IRS ruling positions on grantor trust treatment result in uncertainty.

Quite a few of the more significant estate planning trust techniques currently rely for their overall tax savings on creating a trust in a manner that will cause it to be treated as a grantor trust under Secs. 671-678. One type of benefit sought to be obtained from grantor trust treatment - exemplified by the "defective-trust" - is the payment of income tax by the donor on income that will inure to the benefit of other family members (such as children), who are remaindermen of the trust.

Other trusts need to be grantor trusts to prevent the recognition of gain or other income on dealings between the grantor and the trustee of the trust. Residence grantor retained interest trusts GRITS) and grantor retained annuity trusts (GRATs) fall into this category. In the case of residence GRITS, it is typically anticipated that the grantor will purchase the residence back from the trustee just before the trust term expires in order to (1) retain the opportunity to live in the house and (2) reestablish the potential for a step-up in basis on death. For GRATs, grantor trust status is critical to (1) prevent gain recognition if or when appreciated trust property is used to satisfy, the trustee's fixed annuity payment obligation and (2) make the trust a qualified shareholder of S stock if such stock is to be used in the GRAT. Assuming one achieves grantor trust status, the Service continues to routinely cite Rev. Rul. 85-13 for the proposition that no gain is recognized when a grantor deals with his own grantor trust; see, e.g., Letter Rulings 9535026 and 9519029.

It has become difficult, however, to be certain that grantor trust status has been achieved in a manner consistent with the trust's estate and gift tax objectives. Part of the problem has been the IRS's pattern of issuing favorable letter rulings under one approach only to subsequently change that position (or adopt a norule position) without making any public disclosure.

The first example of this change in ruling posture occurred with respect to a grantor's retained nonfiduciary power to substitute assets of equivalent value for trust assets under Sec. 675 (4). The Service issued what was probably the last "clean" favorable grantor trust ruling based on such a trust provision in Letter Ruling 9352017. In that ruling, the taxpayer and his spouse both created GRATs that were held to be grantor trusts by virtue of a Sec. 675(4) substitution power. Two other GRAT rulings issued the same week relied on Sec. 675(4) for grantor trust status, but were conditioned on subsequent factual determinations (Letter Rulings 9352004 and 9352007). Specifically, the IRS concluded that grantor trust status was dependent on the District Director ultimately determining, on an examination of the trust income tax returns, that the grantor's power was in fact held in a nonfiduciary capacity. Subsequent unofficial comments by IRS personnel have not clarified what facts and circumstances would support a finding that the power was a nonfiduciary one.

Naturally, receipt of a ruling with such a caveat would be somewhat unsettling to taxpayers who want the assurance that the trust is qualified to hold S stock. That is why potential GRAT grantors (and their advisers) were cheered to see a string of letter rulings in which the Service ruled that "[t]he grantor is the owner of the entire trust under [sections]677(a) because [the trust] provides that the annuity installment is to be paid from income and, to the extent income is not sufficient, from principal"; see Letter Rulings 9504021, 9451056, 9449012 and 9449013. Because all GRATs have this provision, the rulings effectively meant the IRS believed all GRATs were wholly owned grantor trusts.

Unfortunately, shortly after the issuance of Letter Ruling 9504021 in October 1994, the Service reconsidered its Sec. 677 position, and without making any formal announcement, stopped ruling that GRATs were grantor trusts under Sec. 677. A key concern was that the typical GRAT document did not necessarily require all trust income to be available to the grantor; it only requires payment of an annuity.

The next grantor trust ruling approach for a GRAT involved the use of a reversion to the grantor's estate in the event the grantor died during the trust term. Because the actuarial value of the reversion (based on the grantor's age and the Sec. 7520 rate) was projected to be over 5% of the trust's value, it was held to be a grantor trust under Sec. 673(a). This approach is straightforward and conservative, but win not work for GRATs attempting to reduce the gift value of the remainder interest by providing a contingent revocable annuity for the grantor's spouse; see, e.g., Letter Ruling 9449012.

Finally, the most recent ruling to confer grantor trust status on a GRAT (Letter Ruling 9525032) relies on the grantor's retained power to borrow trust corpus or income, directly or indirectly, without security. Sec. 675 (2) provides that such a borrowing power exercisable by the grantor or a nonadverse party (or both) causes the grantor to be treated as the trust's owner. The facts of the ruling indicate that the grantor also retained a nonfiduciary power to substitute assets (as an alternate grantor trust approach) and that the document prohibited the grantor and his spouse from becoming trustees.

Importantly, the IRS ruled that the transfer of the remainder interest in the GRAT was a completed gift at the creation of the trust. There is no discussion of this issue in connection with the retained power to borrow without adequate security. It may be possible that such a power, held in a nonfiduciary capacity, gives the grantor a degree of control over the trust property that affects the grantor's ability to value the gift of the remainder and renders the gift incomplete.

Advisers must therefore be cautious when relying on the rationale of grantor trust letter rulings in planning their clients' transactions. Nevertheless, in the absence of more formal guidance, such rulings tend to pro vide the best insight into the Service's current thinking on how grantor trust treatment can be assured in estate planning transactions.

From Robert B. Coplan, Esq., Washington, D.C.