Scott E. Vincent
Vincent, Fontg & Hansen, L.L.C.
Kansas City

The Internal Revenue Service recently issued guidance for taxpayers seeking to create irrevocable grantor trusts with grantor retained powers to substitute property. In Revenue Ruling 2008-22, 2008-16 IRB 796, the IRS provided that a grantor’s power, exercisable in a nonfiduciary capacity, to acquire property held in trust by substituting other property of equivalent value will not, by itself, cause the value of the trust corpus to be includible in the grantor’s gross estate. The IRS conditioned the ruling on the grantor’s exercise of the power in a nonfiduciary capacity, the trustee’s fiduciary obligation (under local law) to ensure equivalent value of the properties acquired and substituted by the grantor, and the limitation that exercise of the substitution power cannot shift benefits among the trust beneficiaries.

Background Facts

The IRS provided the following factual scenario for purposes of the ruling:

“In Year 1, D, a United States citizen, established and funded Trust. Trust is an irrevocable inter vivos trust for the benefit of D’s descendants. T is the trustee of Trust, and D is prohibited from serving as trustee under the terms of Trust. The governing instrument provides that D has the power, exercisable at any time, to acquire any property held in Trust by substituting other property of equivalent value. The power is exercisable by D in a nonfiduciary capacity, without the approval or consent of any person acting in a fiduciary capacity. To exercise the power of substitution, D must certify in writing that the substituted property and the trust property for which it is substituted are of equivalent value. In addition, under local law, T has a fiduciary obligation to ensure that the properties being exchanged are of equivalent value. Under local law, if a trust has two or more beneficiaries, the trustee has a duty to act impartially in investing and managing the trust assets, taking into account any differing interests of the beneficiaries. Further, under local law and without restriction in the trust instrument, T has the discretionary power to acquire, invest, reinvest, exchange, sell, convey, control, divide, partition, and manage the trust property in accordance with the standards provided by law. D dies in Year 2.”

Applicable Law and IRS Analysis

Code Section 2036(a) generally provides that a decedent’s gross estate includes the value of transferred property to the extent the decedent retained either (1) possession or enjoyment of, or the right to the income from, the property, or (2) the right to designate the persons who will possess or enjoy the property or the income from the property. Code Section 2038(a)(1) further provides that the value of the gross estate includes lifetime transfers where the enjoyment of the property transferred was subject, at the date of the decedent’s death, to any change through the exercise of a power (in whatever capacity exercisable) by the decedent (alone or with any other person) to alter, amend, revoke, or terminate the transfer, or where any such power is relinquished during the three-year period ending on the decedent’s death.

The IRS analysis also referenced a prior tax case, Estate of Jordahl v. Commissioner, 65 T.C. 92 (1975), acq. in result, 1977-2 C.B. 1, in which a decedent with reserved powers to substitute property in an inter vivos trust he had created was not required to include the trust assets in his gross estate. The court found that the decedent was bound by fiduciary standards and was therefore accountable in equity to the succeeding income beneficiary and remaindermen in making any substitutions. As a result, the court concluded that the decedent could not exercise the power to deplete the trust or to shift trust benefits among the beneficiaries and held that the substitution power was not a power to alter, amend, or revoke the trust within the meaning of Code Section 2038.

The IRS noted that under the facts in Revenue Ruling 2008-22, unlike the situation presented in Estate of Jordahl, the trust instrument expressly prohibited D from serving as trustee and stated that D’s power to substitute assets of equivalent value was held in a nonfiduciary capacity. Even though the grantor in the ruling, D, was not subject to “rigorous standards” as a fiduciary, the terms of the trust in the ruling required that the assets D transferred into the trust were equivalent in value to the assets D received in exchange. Further, the trustee, T, had a fiduciary obligation under local law to ensure that any assets exchanged were of equivalent value. Therefore, the IRS concluded that D could not exercise the power to substitute assets in a manner that would reduce the value of the trust corpus or increase D’s net worth. The IRS also concluded that T’s ability to reinvest the assets and T’s duty of impartiality regarding the trust beneficiaries would require T to prevent any shifting of benefits between or among the beneficiaries that could otherwise result from D’s substitution of property. Under these circumstances, the IRS held that D’s retained power did not cause the value of the trust corpus to be included in D’s gross estate under Code Section 2036 or 2038.

Holding and Conclusions

The IRS specifically held that “a grantor’s retained power, exercisable in a nonfiduciary capacity, to acquire property held in trust by substituting property of equivalent value will not, by itself, cause the value of the trust corpus to be includible in the grantor’s gross estate under § 2036 or 2038, provided 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 further provided that the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries.” The IRS further held that “a substitution power cannot be exercised in a manner that can shift benefits if: (a) 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 (b) 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.” These specific holdings provide an excellent road map for practitioners structuring defective grantor trusts for clients that seek to retain powers of substitution without negative estate tax consequences.