A grantor trust generally is a trust whose income is taxed, in whole or in part, to the grantor/settlor, and not the trust or other beneficiaries. Grantor trust status is often intentionally sought as a way to shift tax incidents to the grantor and thus in effect allow transfers to the trust to effectively occur through the tax payments of the grantor without incurring a gift tax, or to avoid income tax consequences for transactions between the grantor and the trust.
As part of tax planning, the grantor may also seek to avoid having the trust being subject to estate tax at the death of the grantor. Therefore, tax planning is undertaken to give the grantor a power over the trust that will create a grantor trust, but which is not so broad as to result in estate tax at the grantor's later death.
One power often used to accomplish this dual purpose is to give the grantor the nonfiduciary power to replace trust property at any time with property of equivalent value. So long as the grantor is not also the trustee and the grantor's power is a nonfiduciary power, the Internal Revenue Code and Regulations are fairly clear that this will create a grantor trust. What has previously been understood by way of case law precedent is that such a power by itself will not create estate tax inclusion via Code Sections 2036 or 2038.
The IRS has now issued a Revenue Ruling that confirms this treatment under Sections 2036 and 2038, at least if the requirements of the Ruling are complied with. Those requirements are:
a. the trustee has a fiduciary obligation (under local law or the trust instrument) to ensure the grantor's compliance with the terms of this power by satisfying itself that the properties acquired and substituted by the grantor are in fact of equivalent value, AND
b. the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries.
What exactly is meant by b. is not entirely clear, but the Ruling does provide two safe harbors that satisfy b. This requirement will be satisfied if:
1. the trustee has both the power (under local law or the trust instrument) to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries; OR
2. the nature of the trust's investments or the level of income produced by any or all of the trust's investments does not impact the respective interests of the beneficiaries, such as when the trust is administered as a unitrust (under local law or the trust instrument) or when distributions from the trust are limited to discretionary distributions of principal and income.
Thus, while it may be possible to avoid Section 2036 and 2038 inclusion even without strictly following the above rules, the Ruling is a useful safe harbor to avoid the estate tax inclusion entirely.
Revenue Ruling 2008-22