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May 24, 2011

Is There a Policy Behind the Grantor Trust?

We were all taught in school that statutory laws start with intentional legislative action. This means that federal laws favoring a particular economic faction, for example, were enacted by Congress with the intent to assist that group. We can determine Congressional policy then, by looking at the effect of laws enacted by Congress. The law reflects the intent of Congressional action. Likewise, administrative regulations reflect intent on the part of the responsible agency.
But in their 2010 book Winner-Take-All Politics, the political scientists Jacob Hacker and Paul Pierson ask us to focus, in part, on another aspect of governmental legal activity. Just as important as governmental action is government’s failure to act. Hacker and Pierson identify a form of inaction they call “drift.” Drift results from “systematic, prolonged failures of government to respond to the shifting realities of a dynamic economy.” They give the example of federal minimum wage laws. As inflation reduces the purchasing power of the dollar, minimum wage laws, if they are to keep pace, must be adjusted upward. Failure to make this adjustment in the face of continuing inflation will eventually drain these laws of all of their original effect. This is drift, and the Congressional policy reflected by this drift is that wage floors should not be set by the government.
In a paper prepared for the 2010 meeting of the American Political Science Association, Hacker and Pierson point out that drift often benefits legislators by allowing them to effect (for the benefit of a particular group) what might be broadly unpopular policy without bearing responsibility for that policy. And this form of legislative inaction, just like legislative action, is often mediated by powerful political groups.
Which leads me to the real topic of this post. University of Texas law professor Mark Ascher has written an important paper that shows how Congress, by failing to act, is furthering policies favoring only the high-end estate planning industry and those it serves. Ascher, who is the author of a well-known and regarded treatise on the income taxation of trusts, concerns himself in this article with a device known as the “grantor trust.” A grantor trust is a trust all of the income of which is taxed to the creator and funder of the trust, also known as the “grantor,” or “settlor” of the trust. This is a different taxation regime than exists for those trusts that are not grantor trusts. As a general rule, the typical “non-grantor” trust is liable for tax on income retained by the trust. This means that the trustee must pay the federal income tax out of the trust assets. In contrast, the grantor trust is not seen as separate from the trust’s settlor. All trust income and corresponding deductions are reported on the settlor’s tax return and the settlor is liable for the tax.
The grantor trust rules arose to prevent high-bracket taxpayers from shifting income from themselves to low-bracket trusts, while retaining the benefit of that income. At first, those rules covered only those situations where a settlor retained the right to revoke a trust or retained beneficial enjoyment of the trust’s income. But in a notable Supreme Court case from 1940 called Helvering v. Clifford, the taxpayer created a trust for his wife that was to terminate after five years. He retained the power to determine the amount of any income distributions to his wife. Presumably, the settlor’s goal was to have his wife taxed on income distributed to her from the trust and to have the trust taxed on any income retained by the trust. In this way, he could take advantage of the lower marginal rates to which his wife and the trust was subject.
The Supreme Court held that the settlor was liable for tax on all the trust’s income, which left the law regarding grantor trusts in a state of confusion. A few years later, the Treasury promulgated comprehensive regulations setting out the circumstances under which a trust would be treated as a grantor trust. So these regulations, like the extant grantor trust rules dealing with revocable trusts and trusts that make distributions benefitting the settlor, were enacted to prevent abuses of the income rules by shifting income to trusts. The regulations were later statutorily codified by Congress into the current grantor trust rules.
Between the date of enactment of the grantor trust rules and today, however, Congress also enacted a number of other laws whose combined effect was to virtually eliminate the advantages of using trusts for income-shifting:
• It allowed married to taxpayers to file a joint tax return, essentially treating their combined income as though one-half was earned by each.
• It enacted the “kiddie tax” which generally taxes a child’s unearned income at the parents’ rate.
• It reduced the highest individual tax rate (to which trusts are also potentially subject) from a high of 91% to its current 35% rate.
• It reduced the rate on dividends and capital gains to a maximum of 15%.
• It compressed the trust tax brackets so that trusts are now subject to a tax at the highest marginal rate on all income in excess of $11,350.
• It mandated the treatment of multiple trusts with substantially the same settlors and beneficiaries as one trust.
As a result, Ascher convincingly argues that taxpayers now have little or no incentive to create trusts for the purposes of income-shifting. Congress could therefore repeal the grantor trust rules. Yet it has not done so. As a result, rules enacted to prevent abuse of the income tax rules are now being employed in a number of strategies to avoid transfer (estate and gift) taxes.
Here’s a simplified overview of one of the simplest these strategies. Suppose that TP is a taxpayer whose estate is potentially subject to the federal estate tax. This means that TP’s total wealth exceeds that of well over 99% of all Americans. In order to reduce estate taxes, TP creates a trust for the benefit of his offspring and transfers some of his appreciating assets to the trust. Normally, this trust would be liable for income tax on all income generated by trust investments that is not distributed to trust beneficiaries. But TP makes the trust a grantor trust by inserting a provision in the trust instrument that provides that TP can, if he wants to, replace the trust property by substituting other property of equivalent value. (There is no need to ever actually replace the trust property, this is just language inserted in the trust instrument that allows TP to do this.) The result is that all trust income is now taxable to TP and not to the trust.
Why is this advantageous? The advantage comes when one considers that by paying the tax on trust income from his own assets, TP is essentially making an additional gift to the trust beneficiaries. Moreover, this transfer is not a gift subject to the gift tax because TP is legally liable for the payment of the tax—the tax payment is not a voluntary transfer. The effect, however, is the same as a gift.
Ascher goes into some detail describing a number of other strategies involving grantor trusts being employed by estate planners for the benefit of their wealthy clients. He concludes that these strategies pervert the original purpose of the grantor trust rules and that almost all of those rules should therefore now be repealed. He would preserve the rule that makes a revocable trust a grantor trust.
Ascher’s article is important because it sheds light on policies furthered by Congressional inaction. The integrity of our system of taxation depends on a fair and equitable application of laws. And as Ascher states, ploys like those available to the few under the grantor trust rules exacerbate “the already widely held impression that the [Internal Revenue Code] is a venal collection of provisions designed to allow those whose advisors are ‘in the know’ immense latitude in minimizing their tax liabilities.” Any Congress that fails to reform or repeal the grantor trust rules is by its inaction implementing policies that help bring reality in line with this impression.
Kent Schenkel

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