CAPSULES

Fun Trust Tricks With Adverse and Nonadverse Parties

By Robert A. Mason, CELA, CAP

Controlling the tax status of a trust.

Keep your friends close and your enemies closer.

— Michael Corleone (The Godfather, Part II)

Sound Familiar?

Greta Grantor wants to deed her home into a trust to protect it in case she ever requires a nursing home and Medicaid. Greta also knows a time might come when she needs to downsize and sell her home. Preserving the tax-free sale of the home while not breaching Medicaid rules in order to keep the home a noncountable asset are important goals.

Another client, Sam Settlor, wants to move assets into a trust in order to qualify for VA benefits. Because the VA will likely question the existence of a grantor trust if taxable income from his trust shows up on his Form 1040, avoiding grantor trust status is important. Sam also wants some control over trust distributions and who may inherit.

Answers for Greta and Sam might involve the use of adverse and nonadverse parties. Grantor trust status is achieved by the grantor retaining certain benefits or powers over trust assets (hereinafter called “grantor powers”). In many cases a grantor power can be given to (or shared with) a nonadverse party without jeopardizing grantor trust status. On the other hand, a grantor power will not cause grantor trust status if it requires the cooperation of an adverse party, or if an adverse party can block it.

Who’s Adverse?

An adverse party is someone with a beneficial interest in the trust that will be positively or negatively affected by the exercise or nonexercise of a certain power.1 A nonadverse party is someone who is not adverse.2

If Anthony has been given an income interest in a trust but Greta Grantor has retained a power to appoint the income interest, Anthony will be adverse with respect to that retained power of appointment (POA) because Anthony loses if Greta exercises her power.

An adverse party is less likely to be subject to the influence of the grantor because she might be motivated to take or withhold action to preserve her trust benefits. A nonadverse party is free of those motivations. If a trust design strategy requires a nonadverse party, the grantor will select someone who is not a beneficiary and who will likely do what the grantor wants done.

Example

An individual can be adverse with respect to a portion of a trust only. Assume a trust provides an income interest of equal shares to Anthony, Betty, and Charlie but Greta Grantor reserves a right to appoint the income interest to David with the consent of Anthony. This is a potential grantor power. Code section 674(a) provides that a grantor will be the deemed owner of any portion of a trust over which she has retained a power to affect the beneficial enjoyment thereof, without the consent of any adverse party.

Anthony is adverse with respect to Greta’s retained power of appointment, but only with respect to one-third of the income of the trust. Anthony is nonadverse with respect to the other two-thirds of the income, so the trust would be a grantor trust with respect to two-thirds of the income and a nongrantor trust with respect to a third.3

Another Example

A trust provides an ordinary income interest to Adella with a power for her to appoint the trust principal to Sam Settlor during her life or upon her death with a testamentary POA. Under the trust agreement (and, in the event the trust agreement had been silent, under the state principal and income act) any capital gains are to be added to trust principal. Adella’s powers, too, are potential grantor powers. Code section 677 provides that a grantor will be the deemed owner of any portion of a trust with respect to which the income may be distributed to grantor or held or accumulated for future distribution to grantor without the approval or consent of an adverse party.

In this particular case, Adella’s power is adverse to Sam to the extent that Adella can appoint the principal during her life (because Adella’s income will be wiped out if she appoints the principal to Sam). In that case, ordinary trust income will not be reportable on Sam’s Form 1040 because the ordinary income can be controlled by Adella. The income will be reportable on the trust’s Form 1041. Had Adella been a nonadverse party, her discretionary authority to distribute principal to Sam, Code section 677 would have required ordinary income to be reported on Sam’s Form 1040.

But, Adella’s power to appoint principal to Sam upon her death will result in any capital gains the trust may generate during the year being reported on Sam’s Form 1040 because IRC section 677 says any taxable income (capital gains is taxable income, after all) that could be accumulated for later distribution to grantor results in grantor trust status with respect to that trust portion. In this case, Adella (presumably) doesn’t care what happens to trust income after her death, which renders her nonadverse with respect to Sam and that specific trust portion. In this case, a nonadverse party (Adella) has the grantor power to accumulate income for potential later distribution to the grantor (Sam).4

A Potential Trap

Treasury Regulations state, “[t]he interest of a remainderman is adverse to the exercise of any power over corpus of a trust, but not to the exercise of a power over any income interest preceding his remainder.”5 This exposes a common planning trap.

A testamentary POA does not in and of itself create a grantor trust. If, however, income is accumulated “in the discretion of the grantor or a nonadverse party, or both, without the approval or consent of any adverse party”6 for later testamentary distribution by the grantor, then a grantor trust will result.

As noted above, capital gains are typically not distributed but rather added to corpus under the terms of the trust or the state principal and income act. It follows (one would think) that a retained testamentary POA will create a grantor trust with respect to trust principal because income (in this case capital gains) is being added to corpus for later disposition under grantor’s will.7 But not so fast.

Attorneys often seek grantor trust status with respect to principal (perhaps to ensure favorable capital gains treatment under Code section 121) by simply adding a testamentary power of appointment (realizing that capital gains are being added to principal and thus satisfying the regulation). Here is the catch: The same attorneys may also add a provision in the trust distributions terms that principal may not be distributed to grantor, but may be distributed to some class of other beneficiaries within the discretion of the trustee or some other parties. These sorts of provisions are added to allow a mechanism to strip principal out of the trust without creating potential Medicaid availability issues for the grantor.8

If the consenting trustee or other consenting parties are also remainder beneficiaries, those consenting parties will be adverse. Because these adverse parties have control over distributions of principal, any accumulated capital gains added to corpus will be distributed via grantor’s will only with the tacit consent or approval of adverse parties. After all, these consenting parties may elect to distribute the entire trust prior to grantor’s death.

In this case, if grantor trust status with respect to trust principal is important, you need more than a testamentary POA if any adverse parties have the ability to distribute corpus prior to the grantor’s death. Solutions involve subjecting distributions of trust principal to the discretion of a nonadverse party or allowing grantor or a nonadverse party to add or delete remainder beneficiaries (both are grantor powers under Code section 674(a)).

For example: Greta Grantor retains a testamentary POA over trust corpus. Under the trust and local law, capital gains are added to principal. Greta’s son Anthony Adverse, the trustee and one of the named remainder beneficiaries, has the discretion to distribute principal to or among Greta’s issue. Greta’s testamentary POA is not a grantor power because an adverse party can prevent the accumulation of income for later testamentary distribution by ordering a distribution of principal.

By wisely identifying available potentially adverse and nonadverse parties in the grantor’s universe, and by carefully designing trust provisions to meet grantor’s needs, a drafting attorney can control the tax status of the trust. This accomplishment could insure hero status in the grateful client’s eyes.

Robert A. Mason, CELA, CAP, is owner of Mason Law, PC, Asheboro, NC, and counsel to Ligon, Lindberg & Lanier, PC, Brunswick, Ga.

The CAPsules column is provided by members of the NAELA Council of Advanced Practitioners (CAP).

Citations

1. IRC § 672(a).
2. IRC § 672(b).
3. See Treas. Reg. § 1.672(a)-1(b).
4. See Treas. Reg. § Treas. Reg. 1.672(a)-1(c).
5. Treas. Reg. § 1.672(a)-1(d).
6. Treas. Reg. § 1.674(b)-1(b)(3).
7. Id.
8. 42 U.S.C. § 1396p(d)(3)(B).