Whether the Power to Substitute Trust Assets For Equal Value Creates Estate Tax Inclusion

The power to substitute assets out of a trust for other assets of equal value creates Grantor status in a trust, i.e. the Grantor is taxed on the trust income.  I wrote a memo today about whether such power is sufficient to include trust assets in the grantor’s estate.  The information is useful for those considering forming a IDGT in the last few months of the year.  Spoiler: it wont.  The memo follows.

DISCLAIMER.   THE INFORMATION HEREIN IS NOT MEANT AS LEGAL ADVICE AND CANNOT MEET YOUR NEEDS WITHOUT INDIVIDUAL CONSIDERATION.  FURTHER, IT CONCERNS MATTERS THAT ARE NOT YET ENTIRELY SETTLED IN THE LAW AND CANNOT BE RELIED ON.  IF YOU ARE CONSIDERING FORMING A TRUST, YOU SHOULD CONSULT WITH AN ATTORNEY WHO CAN HANDLE YOUR INDIVIDUAL CASE.

QUESTION PRESENTED

Whether the power under 26 USC § 675(4)(C) [1] to substitute trust assets with assets of equal value will cause inclusion in decedent’s taxable estate.

BRIEF ANSWER

The mere power to substitute trust assets with assets of equal value will not cause inclusion in decedent’s taxable estate.

BACKGROUND

An Intentionally Defective Grantor Trust (IDGT) is a trust that intentionally runs afoul of one of the Grantor rules contained in Sections 671 through 679 of the Internal Revenue Code.  Giving to the Grantor one of these powers causes the trust to be disregarded for income tax purposes such that income of the trust is taxed to the Grantor.  While originally considered a detriment, the Grantor rules have been used to create tax benefits, allowing clients to shift wealth to beneficiaries.

The power to substitute trust assets with assets of equal value is such a “Grantor Power” under IRC 675(4)(C), [2] which states that the grantor shall be treated as an owner when he has a power to reacquire trust corpus by substituting other property of an equivalent value.

Even though the Grantor is treated as the owner of a Grantor Trust for income tax purposes, he or she is not necessarily treated as the owner for estate tax purposes. The estate tax inclusion rules are applied separately to make the latter determination.

IRC 2038 includes in the decedent’s estate any property over which the he had the power alter, amend, revoke, or terminate a beneficiary’s beneficial interest. [3]

In crafting IDGTs, estate planners utilize powers that will cause the Grantor to be treated as the owner for income tax purposes, but not for estate tax purposes.  Such crafting is delicate and dangerous, though, because a mistake could cause a Grantor to be treated as the owner for both purposes.

DISCUSSION

The question in this case is whether the power to substitute trust assets of equal value under IRC 675(4)(C) will cause estate inclusion under IRC 2038 (power to alter, amend, revoke, or terminate an interest).  Precedent dictates that it will not.  The possession of a power to substitute assets of equal value is not a power to alter, amend, or revoke because substitutions that result in shifting benefits between the income interest or remaindermen do not satisfy the definition of “equal value.”  In other words, a power to substitute trust assets of equal value implies against the holder a fiduciary requirement to treat income interests and remaindermen equally; therefore such an interest cannot implicate 2038 power to alter, amend, revoke, or terminate an interest

The IRS specifically ruled on this issue in Estate of Jordahl v. Commissioner[4].  In Jordahl, Grantor funded an Irrevocable Life Insurance Trust (ILIT).  He acted as trustee, and retained for himself a power to substitute property “of equal value.”  The court first noted that a different power, the power to direct investments, is not a power to “alter, amend, revoke, or terminate.”  Since decedent’s substitution power (assuming equal value) was no more a power to alter than that involved in directing investments, such substitution power did not implicate 2038.

Second and more importantly, the court said that the words “equal value” bound Jordahl, in equity, to treat income beneficiaries and remaindermen equally, i.e. he could not alter, amend, revoke, or terminate their interests (thus avoiding 2038).  The court said:

The Commissioner argues that decedent could, through substitution, institute investment in highly productive property to deprive the remaindermen of benefits or, similarly, in unproductive property to deprive an income beneficiary of property. We do not believe that decedent could have used his power to shift benefits in such a manner. Substitutions resulting in shifted benefits would not be substitutions of property ‘of equal value.’

Thus the very language of Jordahl’s power to substitute property of “equal value” could not implicate 2038.

Some literature raises an objection to this analysis. [5]  However, the objection is based on a misapprehension of the court’s reasoning in Jordahl.  It states:

The power [to substitute assets of equal value in Jordahl] was held in a fiduciary capacity… Thus, some practitioners believe that it is uncertain whether a nonfiduciary substitution power can cause estate tax inclusion.

The statement seems to suggest that if Jordahl had not been a trustee, his power to substitute assets of equal value may have caused estate tax inclusion because he would not have been bound by fiduciary duties.  It says, “there are no reported cases in which the IRS attempted to distinguish between the fiduciary power of Jordahl and a nonfiduciary power.”  But this is a misapprehension.  In Jordahl, the court found that the very words “equal value,” imputed to the Grantor a fiduciary duty, i.e. such duties were inherent in the grant and could not be separated from the requirement of equal value.  Jordahl said, “Even if decedent were not a trustee, he would have been accountable to the succeeding income beneficiary and remiandermen in equity…”

PLR 9413045[6] affirms the result in Jordahl, the underlying reasoning, and that it did not depend on Jordahl’s acting as trustee.  The facts in PLR 9413045 were similar to Jordahl: taxpayers settled an ILIT and retained the right, “to reacquire… trust corpus by substituting other property of an equivalent value…”  In this case, however, taxpayers were not acting as trustees.  To determine whether settlor’s substitution powers would prompt estate inclusion under 2038, the IRS adopted and restated precisely the reasoning from Jordahl:

In [Jordahl] the court held that the possession of a right to substitute assets was not a power to alter, amend, or revoke the trust for purposes of § 2038. The trust agreement in Estate of Jordahl specifically provided that any property substituted must be of equal value to the property replaced. The court held that substitutions resulting in the shifting of benefits to either enhance the income beneficiary or the remaindermen would not be substitutions of property of “equal value”… The court held that the decedent, even if he had not been a trustee, was under a fiduciary duty to treat the income beneficiaries and remaindermen equitably.

Accordingly, in PLR 9413045 the corpus of the taxpayers’ trust would not be included in their estate under 2038.

A final note on the implementation of the power to substitute assets of equal value.  Courts hold an extremely narrow view of “equal value,” i.e. what assets may substitute into a trust. [7],[8]  Thus such a power is most useful to create Grantor status without estate inclusion, not as a power to be utilized in fact.

CONCLUSION

The precedent of Jordahl and PLR 9413045 dictate that the power under 26 USC § 675(4)(C) to substitute trust assets with assets of equal value will not cause inclusion in decedent’s taxable estate.


[1] 26 USC § 675(4)(C) – Administrative powers, General powers of adminestration

The grantor shall be treated as the owner of any portion of a trust in respect of which a power of administration is exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity. For purposes of this paragraph, the term “power of administration” means, [inter alia,] a power to reacquire the trust corpus by substituting other property of an equivalent value.

[2] See FN 1, Supra.

[3] The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, where the enjoyment thereof was subject at the date of his death to any change through the exercise of a power (in whatever capacity exercisable) by the decedent alone or by the decedent in conjunction with any other person (without regard to when or from what source the decedent acquired such power), to alter, amend, revoke, or terminate, or where any such power is relinquished during the 3 year period ending on the date of the decedent’s death.

[4] 65 T.C. 92 (1975)

[5] Drafting California Irrevocable Trusts § 3.41 (3d ed Cal CEB 2006)

[6] I.R.S. Priv. Ltr. Rul. 9413045 (Apr. 1, 1994)

[7] Language in PLR 9413045 suggests that only a life insurance can substitute in for a trust-owned life insurance policy and be of “equal value.”  The letter says, “In the case of an insurance policy the only asset that should be of equal value would be another insurance policy with ‘equal cash surrender and face value, comparable premiums, and a similar form of policy.’”

[8]  One Technical Advice Memo has held that a power to substitute assets of equal value, on the facts of that particular case, was tantamount to a power to withdraw assets (thus includable) because the economic reality of the Grantor’s powers allowed for extracting assets less than equal value.  There, the “purchase price” was predetermined far below FMV, the assets could be withdrawn in exchange for a note at an extremely favorable rate, and the grantor was the remainderman in fact.  The memo distinguished from Jordahl by stating that though the instrument recited an “equal value” requirement, the power in fact allowed extracting value for less than “equal value.”  I.R.S. Tech.Adv.Mem. 8330004 (Mar. 16, 1983).

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About piratejosh85

Currently I am a law student at Santa Clara University specializing in Wills, Trusts, and Tax-and-Estate Planning. This blog is dedicated to what's happening in the field, developments in the law, practice tips, opinions, and interesting applications in the news. In regard to this latter, happily, celebrities provide an endless fount of amusing anecdotes. I specialize in Wills, Trusts and Estates, focusing on the West Coast, especially Oregon and California. But I'm also interested in national trends in the field, and so keep my eye on interesting cases wherever I find them. Posts on this blog have spanned from the 7 Major Errors in estate planning, to examining the new case Cruze v. Hudler, to the emergence of Self-Settled Spendthrift Trusts, to the dark side of guardians and conservators. I have worked in the field in both Oregon and California, including a judicial externship at the Santa Clara Country Probate Court. One summer my assignments included a 50-state survey of law of Wills, Powers of Attorney, and Advance Health-Care Directives. I love the work. Planning an estate is about the challenge of minimizing taxes and even more importantly, harmonizing a plan to achieve the client's outcomes while preserving his other values, such as his family's happiness. I will graduate in December and will be looking for work in Oregon come December. Would you like employ me? Contact me; I'd love to chat.
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One Response to Whether the Power to Substitute Trust Assets For Equal Value Creates Estate Tax Inclusion

  1. Pingback: President Obama’s Proposals Do Away With IDGTs | taxandestateplanning

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