Tax Law Update 2009-12-01 (1)Tax Law Update 2009-12-01 (1)

Beneficiaries' “hanging” withdrawal right does not interfere with grantor trust status

In Private Letter Ruling 200942020 (Oct. 16, 2009), a trust agreement created four subtrusts: each trust is for one of four children, that child's spouse and that child's descendants. In addition, the taxpayer's spouse was a beneficiary of each of the subtrusts. The taxpayer's spouse served as co-trustee of the trusts with another individual who was non-adverse and neither related nor subservient to the taxpayer under the definitions of Internal Revenue Code Section 672.

The trust provided that the trustee (other than the spouse) may distribute principal and income to the beneficiaries in the trustee's sole discretion and may amend the trust agreement as long as only the taxpayer's spouse, descendants, their spouses or charitable organizations are beneficiaries.

The taxpayer's spouse and children had withdrawal rights over property contributed to the trusts. The spouse's withdrawal right was limited to the lesser of:

After the spouse, each child and their descendants had a withdrawal right over any other property contributed to their respective trust. Their withdrawal rights would lapse by the greater of $5,000 or 5 percent of the value of the trust property on January 31 of each year.

IRC Section 678(a) provides that a beneficiary's withdrawal right (“a power exercisable solely by himself to vest the corpus or the income therefrom in himself”) or a withdrawal right that has been released, may cause the trust to be a grantor trust to the beneficiary. But Section 678(b) provides an exception: Section 678(a) does not apply to a trust if the trust would otherwise be treated as a grantor trust to the grantor under other IRC sections.

The Internal Revenue Service ruled that the trusts were grantor trusts to the taxpayer due to:

As a result, because the trust already was a grantor trust to the taxpayer, the beneficiaries' current, hanging withdrawal rights, and those that were previously released, did not cause the trust to be considered a grantor trust to the beneficiaries.

This conclusion is consistent with several prior PLRs. But this ruling addressed continuing, hanging withdrawal rights, while the prior ones addressed withdrawal rights that lapsed each year.

Self-settled asset protection trust still vulnerable to IRC Section 2036 inclusion

In PLR 200944002 (Oct. 30, 2009), the taxpayer created an irrevocable trust for the benefit of himself, his spouse and his descendants. Under state law, the trust would not be reachable by the taxpayer's creditors: The trust was a self-settled asset protection trust. The trustee, who was not a related or subordinate party under IRC Section 672(c), could distribute income and principal to the taxpayer, his spouse and his descendants in the trustee's sole discretion. The beneficiaries, any spouse of a beneficiary and any related or subordinate party were prohibited from being a trustee.

The trust was a grantor trust to the taxpayer because:

The trustee was prohibited from reimbursing the taxpayer for income taxes for which the taxpayer was liable as a result of the trust being a grantor trust.

The taxpayer requested a ruling on whether transfers to the trust would be a completed gift and whether the assets of the trust would be included in the taxpayer's gross estate. The Service ruled that, because the taxpayer retained no power to vest the beneficial title in himself or to change the interests of the beneficiaries, transfers to the trust would be completed gifts. Apparently, the taxpayer's right to substitute trust assets and his interest as a beneficiary did not prevent gifts to the trust from being complete for gift tax purposes.

The Service declined to rule on the estate tax inclusion question. But the Service did note that the substitution power held by the taxpayer would not, by itself, cause estate tax inclusion. This holding follows Revenue Ruling 2008-22, which provided that as long as the trustee has a fiduciary obligation (under local law or the trust instrument) to ensure that properties acquired and substituted by the grantor are in fact of equivalent value and the substitution power cannot be exercised in a manner that shifts benefits among the trust beneficiaries, the substitution power should not cause estate tax inclusion.

Earlier this year, PLR 200910008 (March 6, 2009) ruled that a power of substitution affected beneficial enjoyment within the meaning of Section 674(a) to cause several trusts to be considered grantor trusts, but it was not clear whether the trusts in that ruling failed to meet the requirements of Rev. Rul. 2008-22. As a result, PLR 200910008 introduced some confusion as to whether a substitution power affects beneficial enjoyment, and, if so, whether such power could be considered a retention of a right to “designate the persons who shall possess or enjoy the property” under IRC Section 2036.

This new ruling, while not directly mentioning PLR 200910008, clarifies that a substitution power should not itself cause inclusion and is in line with Rev. Rul. 2008-22.

Also, because the trustee was prohibited from reimbursing the taxpayer for any income taxes paid, there was no risk of estate tax inclusion from reimbursement (prior Rev. Rul. 2004-64 found that a mandatory tax reimbursement clause does cause inclusion under Section 2036, but a discretionary ability to reimburse the taxpayer, without any pre-existing arrangement to do so, does not).

Further, based on an analysis of Rev. Rul. 2004-64, the Service ruled that the trustee's discretion to distribute income and principal to the taxpayer did not, by itself, cause inclusion under Section 2036, but it refused to rule as to whether such beneficial interest, in combination with other facts, such as an understanding or pre-existing arrangement between the taxpayer and the trustee, could cause estate tax inclusion. (Rev. Rul. 2004-64 also described a grantor's power to remove the trustee and name himself as successor trustee or local law subjecting the trust assets to the claims of the grantor's creditors as other facts, which together with the beneficial interest, could cause estate tax inclusion).

While this ruling is helpful, self-settled asset protection trusts still are vulnerable to a “facts and circumstances” test that risks Section 2036 inclusion.

Family limited partnership assets are included in taxpayer's estate and indirect gifts of underlying assets

In Estate of Malkin v. Commissioner, T.C. Memo. 2009-212, 2009 WL 2958661, the Tax Court ruled on Sept. 16, 2009, against the taxpayer, holding that transfers of two family limited partnership (FLP) interests were in fact indirect gifts of the assets transferred to the partnerships, and that the assets of the partnerships were included in his gross estate under IRC Section 2036.