Traps Await for Beneficiary-Owned Trusts Under Section 678

“Traps Await for Beneficiary-Owned Trusts Under Section 678,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Travis Hayes, ACTEC Fellow from Naples, Florida. There are some great planning strategies using beneficiary-owned trusts under Section 678, but if you’re going to use these planning strategies, you need to be aware of some big traps for estate planners. To discuss this topic, you’ll be hearing today from ACTEC Fellow Justin Miller of San Francisco, California. Welcome, Justin.

Thank you, Travis. So, today we’re talking about Section 678 under the Internal Revenue Code, and this is about treating the beneficiary as the deemed owner of the trust for tax purposes.

Now, Section 678 is a tremendous opportunity for planning purposes. Today I’m mostly going to be focused on traps under 678 but remember there are certainly some tips and tricks that you can use with Section 678.

What is Section 678?

Let me take a step back. What is Section 678? How does it work? And what are the traps we have to be careful of falling into? So, let’s start with Section 678.

Section 678 is part of Subchapter J. Now, Subchapter J mostly is about non-grantor trust taxation. Depending on what happens with proposed legislation, all of us are going to have to become more familiar with income taxation of non-grantor trusts. But within the non-grantor trust rules under Subchapter J, you have Subpart E. Subpart E includes the grantor trust rules and that’s where you treat the grantor as the deemed owner of the trust for tax purposes. Now, it could be the owner of part of the trust, income, principal, or even a portion of the trust, but most of Subpart E of Subchapter J deals with the grantor trust rules treating the grantor as the owner.

Then you get this one code, Section 678, that says, wait a minute. What about the possibility of treating someone other than the grantor as the deemed owner of the entire trust or a portion of the trust? And that’s what 678 deals with. And so, it really is focused on someone who is a beneficiary and a trustee, and that person has a power exercisable solely by himself or herself. The code section just says himself, but it does apply to anyone. So, any individual to vest corpus or income in himself, herself, themselves, it doesn’t matter. If they can do that, then they will be treated as the deemed owner of the trust, meaning, they’re going to have to pay taxes on the income of the trust whether they take it out or not just because they can.

Now, a couple things I want to clarify and that is on Part (b) of Section 678, 678(b) is very clear, and it says, wait a minute. If it is a grantor trust, meaning, if at any part of Subpart E treats the grantor as the deemed order, then that will supersede Section 678. Then we don’t care what rights the beneficiary has if the grantor is treated as an owner, meaning, it’s your typical, let’s say, defective grantor trust, then the grantor is the deemed owner, not the beneficiary.

Traps – Intentional and Unintentional

What are the traps that we need to be careful of? What are some of the traps? So, the first trap we want to be careful of is what I call an Unintentionally Defective Grantor Trust, or an UDGT. Some of you may have never heard of this acronym, and it’s probably because I made it up. But we should all be familiar with Intentionally Defective Grantor Trust (IDGT). So, this is the bread and butter of estate planning, intentionally defective grantor trust. This is where you have certain provisions, and you want the grantor to be the taxpayer for the trust. And this is what the proposed legislation is trying to get rid of, or at least limit.

Now, the idea of the defective grantor trust – these are irrevocable grantor trusts that the grantor can pay the taxes for the trust and allow the trust itself to basically grow tax free while the grantor is reducing their estate subject to estate taxes. And we’ve gotten lots of revenue rulings, 2008-22, 2004-64, Revenue Ruling 85-13. There’s a lot of support, and that’s why a lot of estate planners have a lot of intentionally defective grantor trust documents. And they have things like the ability to swap or substitute assets. It makes it a grantor trust under Section 675. So, there’s all these things that people are used to when drafting these defective grantor trusts. But if you want it to be a beneficiary on trust, if you’re purposely drafting this to take advantage of Section 678, you can’t make it a grantor trust. And you don’t want to do that by accident because remember, the grantor as owner supersedes the beneficiary as owner under Section 678.

So, we want to avoid Unintentionally Defective Grantor Trust. And an UDGT really means somebody messed up. They made a mistake. And that’s somebody that shouldn’t have been drafting these types of trusts. That might mean a real estate attorney or business attorney who doesn’t do this all the time. They left in a provision that made it a grantor trust, but it’s a reminder to all the estate planners out there, the drafting attorney, if you want it to be a Section 678 trust, make sure there are no other grantor trust triggers, and you have to be very explicit that’s what you’re trying to do. So, that’s the first trap. Don’t make it an Unintentionally Defective Grantor Trust, or UDGT.

The other big trap. The other big trap is we’ve got to be very careful how we draft these trusts if you don’t want to do a beneficiary on trust. Because, sure, it can be a great planning strategy. But you don’t want to accidentally fall into the trap of being a beneficiary on trust unless that is specifically what you wanted to do in the first place.

So, just to give you an example, if my parents draft a trust for me and I’ve got a bunch of siblings, and they give me the power, unrestricted, I can take the principal or income out and use it for my own benefit or my own sibling’s benefit because they trust me. Well, guess what, I might be the taxpayer for that entire trust, not just for me, which is fine. And don’t get me wrong, I love my siblings, but I don’t want to pay all the taxes on the trust for their benefit. I guess I don’t love them that much. I have enough taxes on my own.

And what could unfortunately be triggered under Section 678, if I have too much control and ability to take that money out willy-nilly for myself, I will be treated as the owner of that trust. So, we don’t want to have an Unintentional Defective Beneficiary-Owned Trust. So, once again, I call this an UDBOT. You’ve never heard that term before because, once again, I made it up. But an Unintentionally Defective Beneficiary-Owned Trust, or UDBOT for short. We want to avoid triggering 678, unless that’s specifically what we wanted to do in the first place for some fancy, schmancy planning.

Triggers – Intentional and Unintentional

When would you unintentionally trigger 678? There are some cases where you can – having a HEMS standard might be a way to avoid that unintentional trigger. HEMS meaning Help Education Maintenance and Supports is an ascertainable standard out of an abundance of being conservative and protection. If you don’t want it to be a 678, not only might you have a HEMS standard, but you might have a HEMS standard and say you have to take into account other assets that that beneficiary has.

So, what you want to say is that the trustee can’t just willy-nilly give out that money to others including himself or herself or themselves. That’s what you want to be careful of. This is also another reminder why it’s sometimes so important to have a good independent trustee. This is what good independent trustees do for a living. And, if someone else has the ability to give the money out to the beneficiaries – don’t get me wrong, they could be fired and replaced by the beneficiaries – but if you have a good independent trustee it’s a great way of avoiding an unintentional 678 trigger.

Now, there are some great cases in support of having that HEMS standard to avoid Section 678. You have the US v. De BonChamps case, or however you pronounce it. That’s a 1960 9th circuit case. There’s the Funk case, that’s a 3rd Circuit 1950 case and it lends support that as long as there is enough of a standard that the person just does not complete and utter absolute discretion to take this money out, then it won’t trigger 678 even if the beneficiary is trustee.

But there are also a couple of cases that we have to look out for. There’s the Kaufman case; that’s a 6th Circuit 1962 case, and it said 678 applied because the beneficiary got to determine the reasonableness of her withdrawals for support. There is the Salotto case. That’s a 5th circuit 1952 case that had a predecessor rule, but it dealt with a brother and sister cross-trustee trust. So, we do have to be careful on unintentionally triggering this 678 provision.

Example: Beyond Words and Paper, Administration Matters

And I’m going to leave you with a more recent case, just to show you it’s not just how good the attorneys are. You can have the best attorney in the world drafting the absolute best trust in the world and that trust is absolutely clear. 678 isn’t supposed to be triggered. This is complete. You’ve got all the bells and whistles. In fact, this is such a great trust agreement it should be framed and hung on the wall. So, you could have the perfect attorney and the perfect trust draftings. But we have to pay attention to not just form but substance. How are these trusts actually administered?

The case I’m talking about is the United Food and Commercial Workers Union v. Magruder Holdings. So, this was March 27, 2019, US District court case. This was actually an ERISA case, Employee Retirement Income Security Act. So, this is an actual ERISA case, but it looked at Section 678 of the Code. And it had to deal with there was a pension fund, and it had to do with not only going after Magruder, which is a company that went out of business. But it was looking at companies not only that owned Magruder but that had the same effective control and controlling interest to try and go after some related entities.

And what happened is they started going through and there was this sort of family partnership or family LLC, and it was owned 51 percent by these grantor trusts. So, it covered the ERISA affective-control group, but the other 49 percent was owned by this family trust. It was supposed to be a non-grantor trust.

So, the question dealing with ERISA was whether you had a controlling interest, which is an 80 percent or more interest. So, what the court did in this Magruder holdings case is looked at that family trust. Now, the family trust was well drafted, at least, as much as we can understand from the court case. You had four siblings who were trustees of the family trust, and you had four separate trusts, one for each sibling, that were beneficiaries of the family trust. And the siblings – it was pretty clear in the trust agreement. You could withdraw income and principal under the HEMS standard, Health Education Maintenance and Support. So, theoretically, you could argue 678 shouldn’t apply. It was a good non-grantor trust. You can’t kind of pierce the veil and look through to these individual beneficiaries. They were not the deemed owners, at least, according to the trust agreement.

Here was the problem. What happened in reality is the siblings took payments directly from the family trust, and they ignored the HEMS standards. They basically just said, well, money came in. They took money out. There was no independent trustee. There was no discretion being applied. There was no independent trustee. There was no trust committee, let’s say, a corporate trustee with good fiduciary officers looking through and should we make the distributions? Does it make sense?

So, the problem is, even though it was drafted with the HEMS standard, here’s what the court found. The actual usage is evidence of the siblings’ power exercisable solely by themselves to vest the corpus or the income or any portion of the trust in themselves. Really what the court found is 678 applied because these beneficiaries, as trustees, could take the corpus or income out and give it to themselves. And the court went on to say – and this is what’s important – and I’ll quote on this one. “A HEMS provision that exists only on paper cannot be said to restrict the power exercisable by the siblings as to the family trust.” So, if it’s only on paper, it cannot be said to restrict the power exercisable by the siblings as to the family trust. The final trap we want to be careful of is, it’s just not how well you draft this trust agreement. We have to be very careful about the actual administration of trust if we do not want to unintentionally trigger Section 678.

And with that, I hope this helps you with your planning for your client, and I hope you all have a great day. Thank you.

Thank you, Justin, for discussing planning strategies and potential traps relating to the beneficiary on trusts under Section 678.

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