Q: IRC 671-679 is not an easy read. Do you have a recommended checklist for tax review of a document for determining if a trust is an Intentionally Defective Grantor Trust?
A: There are a few intentional violations of IRC 671-679 that attorneys utilize when creating an irrevocable trust that is a defective grantor trust for income tax purposes, but not for estate tax purposes. The most common intentional violations are the following:
The Substitution Power. Under IRC 675(4)(C), if the grantor or any person that is a non-adverse party retains the power, in a non-fiduciary capacity, to substitute assets of the trust with assets of equivalent value, the trust will be a grantor defective trust. Further, the IRS has issued a ruling that this grantor trust power, if drafted properly, will not cause inclusion of the trust in the grantor’s estate for estate tax purposes.
The Power of an Independent Trustee or Trust Protector to Add Beneficiaries. Under IRC 674(c), if an Independent Trustee or Trust Protector has the ability to add to the class of beneficiaries of the trust, the trust will be a grantor defective trust. In order to avoid inclusion of the trust in the grantor’s or the power holder’s estate, the power holder should be precluded from adding to the class of beneficiaries the power holder, the power holder’s estate, the power holder’s creditors or the creditors of the power holder’s estate.
Inclusion of Grantor’s Spouse as Beneficiary. Under IRC 677, if the income of the trust may be distributed or accumulated for the benefit of the grantor’s spouse, the trust may be considered a grantor defective trust for income tax purposes.
Life Insurance on Grantor’s or Grantor’s spouse’s Life. Further under IRC 677, if the income of the trust may be utilized to acquire life insurance on the life of the grantor or the grantor’s spouse, the trust may be a grantor defective trust. It is important to note that the grantor defective trust status under this provision alone is not guaranteed unless the trust actually utilizes income to purchase such life insurance. Therefore, it is important to combine this particular grantor trust power with other grantor trust powers.
Non-Independent Distribution Trustee. If the trust is a fully discretionary trust (not limited to the ascertainable standard of health, education, maintenance and support) and the Trustee that has discretion to make distributions is a related party or subordinate party (defined by IRC 672(c)), the trust should be considered a grantor defective trust.
In sum, when reviewing a trust document to determine if an irrevocable trust is an Intentionally Defective Grantor Trust, you should look for one or more of the foregoing provisions. Additionally, in order to ensure that the trust is an Intentionally Defective Grantor Trust, the trust itself should use a “belts and suspenders” approach and utilize more than one of the foregoing grantor trust powers.