of the trust property,” as constitutes a Section 2036(a)(2) retained right.14
Another case, Estate of Vak v. Comm’r, considered the grantor’s ability to remove and replace a trustee with a new trustee who wasn’t related or subordinate to the grantor within the meaning of Section 672(c), in the context of whether a gift to a trust over which the grantor retained such powers was a completed gift.15 The IRS argued that the grantor “had the power to replace the trustees with individuals who would do his bidding.”16 The court rejected the IRS’ argument that the gift to the trust was incomplete because the grantor’s retention of the power to remove and replace a trustee gave the grantor complete control over the trust. Importantly, the court noted that the IRS “overstated its position,” citing the related or subordinate limitation.17
As a result of the backlash against Rev. Rul. 79-353 and cases such as Wall and Vak, the IRS issued Rev. Rul. 95-58, which revoked Rev. Rul. 79-353 and modified Rev. Rul. 77-182.18
Related or Subordinate
Subpart E of Part I, Subchapter J, Chapter One of the Code (the grantor trust rules), provides the guidelines for when a trust’s income will be treated as belonging to the grantor for federal income tax purposes. Generally, the grantor trust rules turn on at least one of the following: (1) the power, authority or benefit at issue, (2) the identity of the holder of the power or authority or the beneficiary of the benefit, and (3) whether anyone has an interest in the trust contrary to the exercise of the authority or benefit at issue. Because certain persons are presumed to be subservient to the wishes of the grantor, Section 672(c) defines the term “related or subordinate party” as:
Any nonadverse party who is—(1) the grantor’s spouse if living with the grantor; (2) any one of the following: [t]he grantor’s father, mother, issue, brother or sister, an employee of the grantor; a corporation or any employee of a corporation in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; a subordinate employee of a corporation in which the grantor is an executive.
The ordinary meaning of “related” includes a person’s parents, siblings and descendants.19 However, it’s critical to note that for purposes of Section 672(c), an individual is considered a “related or subordinate party” only if that person is nonadverse. Accordingly, as to a given trust, it’s possible that a parent, sibling or descendant of the grantor won’t be a “related or subordinate party” within the meaning of Section 672(c).
This raises the issue of who’s nonadverse. Section 672(b) defines a “nonadverse party” as any person who isn’t an adverse party; therefore, it’s necessary to understand who constitutes an “adverse party.” An “adverse party” is:
. . . any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust.20
Although trust beneficiaries are typically adverse parties,21 it may not always be clear when a person has a “substantial beneficial interest” in a trust.22 The regulations indicate that:
. . . [a]n interest is a substantial interest if its value in relation to the total value of the property subject to the power is not insignificant.23
Whether one is an adverse party by virtue of having a substantial interest in the trust is “largely a question of fact to be determined with proper regard to the legal principles applicable to the interests created by the trust instrument.”24 Even contingent interests may be sufficient to make someone an adverse party for purposes of the grantor trust rules.25
The strict language of Section 672(a) seems to define “adverse party” as to a power, not as to a trust.
It’s important to note that one can be a beneficiary of a trust, yet not be adversely affected by the exercise or non-exercise of one or more powers.
In Paxton v. Comm’r, one of the co-trustees, the son of the grantor, held a 3.84 percent interest in the trust, and the trustees had the power to revoke the trust and distribute the trust assets to the beneficiaries in accordance with the beneficiaries’ interests.26 The grantor and grantor’s spouse owned the largest share of the trust.27 The court ruled that the grantor’s co-trustee son was a nonadverse party as to his power, as trustee, to revoke because the son’s interest in the trust wouldn’t be adversely affected by the exercise or nonexercise of the trustee’s power to revoke the trust.28 Accordingly, even though the grantor’s son held a beneficial interest in the trust, he was a nonadverse party when one considered his interests in the trust as to the trustee’s power to revoke.
It’s difficult to imagine someone being an adverse party as to the exercise or nonexercise of any trust power while lacking any beneficial interest in the trust. Accordingly, it seems that those without a beneficial interest of any kind will be nonadverse parties. However, one may have a beneficial interest and still be a nonadverse party as to some powers. Stated differently, all who lack a beneficial interest in the trust are nonadverse parties, but not all who have a beneficial interest in the trust are adverse parties as to all powers. The examples provided in the Treasury regulations support this proposition, showing beneficiaries who would be adverse to one power, but not another.29 Another, perhaps more common, example arises if the grantor’s spouse is a trustee and, subject to an ascertainable standard, a permissible beneficiary of the trust. The spouse has a beneficial interest in the trust that will be adverse to most powers addressed under the grantor trust rules; however, he can’t be adverse to the power to distribute trust income to the grantor’s spouse. In sum, the same individual might be an “adverse party” within the meaning of Section 672(c) as to one power, but not to another. Because one individual can actually be adverse as to one power and nonadverse as to another power in the same trust, to refer to someone as being related or subordinate to another individual within the meaning of Section 672(c) seems a misuse of the phrase because Section 672(c) requires that a person be nonadverse, and a person’s status as adverse or nonadverse can only be measured as to a power, not as to an individual or a trust.
Returning to the line of revenue rulings discussed above, Rev. Rul. 95-58 revoked Rev. Rul. 79-353 and modified Rev. Rul. 77-182 to hold that:
. . . even if the decedent had possessed the power to remove the trustee and appoint an individual or corporate successor trustee that was not related or subordinate to the decedent (within the meaning of [Section] 672(c)), the decedent would not have retained a trustee’s discretionary control over the trust income.
Because Rev. Rul. 79-353 has been revoked, its definitive statement that the replacement power alone doesn’t cause the trustee’s power to be attributable to the grantor inclusion, can no longer be relied upon.
How the modified holding affects Rev. Rul. 77-182 is unclear. It can be interpreted in one of two ways:
(1) the original holding of Rev. Rul. 77-182 still stands (that is, a replacement power alone isn’t problematic), but Rev. Rul. 95-58 adds that even if a removal power had also existed, there would be no inclusion, as long as the successor trustee isn’t related or subordinate to the grantor within the meaning of Section 672(c); or
(2) the original holding of Rev. Rul. 77-182 is modified, and now the “related or subordinate” requirement would apply even if the decedent only retained a power to replace the trustee and not a power to remove.
Regardless of which interpretation the IRS will follow, the language of the IRC provides more options for successor trustees than the words “related or subordinate” suggest. A person with the power to remove and/or replace a trustee may see language in a trust agreement prohibiting appointment of a successor trustee who’s “related or subordinate” and may believe that such language prohibits the appointment of any person who’s a parent, child, employee, etc. However, as outlined above, a related or subordinate party must be nonadverse to qualify as a “related or subordinate party” within the meaning of Section 672(c).
The concept of being adverse to a power makes sense within the context of the grantor trust rules. Generally, the purpose of those rules is to include the trust’s income in the grantor’s income if the grantor retains sufficient power or control over the trust, even if that control is retained through other parties. When an adverse party holds the power, that party isn’t likely to bend to the whim of the grantor. Accordingly, generally, when an adverse person holds a power, the income of the trust isn’t attributable to the grantor by virtue of the existence of that power.
The use of this definition from the grantor trust rules also makes sense in the context of whether a power to remove and replace a trustee should cause the grantor to be treated as holding the powers of the trustee for the same reason that an adverse person isn’t likely merely to do the grantor’s bidding. Stated differently, an adverse trustee, even if related by blood or marriage to the grantor (that is, related in the colloquial sense, but not “related within the meaning of [Section] 672(c)”) wouldn’t be the puppet of the grantor. It seems fair to assume that the use of a definition from the grantor trust rules in the context of a grantor’s power to remove and replace trustees was intentional.
There are also technical reasons to conclude that the adverse/nonadverse distinction of Section 672(c) is a part of the IRS’ guidance and that the IRS isn’t merely using the relationships referenced in Section 672(c). First, if the IRS wanted to use merely the relationships, it could have specified the relationships it intended, specifically referenced subparagraphs (1) and (2) of Section 672(c) or cited to IRC Section 267(c)(4).30
As such, if a trust gives the power to appoint successor trustees, provided that no successor may be “related or subordinate within the meaning of [Section] 672(c),” many trust beneficiaries may be possible successor trustees, assuming the trust agreement permits the appointment of individuals. Furthermore, the IRS shouldn’t argue that powers held by the trustee are attributable to the grantor when, for example, a child-beneficiary may be appointed as trustee, because that child isn’t likely to exercise the power according to the grantor’s direction when it would harm such child’s own interests.
It’s unclear which retained powers cause inclusion in a grantor’s estate; however, the safe harbor is broader than it initially appears, according to the IRS. Because a “related or subordinate party” must, by definition, be nonadverse, and many family members (if holding a beneficial interest in the trust) may be adverse as to the powers of a trustee, they may be potential candidates to be named as a successor trustee, even when successors are limited to persons not “related or subordinate” within the meaning of Section 672(c). Accordingly, when defining a power to replace a trustee in a trust instrument, it’s beneficial to mirror the language of Rev. Rul. 95-58, specifically referencing Section 672(c) to define “related or subordinate.” Not only does doing so bring you within the safe harbor of the revenue ruling, but also, in many cases, the very individuals whom your client desires to name as replacement trustees will fall within the class of permissible trustees.
1. The Uniform Trust Code (UTC) allows a court to remove a trustee for “a serious breach of trust,” conflicts among co-trustees or some failure of the trustee to administer the trust effectively. See UTC Section 706. A trustee may also be removed under other circumstances. See ibid.
2. Treasury Regulations Section 2036-1(b)(3); see also Treas. Regs. Section 2038-1(a)(3) (the same language, substituting “had” for “reserved”).
3. Internal Revenue Code Section 2036(a)(2).
4. IRC Section 2038(a)(1). A grantor may serve as trustee without triggering IRC Sections 2036 and 2038. See, e.g., United States v. Powell, 307 F.2d 821 (10th Cir. 1962); Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947); Estate of Budlong, 7 T.C. 256, 762 (1946).
5. Revenue Ruling 77-182.
7. Ibid. The ruling didn’t discuss inclusion of the trust property in the decedent’s estate under Section 2038.
8. Rev. Rul. 79-353.
11. Estate of Wall v. Commissioner, 101 T.C. 300 (1993).
12. Ibid. at 302.
13. Ibid. at 314.
14. Ibid. at 313 (citing U.S. v. Byrum, 408 U.S. 125, 136 (1972)).
15. Estate of Vak v. Comm’r, 973 F.2d 1409 (8th Cir. 1992), rev’g T.C. Memo. 1991-503.
16. Ibid. at 1414 (citing the Internal Revenue Service brief).
18. Rev. Rul. 95-58.
19. The IRC Section 672(c) definition of “related or subordinate” doesn’t include grandparents, aunts, uncles, nieces, nephews or cousins. The exclusion of grandparents is particularly interesting, given that both parents and descendants are considered “related or subordinate,” and other sections addressing relationships, such as the attribution rules for construction stock owners, include ancestors. See IRC Section 267(c)(4).
20. Section 672(a).
21. See Treas. Regs. Section 1.672(a)-1(b) (“ordinarily, a beneficiary will be an adverse party . . . ”).
22. The IRC confirms that holding a general power of appointment constitutes a beneficial interest in the trust. See Section 672(a). Although the IRC doesn’t specify that holders of general powers of appointment have “substantial” beneficial interest, see Section 672(a), it seems that the beneficial interest of the holder of a general power of appointment would be “substantial” in most cases.
23. Treas. Regs. Section 1.672(a)-1(a).
24. D.G. McDonald Trust v. Commissioner, 19 T.C. 672, 690 (1953); see also Paxton v. Comm’r, 57 T.C. 627, 631 (1967) (“the question of adverse interest is essentially one of fact, which must be determined by considering in each case the particular interest created by the trust instrument and the relative size of that interest”).
25. See Treas. Regs. Section 1.672(a)-1(c) (“the interest of a contingent income beneficiary is adverse to a return of corpus to the grantor before the termination of his interest but not to a return of corpus after the termination of his interest”).
26. Paxton, supra note 24 at 630.
28. Paxton, supra note 24 at 632 (1967).
29. See Treas. Regs. Sections 1.672(a)-1(c) and -1(d). For example, an income beneficiary isn’t adverse to the power to return corpus to the grantor after that income beneficiary’s death.
30. See Section 267(c)(4) (“the family of an individual shall include only his brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants”). Accordingly, if the IRS ruling referred to Section 267(c)(4), all ancestors, not just parents, would be included within the definition, and grandparents would be prohibited from being named as successor trustee. Of course, the Section 267(c)(4) definition misses the employee status that can cause one to be related for purposes of Section 672(c)(2).