Under federal tax law, there are significant differences between grantor and non-grantor trusts. Grantor trusts are treated as disregarded entities. In layman’s terms, this means that the grantor (i.e., the creator or the settlor) and the grantor trust are one and the same. Accordingly, if the trust generates income, that income is generally reported on the grantor’s income tax return. Conversely, if a trust is characterized as a non-grantor trust, the grantor is not subject to income tax—rather, the trust or the trust beneficiary (assuming the beneficiary is different from the grantor) become subject to income tax on the trust’s activities.
Because the grantor trust rules are complex, third parties often mislead taxpayers into believing that they can be easily avoided. Taxpayers should be particularly cautious of these types of claims, or any blanket claim that federal income tax may be avoided altogether through the usage of a trust. Indeed, the IRS and the federal courts have routinely struck down these types of arguments, resulting in significant penalties and interest to taxpayers.
The Grantor Trust Rules
Sections 671 through 679 of the Internal Revenue Code of 1986, as amended, contain the grantor trust rules. Very generally, these rules apply if the grantor retains certain rights over property that is transferred to trust. A common application of the grantor trust rules occurs when a grantor establishes a trust but retains the right to revoke it.[i] Because the grantor has the right to retain the benefit of the trust property through the simple act of revocation, the grantor continues to be treated as the owner of the trust’s assets for federal income tax purposes. Although there are additional grantor trust rules, the takeaway is that if these rules apply, the grantor—and not the trust or trust beneficiary—is subject to income tax on the trust’s activities.[ii]
Substance Over Form
To try to avoid the grantor trust rules, tax promoters commonly incorporate language into trust documents that provide that the settlor or grantor is a third party and not the taxpayer. In these instances, the third party generally makes a nominal contribution to the trust and then “resigns” or removes himself or herself altogether from the trust. Thereafter, the taxpayer contributes more significant assets to the trust. The tax promoter’s purpose in using a third-party settlor here is clear: it is an attempt to distance the taxpayer from application of the grantor trust rules by contending that the true grantor or settlor was the third party and not the taxpayer.
Taxpayers should recognize that the usage of a nominee settlor or grantor like the example above does not avoid the grantor trust rules. Rather, the IRS routinely attacks these types of sham transactions under various theories, including substance over form. Under the doctrine of substance over form, federal courts look at the “objective economic realities” of a transaction instead of the “particular form the parties [have] employed.”[iii] And, federal courts have utilized this doctrine to determine whether a particular trust is a grantor or non-grantor trust.[iv]
The Wyly SEC Case
One of the more notorious instances in which a federal court applied the substance-over-form doctrine to determine whether a trust was a grantor or non-grantor trust occurred in the Wyly SEC case,[v] which involved the wealthy Wyly brothers. During the height of their wealth in the 1990s, the Wyly brothers attended a seminar in New Orleans in which a tax promoter suggested that certain foreign trusts could be utilized by taxpayers for asset protection and for tax-deferral purposes. After the seminar, the Wylys engaged the tax promoter to help create several foreign trusts. According to the promoter, these trusts were non-grantor trusts because third parties would be used rather than the Wylys themselves. Regarding these third parties and their participation in the formations of the trusts, the court stated:
The Bessie Trust and the Tyler Trust were purportedly settled by Keith King, an individual associated with Ronald Buchanan, an IOM trustee selected by the Wylys, with initial contributions of $25,000 each. However, no such contribution was ever made. The trusts were settled with a factual dollar bill . . . plus an indebtedness of $24,999 each on the part of Keith King as settlor. That indebtedness was immediately forgiven.
The LaFourche Trust and the Red Mountain Trusts were purportedly settled by Shaun Cairns, another individual associated with Buchanan, also with initial contributions of $25,000 each. Cairns testified . . . [letters were prepared] stating that Cairns was establishing the trusts ‘to show his gratitude for the Wylys’ loyalty to our mutual ventures and their personal support and friendship. In truth, Cairns had never met nor dealt with the Wylys before establishing the trusts, and had provided only $100 towards the trusts. Shortly after these trusts were settled, Cairns’s trust management company was hired to serve as trustee for some of the Wylys’ IOM trusts.
Based on these facts, the court held that “[t]hese transactions were shams intended to circumvent the grantor trust rules.” In other words, although the third parties were, at least on paper, the grantors or settlors of the trust, the court refused to recognize them as such for federal income tax purposes. Instead, the court concluded that the Wylys should have been subject to federal income tax associated with the foreign trusts because they were the true grantors or settlors of those trusts. In the end, the SEC and IRS successfully obtained over $1 billion in judgments against the Wylys, resulting in them both filing for bankruptcy protection in the Northern District of Texas.
The grantor trust rules are complex. Regrettably, because of this complexity, tax promoters often mislead taxpayers into believing certain trust arrangements sold by the promoters are not subject to federal income tax. As the Wyly case clearly demonstrates, the wording of a trust agreement alone does not govern whether a trust is a grantor or non-grantor trust. Rather, the “economic realities” surrounding the transactions at issue control. Taxpayers should consult with their tax professionals any time a third party assures them of a “too good to be true” type of trust.
[i] I.R.C. § 676.
[ii] Kaplan v. Comm’r, 107 T.C.M. (CCH) 1226 (Mar. 13, 2014); Resolution Trust Corp. v. MacKenzie, 60 F.3d 972, 976-77 (2d Cir. 1995) (“Assets held in a grantor trust are considered the property of the grantor . . . thus making the trust assets taxable to the grantor, until those assets are distributed . . .”).
[iii] Close v. Comm’r, 107 T.C.M. (CCH) 1124 (Feb. 10, 2014).
[iv] See, e.g., U.S. v. Buttorff, 761 F.2d 1056, 1062 (5th Cir. 1985); Zmuda v. Comm’r, 731 F.3d 1417, 1421 (9th Cir. 1984); Hanson v. Comm’r, 696 F.2d 1232, 1234 (9th Cir. 1983).
[v] SEC v. Wyly, 56 F. Supp. 3d 394 (S.D.N.Y. 2014).