Disclaimer: The following is for informational purposes only. It is not intended to constitute legal advice or to recommend a course of action, and does not create an attorney-client relationship between the reader and Renuka Somers, or Somers Tax Law, PLLC.
The grantor trust rules are contained in sections 671-679 of the Internal Revenue Code. The rules aim to prevent income shifting, and override Subchapter J of the IRC. When the rules apply, the trust is ignored as a separate entity and its taxable income, and assets are attributed to the “grantor” or owner of the trust for both income tax and estate tax purposes.
Consequently, it is necessary to be mindful of these rules where structuring trusts, especially in a cross-border context, and when dealing with Australian discretionary trusts. If the rules apply, income tax liability and assets ownership may not align under Australian and U.S. Federal tax law. It is important therefore to review and appropriately structure such trusts to avoid adverse U.S. federal tax consequences. See Australian Trusts: U.S. Tax Consequences.
A grantor is a person who:
- Makes a gratuitous transfer to the trust, and holds a power described in IRC ss.673-677, or
- Holds a power exercisable solely by themselves, to vest trust capital or income in themselves – in which case, they are deemed to own that portion of the trust (IRC s.678).
The ss.673-677 powers include:
- Reversionary interests in the trust’s corpus or income exceeding 5% of its initial value: s.673
- Power over beneficial enjoyment of trust corpus or income – either for themselves or for third parties: s.674
Unless the power:
-
- Relates to the application of income to support a dependent
- commenced only after occurrence of an event
- is exercisable by Will (testamentary power)
- is to allocate among charitable Beneficiaries
- is limited by a reasonable definite standard*
- is to withhold income temporarily*
- is to withhold income for a beneficiary who is legally disabled or under 21*
- is to allocate between principal and income
*the power to add beneficiaries negates the exception
The exceptions apply regardless of who holds power, the grantor, or a non-adverse party:
- Certain powers over disposition, borrowing, or investment of trust property: s.675
- The power to revoke the trust: s.676
- The right to receive current or future distributions of trust income – either to self or to 3Ps: s.677
These rules apply where the grantor may exercise such powers either for themselves, or for the benefit of others. They may also apply where the powers are exercisable by the grantor or a “Nonadverse Party”, or both, without the approval or consent of any “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 non-exercise of the power which the grantor possesses (for example, another beneficiary): IRC s.672(a). A “Nonadverse Party” is a person who is not an adverse party, and includes a related or “related or subordinate party” such as the grantor’s spouse (the grantor is deemed to hold powers that a spouse holds), parents and siblings, the grantor’s issue, and an employee of the grantor (including of a corporation in which the grantor has voting control or is an executive): IRC ss.672(b),(c).
Exceptions to the grantor trust rules include having an independent trustee and limiting powers of distribution to reasonable standards. In each instance, the power to add beneficiaries will negate both exceptions, and trigger grantor trust status.
Foreign Trusts: IRC s.679
Grantor trust status can apply where:
· A grantor who is a U.S. person, transfers property to a foreign trust – the grantor is treated as owning a portion of that trust if the trust has one or more U.S. Beneficiaries, even if the U.S, grantor has no powers or interests in the foreign trusts.
· A foreign grantor becomes U.S. person within 5 years of transferring property to such a trust.
· A U.S. trust becomes a foreign trust.
Transfers to Foreign Trusts: IRC s.684
- A transfer of property by a U.S. person to a foreign trust can result in the realization and recognition (for U.S. tax purposes) of built-in gains. However, if a U.S. person is treated as owner/grantor of the foreign trust, no gain is recognized.
- If the trust becomes a foreign trust, the trust’s assets are treated as having been transferred to the foreign trust.
Renuka Somers.
