FacultyFaculty/Author Profile

Income Taxation of Trusts, Estates and Beneficiaries


SANFORD SCHLESINGER: OK. Welcome back and we're ready for our last subject. And I was apologizing to Alan because it's a very important subject and is much more important as time has gone on. I was telling Alan anecdotally that NYU taxes, which I've been doing forever, one year assigned me to do this subject and they used it in addition to starting on Sunday afternoon running through Friday night. Every night, they would have a session as well from 6:00 to 9:00 and assigned Sections 671 through 679 to me as my subject, OK?

This was long enough ago that nobody even knew what these subjects were, OK? Now it's among the most important subjects, especially with the-- I'll editorialize that-- the egregious taxation of trusts at $12,700, or $12,500 on ordinary income. The income taxation of trusts, estates, and beneficiaries is extremely significant.

And we're lucky to have Alan Halperin here, who is a partner and co-chair of the Personal Representation Department in the New York office of Paul Weiss, Rifkind, Wharton & Garrison. Alan has been an adjunct professor at NYU School of Law. He has taught at Heckerling. He's presented the [INAUDIBLE] lecture at the New York City Bar. He's a fellow of the American College of Trust and Estate Counsel and former chair of the Trusts, Estates, and Surrogate's Courts Committee, now called the City Bar. And I give you Alan Halperin.

ALAN HALPERIN: Thank you, Sandy. Today's topic is Subchapter J. These rules, even by ordinary tax standards, tend to be somewhat dense, and so my goal for the next 55 minutes or so is to break down the rules in a fashion that might be readily understandable. I'd like to create a framework for you to help you analyze and remember the Subchapter J rules.

Where relevant, we have issues or rules, I'd like to describe the background or the perceived abuse that the statute or the rule was designed to address. I'd like to explore recent tax developments. And finally, throughout the presentation, I'd like to highlight planning opportunities. And throughout, if you have questions, just raise your hand, and I'm going to try to engage you with my own questions.

The fundamental principle of any fair tax system is developing a system that creates a fear allocation of the tax burden among the persons benefiting from the income. So we want to-- Subchapter J is designed to have a fair allocation of the tax burden among the parties who are benefiting from the income. But there are challenges in achieving that result. The person who will receive the income might not be known.

There are differences in trust, as you know, on a temporal basis. You have current beneficiaries and you have future beneficiaries. You may have classes of beneficiaries within the same class or different classes. So throughout Subchapter J, there are these sets of rules imposed to try to achieve this fair and reasonable allocation among the parties.

Does anybody know, outside of Subchapter J, what the predicate is for the rules that we're going to examine? So I'm to ask you-- it's not a code provision in Subchapter J. It's outside of Subchapter J. Do we know how it arrived?

Well, under Section 102(a), gifts and inheritances are not subject to income tax. That's 102(a). 102(b) tells us that the rule that I just described, 102(a), does not apply with respect to income earned with respect to gifts and inheritances. So Subchapter J is designed to set up these rules that distinguish on the one hand gifts and inheritances, which are not subject to income tax, and income with respect to gifts and inheritances, which would be subject to income tax. And then to allocate the income or the taxation of the income among the parties that are benefiting. So all I ask is that as you go through the rules and you think about it, think about these overriding principles.

And as Sandy said, one type of trust that we're all familiar with is the grantor trust. That's throughout Sections 671 to 679. And then we have non-grantor trusts, or estates, and the non-grantor trusts and estates in turn are divided into three different categories. We have simple trust, complex trust, and charitable remainder trust. And we're going to go through each one of those.

We all are accustomed to a tax system that is based on an entity-based approach. So you and I, we are taxed as individuals. So that's one level of tax there. Another example might be the corporate tax. That's a tax at the corporate level.

We're also accustomed to a conduit approach, and the conduit approach is where the entity really doesn't pay its own tax. In large part, it's passed through the tax attributes to the members. An example of that is obviously a partnership.

Subchapter J borrows from both of these concepts. It starts out as an entity-level tax. We know that because Section 641 talks about a separate tax on the trust or the estate. It further says that the tax is computed just like the tax in you and I are computed, but on the other hand, there is a special deduction that passes out certain tax attributes to beneficiaries. And that distribution deduction, as we all know, is under Section 651 if it's a simple trust and 661 if it's a complex trust, and at the same time, the beneficiary has income inclusion. And these rules are designed to have one level of tax that's either at the trust or estate level or the beneficiary level, not multiple taxes.

And like most taxes throughout the code, on one level, it's pretty simple. You start out by computing the gross income. You take deductions. Whatever's left over, you have a tax rate, and then you apply credits to it. And Subchapter J is no different.

But the difference after you go through that general paradigm is that you have these rules with defined terms-- and I'm just going to go through some of the defined terms and rules. I don't want to burden you at this late hour of a two-day seminar because most of these rules are in the outline and I will point out where in the outline you can find them. The linchpin of Subchapter J is Distributable Net Income or DNI.

DNI has a primary function of carrying out sources of income to the beneficiaries that have received distributions. And there are two important elements of DNI. One is its quantitative element, which tells you how much income is being passed out, and you have the qualitative element, which tells you the nature of the income. DNI is generally computed by starting out at gross income or taxable income and then making some adjustments. And these adjustments are designed to come close to but not necessarily exactly reach fiduciary accounting income.

Why do we think there is this concept of DNI that looks a little bit like fiduciary accounting income? The answer is because, remember, the whole point is coming up with a rational system that allows for us to tax either the estate or the beneficiary of this one level of tax, and so the thought is, if you have something that starts out as a tax concept and we morph it into somewhat of an income accounting principle, that would help us determine who are the beneficiaries and who is benefiting.

So you start out with taxable income. You make a bunch of adjustments. Those adjustments are on Page 5 through 7 of the outline. The general rule is that capital gains are not part of DNI, but again, as mentioned in the outline, there are exceptions to that rule. The fiduciary accounting income principle is DNI estate law cousin. It varies from state to state and it is similar to DNI but there are some critical differences. And that comes into play throughout Subchapter J.

A couple of principles to bear in mind. One is, generally speaking, for simple trusts, the deduction at the trust level is limited to the lesser of fiduciary accounting income and DNI. The other important thing is throughout the code, whether it's Subchapter J or anywhere else, please focus on both defined terms and references. So throughout Subchapter J, we have words like income, taxable income, distributable net income, and they mean different things depending upon the context.

In Subchapter J, with one major exception, income, unless it's modified by distributable or taxable or gross, means fiduciary accounting income. With one exception, income, unless preceded by distributable net, gross net, things like that means fiduciary accounting income. The one major exception is that in Sections 671 through 679, the grantor trust rules, for some reason, Treasury has switched the assumption and income there means taxable income.

That distinction offers up some planning opportunities. For example, does anybody here wrestle with foreign trusts from time to time? So we know with foreign trusts that you have a problem if the trust has accumulated income for a period of time and then makes a large distribution to a US beneficiary. Under the throwback rules, that distribution could very well carry out Undistributable Net Income, or UNI, and Undistributable Net Income can lead to adverse tax consequences in two ways. One, any accumulated capital gains are recast as ordinary income and therefore taxed at a higher rate, and two, there's an interest charge.

However, if you dig into the throwback rules, which is not part of Subpart E, which is the grantor trust rules, what you learn is that you cannot have UNI carried out unless the distribution exceeds income. And income, as we just went through, is fiduciary accounting income. So as a result, you could have a large distribution and may not be subject to UNI or throwback rules if the distribution does not exceed income.

And income is a state law concept. It's usually distributions from an entity, unless the distribution is considered a liquidating distribution. So you could envelop assets in an LLC, have a large fiduciary accounting income, distribute it out to the beneficiary. That distribution won't exceed fiduciary accounting income, and even if you've had accumulated DNI, there should be no application to the throwback rule in that year. I point out that example only to emphasize the importance of focusing on the defined terms and the references, whether we're talking about Subpart E or talking about the rest of Subchapter J.

So in order to have a simple trust, you need to simply have three requirements. One, all the income must be required to be distributed, and that's again fiduciary accounting income. There can be no charitable contributions and there can be no distribution in excess of current income. That's called a simple trust and the more detailed rules are on Pages 12 to 14. I'll stop there to ask a question, do we know why we have these rules for simple trusts? Why do we have this simple rule, when in reality, if you work through the plumbing of the complex trust rules, you more or less will come to the same result?

The answer is, in 1954 when many of these rules were developed, it was not uncommon for a trust to require all income to be distributed. Nowadays, I assume, other than marital deduction trusts, most of us probably do not drive trusts that mandate all income to be distributed. But back in the day, that was the practice. And Congress wanted to come up with a simple approach that didn't require going through all the plumbing-- obviously this was before the computers did all the work-- and therefore, this was a simple way of calculating the tax.

And then we have the complex trust rules, which I describe on Pages 14 to 16 of the outline. And there are tier systems, and again, I don't want to burden you at this late hour. Suffice to say the rules are more detailed but the result is more or less the same-- if you have a distribution or a series of distributions that exceed DNI, the beneficiaries in some ordering fashion that are set forth in the complex trust rules 662 and 652, they pick up the income and the trust gets a deduction.

If you run through the same principle-- if you have a simple trust, as I mentioned before, and you run through the numbers through the complex trust rules, you likely will come up with the same result. The only difference might be, with a simple trust, for example, you're going to get a distribution deduction and the beneficiary is going to pick up income regardless if the income distribution is made timely. Furthermore, there are certain benefits or flexibility that you have with a complex trust that you may not have with a simple trust. One example is, if a distribution is made within 65 years of the close of a tax year, under certain circumstances, you can elect to have that rolled back into the prior year.

Very important concept in Subchapter J is the charitable deduction rules and that is Section 642(c). It is different from 170 in several respects. First of all, there is no limitation on the percentage that is eligible. You could have a distribution deduction of 100% of the trust income if in fact 100% is distributed. In addition, when individuals make gifts to foreign charities, do we get an income tax deduction under 170? The answer to that is no. But if a domestic trust makes a contribution to a foreign trust, you get a 642(c) deduction.

SANFORD SCHLESINGER: For foreign charity.

ALAN HALPERIN: For our foreign charity, yes.

SANFORD SCHLESINGER: It may not be a trust.

ALAN HALPERIN: Right, it may not be a trust. I apologize. I meant when you have a domestic trust making a contribution to a foreign charity, 642(c) allows for the deduction. The deduction is 100% with one exception. If you have something called unrelated business taxable income, you don't get a deduction under 642(c) for that. Instead what happens is you then separate it and you get a 170 deduction-- well you get a deduction under 581 but it's computed akin to 170.

So if you have $100 distributed and it was deemed to be $60 of regular income and $40 of UBTI, the $60 would be fully deductible under 642(c). The $40 would not be deductible under 642(c). It would be deductible under 581. And then you would have to apply the 170 limitations and only 30% of the $40 in that example, or $12, would be deductible.

There are other very critical requirements. One of the requirements is that the payment must be made pursuant to the trust document. And there's been a fair amount of litigation and rules dealing with this one issue. For example, suppose I have a trust that somebody has a lifetime power of appointment and the person exercises the power of appointment in favor of charity. Is the exercise of the power of appointment pursuant to the terms of the trust? Yes, there are some favorable rulings dealing with that, and they're all described in the outline.

Suppose instead that the trust allows for distributions to charity and they're so made but it wasn't pursuant to the original terms of the trust. Rather, there was a reformation of the trust. The IRS's position is that in such circumstances, that does not meet the pursuant to terms test under 642(c). I question whether or not that's true, because in fact, it is pursuant to the terms. It's pursuant to the reformed terms.

The question then that's raised, can you skirt that result possibly by decanting the trust into a new trust that-- to the extent that decanting is permitted-- that allows for charity to be a beneficiary, maybe pursuant to giving a beneficiary a lifetime power of appointment? That's permitted under Delaware law, for example. So if you have a Delaware trust, you can decant into a trust that gives a beneficiary a lifetime power of appointment in favor of charity even if that authority was not granted in the original trust. And query whether or not such a new trust would be challenged by the IRS.

SANFORD SCHLESINGER: Well one of the other questions here, IRS says you have to give guidance on decanting.

ALAN HALPERIN: That's correct.

SANFORD SCHLESINGER: They were hot on it three or four years ago and now it's not really-- is it on the guidance plan, even?

ALAN HALPERIN: They've removed it from the guidance plan.

SANFORD SCHLESINGER: They've removed it from the guidance plan. So you do it at your own risk.

ALAN HALPERIN: Another very important requirement is that it has to be made from gross income. The payment must be from gross income, which means there's a level of tracing involved. And as a result, there are a bunch of cases out there where the IRS has denied and courts have upheld the IRS's determination that a grant of a conservation easement would not give rise to a charitable deduction under 642(c) because the conservation easement really is a grant out of principal, not out of gross income.

There is a recent case, the Green case, that's described in the materials. There, the trustee acquired trust property with gross income. That's important. It was with gross income and the trustee could establish that. The property then appreciated in value and then the trustee contributed the property, pursuant to the trust terms, to charity. And the question was, what was the 642(c) deduction? The taxpayer took the position that the deduction equaled the fair market value of the property. The court finally determined that it was equal to cost basis because that was the amount that could be traced to gross income.

The last point on 642(c) is-- is everybody familiar with electing small business trusts? So we know that that's a special type of trust that holds Subchapter S, stock. Even if the trust does not allow contributions to charity, if you have a passthrough entity, whether it's an ESBT or a partnership, then it will be deemed to be pursuant to the terms if the underlying entity, the partnership or the ESBT made the contribution pursuant to its applicable state law. But recently, they changed the rules for ESBTs to say, until 2025, under the new tax regime, you don't look at 642(c) for ESBT trust. What you do instead is you look at 170.

There's a lot of history behind Section 67. Rather than spend a lot of time combing through the history, let me just jump to the chase. We know that under Section 67(a), the general rule is that miscellaneous itemized deductions are allowed but only to the extent they exceed 2% of adjusted gross income. We know that under Section 67(e) that if expenses are attributable to a trust that is not subject to the 2% rule and that subject had been the subject of enormous litigation and regulations, and the rule now means that if the expenses are unique to trusts-- and for example, investment advisory fees are not unique to trusts-- then if it's only unique to trusts, then you're not subject to the 2% rule. I'm sorry, if it's unique to trusts, you're not subject to it, but if it's commonplace because you as an individual who had similar assets would engage in the same type of expenses, then we're subject to the 2% rule.

Then comes along Section 67(g) that says until 2025, you're not allowed to even deduct miscellaneous itemized deductions if you're an individual. And there was a big brouhaha about whether or not this rule, Section 67(g), somehow adversely affected the ability under Section 67(e) that allows us to take expenses that are unique to trusts as deductions. And then Treasury came out with the recent notice, 2018-61, that confirms that Section 67(g) will not adversely impact the ability to take 67(e) deductions.

And the rationale for that is-- you really have to dig into the code hard, but the rationale for that more or less is that 67(e) affects adjusted gross income. For the accountants in the room, that means it affects above-the-line items. Miscellaneous itemized deductions are below the line. And therefore, the way the plumbing works in Section 67 is that the 67(e) deductions are effectively above the line and therefore not adversely affected by Section 67(g). But again, there aren't that many expenses that meet that requirement anyway.

SANFORD SCHLESINGER: Well the bottom line, though, do you agree with me that trustee's commissions, legal fees necessitated by the fact that it is a trust, are still deductible despite the abolition of the 2% miscellaneous item?

ALAN HALPERIN: Well certainly I agree with you as to legal fees are deductible. As to trustee's commissions-- I mean, I'd be interested in people's-- your view-- but I'm under the impression that if the trustee is in addition, part of the fee relates to investment advisory services. So if you have a corporate trustee that's charging x but part of x relates to what would otherwise charge for investment advisory services and managing the money, that that part would not be deductible. That you'd have to unbundle it.

SANFORD SCHLESINGER: What about the argument that those advisory services were only necessitated by the fact that there was a trust?

ALAN HALPERIN: I think that--

SANFORD SCHLESINGER: We're back to the bundling issue. We're back to the whole issue on the 2% floor in relation to estates and trusts is where we're going, but what about the argument that I don't have to have an investment advisor, you don't have to have an investment advisor, but as trustee, I have to be or have an investment advisor.

ALAN HALPERIN: So that rule had been argued quite extensively, saying that a trustee has fiduciary obligations, an individual does not. And the courts have rejected that position and Treasury has rejected. The only situation if there is a unique element so the trust mandates a certain type of investment structure that might not be common with individuals. Yes?

AUDIENCE: [INAUDIBLE] preparation or the preparation of a trust or estate accounting?

ALAN HALPERIN: So do we have accountants in the office? And what-- so what do you do?

AUDIENCE: Well up until the change in the law, first of all, I've been working for a law firm, and although I'm an accountant, it gets billed under one fee with the legal fee, but I'm going to be working for an accounting firm soon. I'm just wondering if you're just an accountant preparing the trust or estate.


ALAN HALPERIN: I believe that that is deductible.

SANFORD SCHLESINGER: Well you wouldn't have had a 1041 if you didn't have a trust, right?


SANFORD SCHLESINGER: So that one sort of works easy for me, OK? You wouldn't have had an accounting. I didn't have to do an accounting. the trust or estate does have to do an accounting. Whether a financial statement, yeah, that should be deductible too because I wouldn't have needed it had I not had a trust. So I really can't think-- there may be an accounting function that doesn't qualify. I think you're almost on safer ground for accounting fees than legal fees if you want to know the truth.

ALAN HALPERIN: You wanted to hear that but it's not a formal opinion. You have to hire [INAUDIBLE] for that. I'll just mention one item, given the time constraints, about the 65 day rule. Why is that-- actually, not the 65 day rule. I'm going to-- one item on the paying less than three installments. Why is that rule in the code?

Remember when I started out by telling you that the predicate to Subchapter J is, under 102(a), principal distributions or gifts are not subject to income tax but the income on such principal is subject to income tax. And the thought is that if something could be paid in three or less installments and it's a specific item, that that more looks like a specific request or property that shouldn't be subject to income tax. And again, there's an opportunity here. If you have a foreign trust, even if you were going to make a distribution that otherwise would carry out large accumulated undistributed income, if it's done pursuant to the trust terms in three or less installments, that should be outside the tier system and would not carry out any DNI and therefore would not carry out any UNI.

Given the limited amount of time, let's jump ahead briefly to grantor trusts. So we know that a grantor trust is a trust in which due to certain powers or rights either the grantor himself or herself or beneficiary is treated as the owner. These provisions are overly extensive-- in fact, far more extensive than the estate tax grantor trust rules-- in large part because they were also developed in 1954 at a time when there were 20-- count them, 20-- different tax brackets that ranged from 20%-- or actually, there were 24 different tax brackets-- that ranged from 20% to 91%.

And this was an effort-- these expansive grantor trust rules-- to use as a weapon to stem people from moving income out to people who had lower income tax brackets. So if the grantor himself or herself was at a 90% tax bracket and can create trusts that would be at a lower tax bracket, it was very effective. So the grantor trust rules for income tax purposes are considered to be quite extensive.

But we now use them as our own weapon because we know that the income tax brackets are truncated. Unless we're dealing with state income tax, in most instances, grantor trust is a good result. There are instances where you'd want a complex trust so you could avoid state income tax, but in many cases, we embrace that.

So how do we-- there are two very significant rulings in this area. So if you walk away saying, I only learned two rulings in the grantor trust area, what would they be? The first one is revenue ruling 85-13 and that generally stands for the proposition that a transaction between a grantor and his or her grantor trust is a nonevent for income tax purposes. Can anybody tell me where this comes up in practice and why it's so important? Yes?

AUDIENCE: Sale to a defective grantor trusts.

ALAN HALPERIN: Sale to a defective trusts. Anybody else?


ALAN HALPERIN: Grats. The annuity payments. So the transaction is not a realization event, but if it were a complex trust, that if you transferred appreciated property in satisfaction of an obligation, you would have a taxable event. If the grantor is renting property-- he or she may have transferred residential property to a trust and now is leasing it back-- those rental payments are not taxable income to the trust and therefore we avoid tax on cash that's now going into the trust.

SANFORD SCHLESINGER: As long as it's still a grantor trust at that point.

ALAN HALPERIN: That's right. It's critically important that it's a grantor trust. And of course, you mentioned the sale defective grantor trust. The beauty behind this is not only is the sale itself not an income tax event, but if it's done with a promissory note, the ongoing interest payments on the note will not give rise to a taxable event.

The other critically important revenue ruling in the grantor trust area is revenue ruling 2004-64. That ruling stands for the proposition that-- well two propositions. One, that when the grantor in fact pays the income tax attributable to the trust income, that that itself is not a further gift subject to gift tax. We all assume that to be the case but there was some concern that the IRS may not agree.

And the second element is that if the trustee has discretionary authority-- not mandatory rights but discretionary authority to pay the grantor or discharge the grantor as income tax liability, if it's discretionary and other things that are taken into account, it's not going to result in the state tax inclusion. What is that critical other thing or other things that have to be taken into account?

Well I can think of two. One, it's critically important that the grantor not be deemed to be a beneficiary, because if the grantor is deemed to be a beneficiary, we know that in most jurisdictions, that means the trust is subject to the claims of the grantor's creditors. And if it's subject to the claims of the grantor's creditors, that means that the trust is deemed to be revocable under Section 2038. So we want to make sure that by giving the trustee this discretionary right to pay the income tax, it does not rise to the level of making the grantor a beneficiary or otherwise exposing the trust to the grantor's creditors.

New York was the very first state to respond to revenue ruling 2004-64. Within months, we passed a statute confirming that if you give the trustee this discretionary right, it will not subject the trust to the claims of creditors. This is important. So if you're going to put this provision in your trust, you have to check state law. Not every state has this. In fact, most states don't have this statute. The second element, there can't be a pattern which would then establish an understanding that the trustee would discharge the grantor's tax liability whenever asked to do so.

The structure of the grantor trust rules are that you have the general rule in Section 671 that the grantor is deemed to be the owner, or the deemed grantor if it's a Section 678 power. Section 672 gives you all the definitions. And then Sections 673 to 679 tell you when you have a grantor trust and to what extent.

I'm just going to focus on several of the key rules. Again, all the detailed rules are in the outline. One key rule is that under Section 672(e), we have espousal attribution. So if the spouse has certain rights such as the spouse is a trustee, that will render a discretionary trust a grantor trust, but that rule does not extend for estate tax purposes. So it's very easy to have a grantor trust-- if you have a spouse, to make it a grantor trust by merely having the spouse as the trustee of a discretionary trust. In addition, you can then toggle off grantor trust status if he or she ceases to be a trustee.

One other thing, in terms of definitions, I want to point out something else. Who's the grantor? There are special rules under Section 671 in the regulations that say that the grantor is not just the person who signs the trust agreement as the settlor but it's any party who has transferred assets in a gratuitous fashion to the trust. And if you have a decanting where one trust distributes to the other trust, the grantor of the initial trust is deemed to be the grantor of the new trust for purposes of applying the grantor trust rules.

Most of us that deal with grantor trusts find these grantor trusts either under Section 674 or 675. Again, if you have the spouse as a trustee or beneficiary, it will be a grantor trust-- also, 677, if the spouse is the beneficiary. If the spouse is not a beneficiary and you have a discretionary trust, if more than half the trustees are related and subordinate, you have the grantor trust. And the code defines related and subordinate. Is Sandy, for his most cherished client, is he related and subordinate even though we know that Sandy is a good citizen and if his client, the grantor, wants him to do something it's highly likely he's going to do it? Is Sandy considered related and subordinate?

SANFORD SCHLESINGER: I want to hear the answer.


SANFORD SCHLESINGER: I don't think I am. I'm an independent attorney. If I'm house counsel, I think it's a different story, but I am still an independent attorney even if that client constitutes 70% of my income and that I am still an independent attorney in an independent law firm, I think I'm independent. On the other hand, if I'm house counsel in a situation-- a real estate company while I'm the attorney of the company, then by definition, I think within the section, I'm subordinate. Do you agree?

ALAN HALPERIN: I certainly agree. And as to the first part, we have a helpful case. It's the estate of Hilton Goodwin that's been in the books forever. And there, there was evidence that the trusted lawyer, who was the trustee, did everything at the direction of the grantor. And the court concluded that the trustee/lawyer had fiduciary responsibilities, could be sued if things went poorly, and therefore, he was not related or subordinate.

We have a more recent set of cases-- they were not strictly in the tax scenario, although they related to tax analysis. They were in a recovery proceeding by the SEC and that dealt with the Wyly facts, where it showed that people just did what the grantor wanted, and there, the particular court concluded that the grantor's influence was so great that the trustee really could not have fiduciary obligations. He or she was just doing exactly what the grantor wanted. And now comes this whole notion of de facto control. Is the IRS going to now feel empowered to rely on the Wyly analysis not only to find the trust to be grantor trust, which often is a good thing, but maybe grantor trust for estate tax purposes.

If there's ever a provision in a document to add beneficiaries, then that could make it a grantor trust automatically. One question that I've wrestled with from time to time is, if the trustee has that authority to add beneficiaries, are not those individuals who could be added, aren't they already beneficiaries somehow? So if I have a trust for a, b, and c and they are specifically beneficiaries, but I'm also the trustee and I could add d and e, are d and e current beneficiaries? Well that was in fact the fact pattern in the [? Matterin ?] case and the court did not focus on this, nor did the parties, but it was concluded that even if the trustee has the power to add beneficiaries, that falls within the rule that the power to add renders it a grantor trust.

Let's just skip a couple. It's common to have the power to re-acquire. There are two favorable rulings that say the power to re-acquire property in a non-fiduciary capacity is not going to result in estate tax inclusion but it still can result in grantor trust status. The earlier revenue ruling was a general proposition and then the later one in 2011 dealt with life insurance.

For the people here that draft power to re-acquire, do you always give that to the grantor or do you give that to a third party? Grantor. So do I. I've come across other documents created by other people that periodically give it to third parties, but I think that given these favorable revenue rulings where it was given to the grantor, I don't think it's a problem.

When you give it to the grantor, do you ever exclude any type of properties? For example, I used to exclude from the power to re-acquire the ability to re-acquire any life insurance. Does anybody exclude certain types of property?

AUDIENCE: Isn't life insurance excluded often?

ALAN HALPERIN: Which you don't have to do now because of revenue ruling 2011-24. Any other property? Some people exclude voting stock of closely-held corporations, as defined under 2036(b). The concern is, if the grantor can re-acquire the voting stock, is the grantor himself or herself really have the power to vote? I don't think the answer is yes because you have to in fact substitute the property, but I do see people deal-- what about you, Sandy? Do you exclude it?

SANFORD SCHLESINGER: Now you make me nervous that I don't.

ALAN HALPERIN: Does anybody exclude it? What do you do when the only property is closely-held stock?


ALAN HALPERIN: But even if it's only, if it's closely-held stock, then are you concerned-- if that's the only reason that it's a grantor trust, it's not going to be a grantor trust as to the 2036(b) stock.


SANFORD SCHLESINGER: But that has to be a pattern-- though that's a long discussion of 2036(b), or anything over 2036, you have to have reserve to yourself. And that's where I think the argument then comes back because of a grantor trust provision brings it back in.

ALAN HALPERIN: Right. But my view, just like the two revenue rulings, you actually have to be out of pocket to buy it. Now if it's really thinly capitalized so that the voting stock represents 1/1000 of the company and I'd be a little concerned about that.

AUDIENCE: You were raising questions of other people. Can you digress just for a second and talk about what a lot of us doing with trust protector?


AUDIENCE: Is this an appropriate time for you [INAUDIBLE]

ALAN HALPERIN: Whatever time you'd like, yes. Yes, yes. Is there a specific question or even [INTERPOSING VOICES] appropriate speaker

AUDIENCE: [INAUDIBLE] you were talking about powers in other outside people. Were you considering the trust protector when you made that reference?

ALAN HALPERIN: Excellent point. In Section 675, 675 says that certain powers given to people that are exercisable that could be exercised in a fashion that's not in a fiduciary capacity could render the trust a grantor trust. And so if you don't want it to be a grantor trust, you have to be very careful about what powers are given to the protector. I don't think the mere removal and replacement power of trustees will cause a problem, but if you give the power to add beneficiaries or to modify in certain ways, I think you have to navigate 675 or 674 or the other grantor trust rules.

I'll just mention a couple of things about borrowing. The power to borrow could give rise to grantor trust status, but you would want to do it in a fashion that you don't need adequate security. If you say, the grantor can borrow without paying adequate interest, then you're going to have a state tax inclusion. Actual borrowing is one of the few places where the actual action is what gives rise to the grantor trust status. In most situations, it's the mere existence of the power, but with borrowing, if there is a borrowing, that fact could render the trust a grantor trust.

In fact, this is very useful. There is a revenue ruling, 86-82, that if the borrowing occurred at any time during the year, even if it was paid at any time during the year, it's a grantor trust for the whole year. And so if you have had a transaction that you wish that the complex trust was a grantor trust for some reason, navigate 86-82 and you may have a way of retroactively making it a grantor trust for that full year by imposing some borrowing. There is some uncertainty as to, when you borrow, is it a grantor trust as to the whole or to what's borrowed or to the income that's generated with the borrowed assets, all of which is unsettled and I discuss that in the outline.

Let me mention something about the spousal attribution rules, particularly when the spouse is a beneficiary. There are two conflicting provisions in the code. You have Section 677(a) and you have Section 672(e). 677 predates 672(e). Under section 672(e), the spousal attribution turns on the marital status when the right or interest or power was created. So if the person was a spouse at the time the interest was created, that is to say when the trust was created, and they get divorced, 672(e) assumes-- and if the spouse is still, say, a beneficiary or still has the power, 672(e) will result in ongoing grantor trust status.

677 adopts a different rule that says you have to be married at the time that you measure the 677 interest. Section 682 came to the rescue in large part because it said that, look, we know that this could be a hardship for people who've gotten divorced and now we're having a trust that's distributing out income to the spouse, the ex-spouse, and the grantor is paying the income tax, so 682 used to say, you make a distribution, then the spouse picks up the income-- the ex-spouse. That's been revoked recently. But it's been revoked for trusts going forward and we're awaiting Treasury regulations on how to interpret the old trust. Let me just see--



AUDIENCE: If you don't mind, just one question going back to the power to re-acquire. If the trust does have a third-party named as the person with that power, is the definition of re-acquire broad enough to allow that third person to exercise the power such that it would be [INAUDIBLE]

ALAN HALPERIN: So this is an excellent question. So how can you have a power to re-acquire if it's given to a third party? Anybody have an answer to that?

AUDIENCE: What I do is I make sure that the trust has another power that would make it a grantor trust. I don't know the answer to that.

ALAN HALPERIN: So the IRS or Treasury has actually come out and said, it's OK. And where have they done that? In the charitable lead trust rev procs. There are two rev procs that are the holy grail of charitable lead trusts. They are extraordinary. They give you the sample of trust language, they annotate it, they tell you what to do, and they deal with this issue.

Because if you want a charitable lead trust to be a grantor trust, one way of doing it is giving a power of substitution. But a charitable lead trust where the lead interest is at least 60% or more of the value is considered a foundation under the prohibitive transaction rules under Section 4941. That means there can't be self-dealing. That means for the charitable lead trust, you cannot give the grantor power of substitution. So the rev procs tell you that you can give somebody else the power of substitution and still make it a grantor trust.

So we have five minutes-- I'm going to ask for a show of hands and you have to vote and you can only vote once. I'm going to give you a choice of three topics we can talk about. OK? One topic is charitable remainder trust, one topic is charitable lead trust, and one topic is New York state income tax [INAUDIBLE] trusts. You get to vote once.

SANFORD SCHLESINGER: Well I think-- and I only get one vote also but I think we basically did cover charitable trusts to a great extent with [INAUDIBLE].


SANFORD SCHLESINGER: I think New York trust taxation would be-- anybody disagree with me?



ALAN HALPERIN: OK. There have been a bunch of cases. They're all described in the outline. When is it proper for a state to impose a tax? The taxpayers have been very successful in a series of cases. They generally stand for the proposition it's not enough under our Constitution which requires due process and under the Commerce Clause to tax a trust merely on its accumulated income and capital gains merely because either the grantor was a resident of that state or alternatively you have beneficiaries in that state. That's not enough. You need more to tax in that state, generally. And a description of the cases are set forth in the outline.

So New York will tax New York resident trusts on accumulated income and capital gains. New York resident trust generally is a trust created by a New York grantor. That's the general rule.

The exception to that rule is that even if you have that type of trust, which is called a resident trust, if you meet three tests-- no New York trustee, no New York source income, and no New York property-- you're not subject to New York tax. So for years, we were careful to immunize or ring fence assets to avoid having New York tax on New York source income, if we can, to-- it has to be a complex trust, because if it's a grantor trust, the grantor picks it up directly.

But if we could isolate and put in a silo a trust that doesn't have New York trustees, doesn't have New York source income, and doesn't have New York property, we could avoid New York tax. New York's response to that is we now have the throwback rules, and under the throwback rules, it says that's all very good and fine. We're not going to tax that accumulated income or capital gains on an arising basis if you meet this test, but I'll tell you what. If you make a distribution to the beneficiaries, if they happen to be New York residents, we're going to tax not only what they receive but any accumulated income.

That looked like it was a terrible rule for New York people, but frankly, it is so easy to avoid. First of all, New York was a little lazy in enacting this statute because they rely on the federal rules and they don't really match up, the throwback rules, as they apply here. As a result-- and it's discussed in the outline-- capital gains that are distributed out will not-- as long as they're not part of DNI-- will not apply to the throwback rules. The throwback rules also don't apply to any income that was accumulated when a beneficiary was a minor, nor does it apply to any accumulations that occurred while the beneficiary was not a New York resident, and it doesn't apply to distributions to non-New York people, even if they were New York people when the income was accumulated.

One other thing, it's very common to have an incomplete gift trust where you try to make it a complex trust for income tax purposes but an incomplete transfer for gift purposes and the reason for that is that you want to have a separate taxpayer. And maybe if you meet the three-prong test, that separate taxpayer's not subject to New York tax. New York's reaction to that is to say, if you do that, then the trust is a grantor trust for New York purposes.

And the last point on New York is we all think that transactions between a grantor and a grantor trust under that famous revenue ruling I told you is the most important thing you're ever going to learn, it doesn't have any tax consequences. Please bear in mind that that is an income tax rule. That does not apply throughout all tax.

For example, it doesn't apply to sales tax. So if I have a painting and I sell it to my defective grantor trust, they're sales tax because that's an actual transaction. If I then rent the art so I can hang it on my walls, that's subject to sales tax.

You can try to avoid some of these issues, like the sale part, if you convert the tangible property to intangible property. How do you do that? You wrap it with an LLC. It can't be a disregarded entity because New York state will look through it, I think incorrectly so, and I go into that-- I think New York's wrong about that. But in addition, in order for it to be recognized, it has to be legitimate non-tax business purpose for doing it. So given the time, I think we're done.

SANFORD SCHLESINGER: Done. Thank you very much. Thank you. Thanks a lot, Alan. That was really good. Thank you. Hopefully we'll see you next year. Hopefully we'll have more tax legislation.


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