Tax Law Update 2010-02-01 (1)Tax Law Update 2010-02-01 (1)
Beneficiary is treated as an owner of a trust under Internal Revenue Code Section 678 In Private Letter Ruling 200949012 (Dec. 4, 2009), the grantor proposed establishing a trust for the benefit of another individual. The beneficiary had two withdrawal rights: to withdraw or direct the net income and/or principal to be paid to him for his health, education, maintenance or support (HEMS); and a Crummey
David A. Handler, partner in the Chicago office of Kirkland & Ellis LLP, & Alison E. Lothes, asso
Beneficiary is treated as an owner of a trust under Internal Revenue Code Section 678 — In Private Letter Ruling 200949012 (Dec. 4, 2009), the grantor proposed establishing a trust for the benefit of another individual. The beneficiary had two withdrawal rights:
to withdraw or direct the net income and/or principal to be paid to him for his health, education, maintenance or support (HEMS); and
a Crummey right to withdraw any property transferred to the trust, which lapsed each year in an amount equal to the greater of $z or y percent (presumably $5,000 or 5 percent, the “5 and 5 amount.”)
The trust was drafted to be a non-grantor trust as to the grantor. Under IRC Section 678(a), a person other than the grantor is treated as the owner of any portion of a trust with respect to which such person has:
a power exercisable solely by himself to vest the corpus or the income therefrom in himself; or
such person has previously partially released or otherwise modified such a power and after the release or modification retains such control as would, within the principles of IRC Sections 671 to 677, cause a grantor of a trust to be treated as the owner.
The Internal Revenue Service ruled that the beneficiary would be treated as the owner of the trust under IRC Section 678, before and after the lapse of the beneficiary's Crummey right.
It appears that the two withdrawal rights were designed to fit the requirements of IRC Section 678(a)(2) without triggering estate tax inclusion in the beneficiary's estate. The beneficiary's cumulative withdrawal rights consisted of:
the Crummey right to withdraw contributions to the trust (lapsing by 5 and 5 each year); and
the continuous right to withdraw trust property for HEMS.
Before any lapse of the Crummey withdrawal right, the trust was a grantor trust to the beneficiary under IRC Section 678(a)(1) because of the beneficiary's right to withdraw any property transferred to the trust. Each lapse of the Crummey right constituted a “partial release” of a power to vest the corpus or income in the beneficiary, satisfying the first requirement of IRC Section 678(a)(2).
Eventually, the Crummey rights would lapse in full, but because the HEMS withdrawal right would never end, even the final lapse of the Crummey right constituted only a “partial release” of a power to vest the corpus or income in himself, fulfilling the first requirement of IRC Section 678(a)(2). Because the beneficiary would be treated as the owner of the trust under IRC Section 677(a)(1) if he were the grantor of the trust, the second requirement of 678(a)(2) also was satisfied.
Because such partial release would be limited to the “5 and 5 amount,” and the ongoing withdrawal right was limited by ascertainable standards, there would be no risk of a deemed gift or estate tax inclusion.
Such a trust can be useful for the beneficiary's own estate planning. For example, the beneficiary could use the “sale to grantor trust” technique by selling assets to the trust for his own benefit.
The HEMS withdrawal right alone would not be sufficient to make it a grantor trust under Section 678 based on United States v. De Bonchamps, 278 F.2d 127 (9th Cir. 1960). Therefore, it was critical that the trust be a grantor trust based on the Crummey withdrawal right and its partial lapse.
But the Crummey withdrawal right was only over the dollar value of the property contributed to the trust, which doesn't include income and growth. Treasury Regulations Section 1.671-3(a)(3) says: “If the portion of a trust treated as owned by a… person consists of… an interest represented by a dollar amount, a pro rata share of each item of income, deduction, and credit is normally allocated to the portion. Thus, where the portion owned consists of an interest in or a right to an amount of corpus only, a fraction of each item (including items allocated to corpus, such as capital gains) is attributed to the portion. The numerator of this fraction is the amount which is subject to the control of the grantor or other person and the denominator is normally the fair market value of the trust corpus at the beginning of the taxable year in question. The share not treated as owned by the grantor or other person is governed by the provisions of subparts A through D.” [emphasis added]
Therefore, if the initial gift to the trust is $20,000, the trust will be a wholly grantor trust to the beneficiary the first year. Under the regulation, because the beneficiary would have the right to withdraw the full amount of the gift to the trust by exercising his Crummey withdrawal right, the fraction of the tax items allocable to the beneficiary would be $20,000/$20,000, or 100 percent. Assume that at the start of Year 2 the trust is worth $25,000 and the withdrawal right has lapsed by $5,000. The fraction of the tax items allocable to the beneficiary would be recalculated as: $20,000/$25,000, or 80 percent.
This ruling does not delve into this issue, but it is not clear that the trust will continue to be a 100 percent grantor trust in future years.
The ruling merely concludes, “We further conclude that Beneficiary will be treated as the owner of Trust for federal income tax purposes under §§ 671 and 678, before and after the lapse of Beneficiary's power of withdrawal with regard to any transfer to Trust.”
It's possible that Treas. Regs. Section 1.671-3(a)(3) would apply to make it partially a non-grantor trust as the trust value increases.
Tax Court upholds transfers to a family limited partnership as a bona fide sale and rules on deemed date of death funding for a marital trust — The Tax Court held that a decedent's transfer of stock to a family limited partnership (FLP) in exchange for an interest in the partnership constituted a bona fide sale under IRC Section 2036(a) in Estate of Black v. Commissioner, 133 T.C. No. 15 (Dec. 14, 2009).
In a lengthy opinion, the Tax Court also ruled on the date of deemed funding of a marital trust for the decedent's wife, who died before the marital trust could be funded, and the deductibility of various expenses, including interest on a Graegin loan and the costs involved with a secondary offering of stock used to raise cash to pay estate taxes and fees.
Samuel P. Black, Jr., joined Erie Indemnity Co., an insurance company, when it was first established in 1925, continued to work at Erie until his retirement in 1962, and served on its board of directors until 1997 at the age of 95. Over the years, he acquired a great deal of Erie stock and...
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