Tax Strategy & Planning
As is perhaps implicit in the name, choosing a trustee for an irrevocable trust is a matter of trust for grantors. Often, the first question grantors ask is if they can themselves act as the trustee, or name a close relative, usually a spouse, child, parent, or sibling. Assuming naming these individuals does not cause jurisdictional issues, such as creating a foreign trust,1 the main issue practitioners often grapple with are the estate and income tax issues that arise if a trustee is “related or subordinate”2 to the grantor or beneficiary.
In some circles, the fear of inadvertently causing estate inclusion of trust assets for the grantor or beneficiary or causing the trust to be treated as a grantor trust,3 which is disregarded as separate from the grantor for income tax purposes, is so deep that practitioners may insist that all fiduciary roles must be occupied by independent parties. While an independent fiduciary is the ideal, clients often resist handing over control of significant assets to a third-party fiduciary. Other practitioners use the rule of thumb that limiting trustee decisions to an “ascertainable standard” is an effective countermeasure, but that approach does not address every decision category, including investment decisions.
This article aims to break down the estate and income risks and identify situations in which a related and subordinate trustee may act in a manner that allows the grantor and their tax advisers peace of mind.4
I. Tax Risks to the Grantor
Transfer tax risk (estate re-inclusion) and income tax risk (grantor trust status) are usually top of mind when grantors want to act as trustees or name a related or subordinate person (RSP). The risk to the grantor arises only if the trustee is an RSP as to the grantor. A trustee may be an RSP to the beneficiary and not the grantor, and in that case the potential risk falls to the beneficiary.
A. Estate Inclusion for the Grantor
Practitioners often worry about estate re-inclusion for the grantor due to retained control, directly (grantor as trustee) or indirectly (RSP as trustee).
Commonly cited risk areas include:
- Power to make discretionary distributions to current income beneficiaries (and the related power to allocate income and corpus or accumulate income)
- Power to appoint to a class of beneficiaries
- Power to add or remove beneficiaries
- Power to make investment decisions over trust assets
Re-inclusion is often analyzed under IRC sections 2036, 2038, and 2041. Section 2036 is personal to the grantor, with a key exception when the grantor can remove a trustee and appoint themselves.5
Section 2038 is similarly personal to the grantor and broad in scope.
Section 2041 applies only if a general power of appointment exists and only as to the power holder.6
Treasury regulations describe powers of appointment broadly and include, for example:
- A power to amend, revoke, or terminate a trust
- A power to appropriate or consume trust corpus
- A power to remove a trustee and appoint oneself (with important nuances)
The regulations also distinguish mere management and fiduciary administration from powers of appointment.78
Table 1. Estate Inclusion Scenarios
a If the power holder is a beneficiary, discretionary distributions not limited by an ascertainable standard could be a general power of appointment. However, IRC section 2041(b)(1)(C) and Treas. reg. section 20.2041-3 provide exceptions in some shared-power situations.
b See cases cited in the numbered citations list.— (The table’s case references are captured in citations — below.)
B. Income Tax Inclusion for Grantor and Grantor Trust Status
From an income tax perspective, retained control by the grantor (or attributable to the grantor through an RSP) can cause grantor trust treatment.
A key point is that any power or interest held by the grantor’s spouse may be imputed to the grantor under section 672(e).9
IRC section 674 generally treats a trust as a grantor trust to the extent a power of disposition is exercisable by the grantor or a non-adverse party without adverse party approval. A broad carveout is obtaining adverse party consent.
Section 674 also provides exceptions that may prevent grantor trust status even without adverse party consent, including:
- Power to distribute corpus limited by a reasonably definite standard (aligned with ascertainable standard)10
- Testamentary power of appointment over corpus exercisable solely by will (not a blanket exception for all limited powers)11
- Power to allocate receipts and disbursements between corpus and income12
- Some distribution powers exercisable by an independent trustee13
- Power to distribute income limited by a reasonably definite standard by a trustee who may be an RSP but is not the grantor or the grantor’s spouse living with the grantor14
Certain administrative powers can also trigger grantor trust status if exercisable in a nonfiduciary capacity without requiring fiduciary approval including powers to control investments, as addressed under IRC section 675(4).
Table 2. Grantor Trust Status Scenarios
a See section 674(d), with related estate inclusion considerations in some remove-and-replace settings.
b See section 674(b)(5)(A), with related estate inclusion considerations.
c See section 674(b)(6), with related estate inclusion considerations.
d See section 674(b)(8), with related estate inclusion considerations.
II. Tax Risks to the Beneficiary (During Grantor’s Lifetime)
If the trust is a grantor trust, the income tax consequences rest with the grantor. If the trust is a non-grantor trust while the grantor is living, an RSP to the grantor can inadvertently create a grantor trust as discussed above.
An RSP appointment with respect to a beneficiary should not create income tax liability for that beneficiary.
A beneficiary might be liable if section 678 applies or through withdrawal powers, which are outside the scope of this article.15
During the grantor’s life, trust assets may be included in a beneficiary’s estate if the beneficiary is deemed to hold a power of appointment under section 2041.16
III. Tax Risks to the Beneficiary (Upon Grantor’s Death)
After the grantor’s death, trustee selection does not create grantor trust status. Section 678 status does not arise solely due to the grantor’s death.18
Estate inclusion risk focuses on whether the beneficiary possesses a general power of appointment under section 2041.19
Administrative powers can sometimes be treated as powers of appointment. Examples include powers that affect beneficial enjoyment by altering, amending, revoking,
or terminating the trust instrument.20 Certain powers vested in a beneficiary can also create section 2041 concerns.21
The capacity in which a beneficiary holds these powers may not control the analysis.
If a beneficiary’s power is limited by an ascertainable standard, it avoids general power classification and estate inclusion.
Appointment of an RSP to a beneficiary generally does not trigger estate inclusion, unless an RSP is appointed through a beneficiary’s remove-and-replace power.23
Agreements or understandings between a trustee and beneficiary may cause the trustee’s powers to be attributed to the beneficiary.
B. Power to Remove and Replace Trustees
Regulations address cases where an unrestricted power to remove a trustee and appoint oneself can result in treating the powerholder as possessing a power of appointment.24
A safe harbor exists where the replaced trustee is independent, as addressed in Rev. Rul. 95-58, and later guidance has applied similar reasoning for beneficiaries in certain settings.25
Table 3. Trustee Appointment Considerations and Consequences
a Independent trustee concept discussed in Rev. Rul. 76-368.—
b This exception can apply with an individual holding a substantial adverse interest or in certain co-trustee settings; practical complications can arise in family dynamics.
IV. State Tax and Creditor Protection
State tax treatment generally follows federal tax rules. Estate re-inclusion can also create state estate tax consequences where applicable.
Grantor trust status can cause the grantor’s state of residence to tax all trust income under that state’s rules.26
Creditor protection is also central. Generally, creditors cannot reach assets of a grantor’s irrevocable trust absent fraudulent transfer, but creditor rights vary by state and can expand where beneficiaries hold withdrawal or demand rights.
If a grantor is a beneficiary, some restraints can be invalid as to creditors, and creditors may reach amounts a trustee could distribute to the grantor under the trust terms.27
These rules matter for grantor tax reimbursement provisions. Rev. Rul. 2004-64 addresses when a discretionary reimbursement power held by an independent trustee may avoid section 2036(a) inclusion, while noting results may differ where state law subjects trust assets to creditor claims.
State law can also drive inclusion analysis in certain self-settled trust contexts, as discussed in Estate of Paxton.28
V. Conclusion
An independent trustee often simplifies income and estate planning. Still, related and subordinate trustees can hold many powers without triggering adverse consequences when the structure prevents problematic remove-and-replace mechanics, avoids per se grantor trust powers without safeguards, and accounts for state creditor rules.
Numbered Citations
1. See, e.g., Treas. reg. section 301.7701-7(d) (powers held by a non-U.S. person that can cause a trust to be treated as a foreign trust).
2. IRC section 672(c) (definition of “related or subordinate” party).
3. See IRC sections 671-679 (grantor trust rules).
4. References to trustee in this article include all fiduciary roles, even if designated differently such as a power holder or protector.
5. Treas. reg. 20.2036-1(b)(3) (unrestricted power to remove trustee and appoint self as trustee treated as holding trustee powers).
6. Treas. reg. section 20.2041-3(a)(1) (inclusion limitation to the “power holder”).
7. Treas. reg. section 20.2041-1(b) (examples of “powers of appointment”).
8. Treas. reg. section 20.2041-1(b) (mere power of management/investment in fiduciary capacity not a power of appointment).
9. IRC section 672(e); see also PLR 9625021 (Mar. 20, 1996) (spousal attribution applied based on marital status when trust created, even if later divorce).
10. IRC section 674(b)(5)(A) (reasonably definite standard exception).
11. IRC section 674(b)(3) (testamentary power exception parameters).
12. IRC section 674(b)(8) (allocation between income and principal).
13. IRC section 674(c) (independent trustee exception).
14. IRC section 674(d) (income distributions limited by reasonably definite standard; limitations regarding grantor/spouse).
15. IRC section 678(b) (section 678 treatment limited to extent grantor not otherwise treated as owner under sections 673-677 and 679).
16. IRC section 2041 (estate inclusion for certain powers held by beneficiaries and others).
17. Treas. reg. section 20.2041-1(b)(2) (relationship of section 2041 rules to other Code sections).
18. IRS ruling discussion indicating section 678 would not become operative upon grantor’s death (as referenced in the article).
19. IRC section 2041 (estate inclusion applies to individuals with relevant general powers of appointment).
20. Treas. reg. section 20.2041-1(b)(1) (power affecting beneficial enjoyment as power of appointment; amend/revoke/terminate examples).
21. Treas. reg. section 20.2041-1(b)(1) (beneficiary-held administrative powers may be treated as general powers if exercisable in uncontrolled discretion to shift beneficial interests).
22. Mason Walsh Jr., “The Irrevocable Inter Vivos Trust: Income and Estate Tax Consequences to the Donor and the Trustee,” 4 Duq. L. Rev. 303 (1965).
23. Rev. Rul. 95-58, 1995-2 C.B. 191 (safe harbor addressing remove-and-replace trustee powers).
24. Treas. reg. section 20.2041-1(b)(1) (unrestricted power to discharge trustee and appoint self as trustee treated as having power of appointment).
25. PLR 199909016; PLR 9746007 (application of Rev. Rul. 95-58 safe harbor reasoning in beneficiary contexts, as discussed in the article).
26. Discussion in article: state income taxation of trusts varies; trustee/beneficiary residence and situs can matter; source income considerations.
27. Cal. Prob. Code section 15304(a) (restraint invalid against creditors where grantor is beneficiary; referenced in article).
28. Estate of Paxton v. Commissioner of Internal Revenue, 86 T.C. 785 (1986).