Irrevocable trusts have been structured for many years as “grantor” trusts for income tax purposes while still maintaining tax-free status for estate tax purposes.
A number of favorable Internal Revenue Service rulings over the years have solidified the irrevocable grantor trust “power of substitution” concept under Internal Revenue Code Section 675(4)(C). This concept allows a grantor to substitute assets of equal value for assets already in the trust without causing any of the asset value to be included in the gross estate for estate tax purposes.
How can this string of positive rulings from the IRS be used from a practical estate planning point of view to improve wealthy estate owners’ plans? Keep in mind that the trustee of an irrevocable trust has a fiduciary obligation to ensure that any “substituted” assets are of equal value to the assets already in the trust.
Let’s look at a hypothetical wealthy client and their estate profile.
The client has a gross estate well in excess of the estate tax exemption (currently indexed in 2015 to $5.43 million for a single individual and $10.86 million for a married couple) so that the excess is subject to a 40 percent federal estate tax rate plus state death taxes in many Northeastern states.
Over the years, the client has made significant gifts of capital assets in a gain position to a “grantor” irrevocable trust to remove future appreciation from the gross estate. The “grantor” irrevocable trust contained a Section 675(4)(C) “power of substitution” clause. The gifts were lifetime gift tax exemption gifts (currently indexed in 2015 to $5.43 million for a single individual and $10.86 million for a married couple). Form 709 U.S. Gift Tax returns were filed to document the gifts and their value.
These gifted capital assets were real estate, publicly traded securities, and shares in privately owned S corporations or limited liability corporations. Under IRC Section 1015(a), the adjusted cost basis of these lifetime gifts “carries over” and remains the cost basis for any future sale of those capital assets by the trust. This contrasts with capital assets included in the gross estate at death, which would get a “stepped-up” basis to date-of-death value under IRC Section 1014(a)(1).
The client kept a part of their investment portfolio liquid in the form of significant money market account or bank holdings.
Given this estate profile, are there any recommendations that could be made to improve the estate plan using the Section 675(4)(C) “power of substitution” clause of the grantor’s irrevocable trust?
The grantor and their trustee could consider transferring money market cash to the trust as a substitute for a portion of the capital assets currently held by the trust. This cash would have to equal the appraised fair market value of the capital assets now held by the trust. The capital assets would be returned to the grantor estate owner and ultimately would be included in the gross estate at “stepped-up” basis value for capital gains purposes for the estate owner’s heirs.
The substituted cash could be used by the trustee to buy a single pay or annual pay no-lapse guaranteed universal life (UL) or no-lapse guaranteed survivorship universal life (SUL) policy owned by the trust. The leveraged death benefit of this policy would be income-tax-free and estate-tax-free, and would provide an excellent guaranteed internal rate of return (IRR) at life expectancy.
Let’s take a look at an example of how this may be beneficial to a wealthy client who has an estate asset profile similar to the one described earlier.
The client and spouse are each 67 years old and have a gross estate in excess of $30 million. They made lifetime exemption gifts of capital assets to a “grantor” irrevocable trust over the years totaling $5 million with an original cost basis of only $500,000. This $500,000 cost basis “carried over” to the trust for purposes of any future sale, in accordance with IRC Section 1015(a). Form 709 U.S. Gift Tax returns were filed in a timely manner as these capital assets were gifted.
Subsequently, the clients sold other personally owned investment real estate. The net after-tax cash received on the sale was $6 million, which was deposited into a money market account.
Their “grantor” irrevocable trust holding the gifted capital assets has a clause that permits asset substitution under IRC Section 675(4)(C).
Here is what we would recommend to take advantage of the “power of substitution” clause.
First, we would have the grantor transfer $5 million in cash by “substitution” from the money market account into the trust. The cost basis of this cash is $5 million. Then the trustee transfers $5 million of capital assets that were originally gifted to the trust back to the grantor to complete the “substitution” transaction under Section 675(4)(C).
If the grantor holds these returned capital assets until death, there will be a “stepped-up” basis to date of death value, according to IRC Section 1014(a)(1). Assuming a 25 percent combined capital gains tax bracket, this potentially will avoid at least $1.125 million of capital gains taxes for the grantor’s heirs when compared with the original “carry-over” basis of the lifetime exemption gifts to the trust ($5 million minus $500,000 cost basis = $4.5 million potential capital gain x 25 percent capital gains tax = $ 1.125 million).
The trustee uses the $5 million of substituted cash to purchase a single-pay no-lapse SUL policy with a face amount of $17.449 million (on a man and a woman, both age 67 and both rated preferred) from a competitive carrier. The policy is a modified endowment contract (MEC) under IRC Section 7702A, but death benefits of MECs are still income tax-free under IRC Section 101(a)(1). The death benefit is also estate tax-free based on the rationale of Revenue Ruling 2011-28, which held that a Section 675(4)(C) “power of substitution” will not be considered to be an “incident of ownership” under IRC Section 2042(2).
The guaranteed IRR on the SUL policy at joint life expectancy (23 years) is 5.58 percent. In a 30 percent tax bracket, the pretax equivalent is 7.97 percent. This is truly outstanding in the continuing low-interest-rate environment for fixed financial assets and a significant improvement over the close to 0 percent current yield on money market accounts.
As an alternative, the $5 million of “substituted” cash could be invested by the irrevocable trust in a portfolio of investments. Some of the interest, dividends or capital gains could be used to pay an annual no-lapse premium for an SUL policy instead. Since the trust is a “grantor” trust for income tax purposes, the grantor will report any income on their personal Form 1040 U.S. Income Tax return during their lifetime. This payment of income taxes on trust income indirectly will reduce the grantor’s estate for estate tax purposes. So, the full gain on trust investments will be retained by the trust and could be used to pay the annual SUL premiums.
For example, a $200,000 annual premium (4 percent rate of return on $5 million trust principal) could purchase $13.524 million of SUL no-lapse protection on the same 67-year-old couple rated preferred as was illustrated in the single-pay scenario described earlier. The IRR at joint life expectancy (23 years) is 8.20 percent. In a 30 percent tax bracket, the pretax equivalent is 11.71 percent.
The client described in this article has avoided significant capital gains taxes for their heirs by using the “substitution” technique allowed for “grantor” trusts under IRC Section 675(4)(C). And the “grantor” trust has used the substituted cash to purchase tax-free guaranteed SUL life insurance that provides not only a benefit for the heirs but a great IRR at joint life expectancy.
Pertinent IRS Rulings
A number of important IRS revenue rulings permitted “grantor” trusts and the “power of substitution” concept:
Revenue Ruling 85-13 was the first ruling that stated a grantor of an irrevocable trust would be treated as owner of the trust assets only for income tax purposes but not for estate tax purposes.
In Revenue Ruling 2004-64, the IRS ruled that a grantor’s payment of income taxes on investment income of assets held in an irrevocable trust was not a taxable gift to the trust.
The IRS, in Revenue Ruling 2007-13, determined that a transfer of a life insurance policy from one irrevocable grantor trust to another irrevocable grantor trust would not violate the transfer-for-value rule. The death proceeds retained their income-tax-free character under IRC Section 101.
Revenue Ruling 2008-22 was the first ruling to outline how a grantor trust with a Section 675(4)(C) “power of substitution” clause could be used so that a grantor could substitute assets of equal value for assets already held by the grantor’s irrevocable trust. The ruling stated that the trust assets would not be included in the grantor’s gross estate as a retained life interest under IRC Section 2036 and would not be included as a power to alter, amend or revoke under IRC Section 2038.
Finally, Revenue Ruling 2011-28 ruled that the Section 675(4)(C) “power of substitution” would not cause life insurance owned by a “grantor” irrevocable trust to be included in the gross estate as an “incident of ownership” under IRC Section 2042(2).