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DAPT Discretionary Distribution Clauses and Grantor Trusts

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Introduction: A discretionary distribution provision in an asset protection trust (“DAPT”) gives the trustee the absolute discretion in making distributions, including whether and when, as well as what to distribute. This provision protects the beneficiary from the risks of judgments, litigation, and other claims and interference, including marital assessments, but not child support obligations.

Since the decision to make distributions is entirely within the trustee’s discretion, the beneficiary has no property interest; therefore, there is nothing to attach and nothing to enforce; further, a creditor cannot force the trustee to make a distribution.

A separate article on our website discusses a discretionary distribution provision limited by an ascertainable standard and the effects of that limitation on an asset protection trust under Wyoming law. The discussion in that article will not be repeated here.

Wyoming law on discretionary distributions is clear on the characterization of the beneficiary’s interest and the ability of a beneficiary’s creditors to force trust distributions. W.S. §4-10-504 “Discretionary trusts; effect of standard” without equivocation provides:

(b) When the terms of the trust provide that the trustee may only make discretionary distributions to a beneficiary, whether or not the trust contains a spendthrift provision [emphasis added], a creditor or assignee of the trust beneficiary . . . may not compel the trustee to distribute any income or principal, or both, from the trust or reach or attach the interest of the beneficiary unless and until a trust distribution is received by the beneficiary, even if:

(i) The trustee has discretion to make distributions for purposes stated in a standard of distribution;

(ii) The trustee has abused the discretion; or

(iii) The trustee makes distributions directly to third parties for the benefit of the beneficiary in accordance with the terms of the trust.

Subsection (g) of this provision provides:

Terms of a trust providing a trustee may make discretionary distributions to a beneficiary, whether or not the discretionary distributions are pursuant to a standard of distribution, shall not create any property interest in the beneficiary or any enforceable right to a distribution for the beneficiary.

The efficacy of the distribution standard in the asset protection trust is clear. What then is the tax effect of the foregoing? Specifically, does the IRC apply attribution rules against the trustee, the grantor, a trust protector, or the beneficiary and if so, will attribution affect the ability to plan either a grantor or non-grantor trust?

Grantor Trust Provisions. The IRC grantor trust provisions are found in §§671 - 679, inclusive. If these sections apply, the income tax attributes of the trust are attributable to the “grantor” and included on the grantor’s Form 1040. If not, the trust recognizes the tax on Form 1041 and distributions to the grantor are reflected in a K-1 in proportion to the income and corpus distributed to accord with IRC §643. Irrespective of whether the trust falls within the grantor trust provisions, the trust and its beneficiaries, unlike a corporation, do not suffer from double taxation.

The general rules for the grantor trust, as it pertains to discretionary distributions within the context of asset protection trusts, are set forth in §§674, 675, and 677. The exceptions to grantor trust status and the exceptions to the exceptions are specified within each rule.

IRC §674: Power to Control Beneficial Enjoyment:

General Rule: The grantor is treated as the owner of any portion of a trust over which there exists a power to distribute income, corpus, or both which is held by (i) the grantor, (ii) a non-adverse party, or (iii) both, without consent of an adverse party.

  • Examples are the power to:
    • add or eliminate beneficiaries;
    • distribute, appoint, or withhold corpus or income; and
    • determine who receives distributions, when, and what they consist of.

Exceptions:

IRC §674(b)(1): Powers Described in IRC §677(b): Grantor trust status does not arise because of a power described in §677(b) (a power to apply or distribute income for the support or maintenance of a dependent of the grantor) to the extent that the grantor would not be subject to tax under the IRC sections set forth in §677(b).

IRC §674(b)(2): Power Subject to Condition Precedent: Grantor trust status does not arise from a power which can only affect the beneficial enjoyment of the income for a period commencing after the occurrence of an event in which a grantor would not be treated as the owner under IRC §673 (reversionary interests).

Example: A power to distribute trust corpus and income exercisable only when a current beneficiary reaches age 65, where the actuarial value given the beneficiary’s age is less than 5% of the value of the trust property.

IRC §674(b)(3): Power Exercisable Only by Will: Grantor trust status does not arise from a power exercisable only by will. This exception does not apply when income may be accumulated within the trust for disposition by the grantor or may be accumulated in the discretion of the grantor or a non-adverse party, or both (without the approval or consent of an adverse party).

Example: Non-adverse trustee has discretion to distribute income to the grantor’s children for grantor’s life, with grantor holding a testamentary power of appointment over accumulated and undistributed income.

§674(b)(4): Power to Allocate among Charitable Beneficiaries: Grantor trust status does not arise from a power to irrevocably pay corpus or income to an (i) IRC §170(c) cause; or (ii) employee stock ownership plan so long as the transfer qualifies as a gratuitous transfer under in IRC §664(g)(1).

Example: A grantor retained power under a charitable remainder trust to name charities as remainder beneficiaries and to determine the proportion of their beneficial interests.

IRC §674(b)(5): Power to Distribute Corpus: Grantor trust status does not result from a retained power to distribute corpus provided either the: (i) power is limited by a reasonably definite standard set forth in the trust; or (ii) distribution of corpus is assessed against the proportionate share of corpus held in trust for the payment of income to the beneficiary as if the corpus constituted a separate trust.

These exceptions do not apply (i) if any person has a power to add beneficiaries or to a class of beneficiaries - except after-born or after-adopted persons; and (ii) to a power held by a beneficiary to substitute others to succeed to his or her beneficial interest or to testamentary powers that qualify under IRC §674(b)(3)

Example: Non-adverse trustee’s power to distribute trust corpus for the beneficiaries’ health, education, maintenance, and support.

Example: Non-adverse trustee’s power to distribute trust corpus to a current income beneficiary, where: (i) the trust provides that all current income beneficiaries are to receive an equal share of the trust’s income annually; and (ii) following the distribution the recipient beneficiary’s share of trust income is reduced as though his or her share of trust corpus generating income were reduced by the value of the distribution.

IRC §674(b)(6): Power to Temporarily Withhold Income: Grantor trust status does not apply to a distribution power over ordinary income (but not capital gains) to or for any current income beneficiary, or to accumulate the income for such beneficiary, provided that any accumulated income must ultimately be payable:

to the beneficiary from whom it was withheld, the beneficiary’s estate or appointees under a power of appointment that does not exclude from the class of possible appointees any person other than the beneficiary, or the beneficiary’s estate, creditors, estate creditors; or

to the beneficiary from whom it was withheld, if they do not survive a date of distribution that could reasonably be expected to occur within their lifetime, to their appointees under any power of appointment, or if they have no power of appointment to one or more designated alternate takers (other than the grantor or the grantor’s estate) whose shares have been irrevocably specified in the trust; or

on termination of the trust, or in conjunction with a distribution of corpus augmented by such accumulated income, to the current income beneficiaries in shares irrevocably specified in the trust.

The exception does not apply if any person has a power to add beneficiaries, except to provide for after born or after adopted persons. This exception to the exception does not apply to a power held by a beneficiary to substitute others to succeed to his or her own interest in the trust, or to testamentary powers that qualify under IRC §674(b)(3).

IRC §674(b)(7): Owner to Withhold Income During Beneficiary’s Disability: Grantor trust status does not arise because of a power exercisable only during: (i) the legal disability of any current income beneficiary, or (ii) a period when an income beneficiary is under the age of 21 years, if the accumulation is distributable or accumulated for that beneficiary.

IRC §674(b)(8): Power to Allocate Between Income & Principal.

IRC §674(c): Exception for Certain Powers of Independent Trustees. Grantor trust status does not obtain if the power is exercisable (without the approval or consent of any other person) to (i) distribute, apportion, or accumulate income to or for a beneficiary; or (ii) pay out corpus to a beneficiary (whether or not income beneficiaries). To apply this exception, the trustee may not be the grantor, nor may the majority of persons comprising the trustee be related or subordinate to the grantor or the grantor’s spouse.

This exception does not apply if any person has a power to add to the beneficiaries, except to provide for after-born or after-adopted children.

This exception to the exception does not apply to a power held by a beneficiary to substitute others to succeed to his or her own interest in the trust, or to testamentary powers that qualify under IRC §674(b)(3) (discussed above).

If grantor or the grantor’s spouse has the power to remove, substitute, or add trustees, this exception may not apply; however, a grantor’s power to remove or discharge an independent trustee on the condition that he or she substitute another independent trustee should not prevent a trust from qualifying under §674(c).

IRC §674(d): Power to Allocate Income Subject to Standard: A trust is not a grantor trust because of a power exercisable (without the approval or consent of any other person) by a trustee (if the trustee is not the grantor or the grantor’s spouse living with the grantor) to distribute, apportion, or accumulate income to or for a beneficiary, if the power is limited by a reasonably definite external standard set forth in the trust instrument.

This exception does not apply if any person has a power to add to the beneficiaries, except to provide for after-born or after-adopted children This exception to the exception does not apply to a power held by a beneficiary to substitute others to succeed to his or her own interest in the trust, or to testamentary powers that qualify under §674(b)(3).

A power in the grantor or the grantor’s spouse to remove, substitute, or add trustees may prevent qualification for this exception; however, if the grantor has the power to remove and replace the trustee, it may be sufficient to prohibit the grantor from replacing a removed trustee with the grantor, the grantor’s spouse (if living with the grantor), or any related or subordinate party to the grantor or grantor’s spouse.

IRC §675: Administrative Powers

General Rule: Grantor trust status pertains if certain administrative powers are present.

  • Power to deal for Less than Adequate and Full Consideration.
  • Power to Borrow without Adequate Interest or Security.
  • Actual Borrowing of Trust Funds (directly or indirectly).
  • Power to Vote Certain Securities: If any person (acting in a nonfiduciary capacity without the approval or consent of any person in a fiduciary capacity) may vote or direct the voting of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control.
  • Power to Control Investment of Trust Funds: If any person (acting in a nonfiduciary capacity without the approval or consent of any person in a fiduciary capacity) may control the investment of the trust funds (either by directing or vetoing proposed investments or reinvestments) to the extent the funds consist of stocks or securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control.
  • Power to Reacquire Trust Corpus: If any person (acting in a nonfiduciary capacity without the approval or consent of any person in a fiduciary capacity) may reacquire trust corpus by substituting other property of equivalent value. A swap power exercisable by a trustee presumed to be in a fiduciary capacity.
  • Power to Amend Administrative Trust Provisions: If a grantor may amend the administrative provisions of a trust so as to cause the grantor to be treated as the owner of a portion of the trust under IRC §675.

IRC §677: Income for Benefit of Grantor

General Rule: Grantor trust status applies, irrespective of the application of IRC §674, if income from the trust (without the approval of an adverse party) is, or in the discretion of the grantor (or a non-adverse party) may be (i) distributed to the grantor or the grantor’s spouse; (iii) held or accumulated for future distribution to the grantor or the grantor’s spouse; or (iii) applied to the payment of premiums of policies on the life of the grantor or the grantor’s spouse (unless for IRC §170(c) purposes).

This does not apply to income distributions to persons for whom the grantor is legally obliged to provide support if the distribution is not made. Corpus distributions fall with IRC §662.

IRS NOTICE 2008-63 AND THE WYOMING PTC

In this notice, the IRS, for purposes of this discussion, was presented under alternative (5) with a Private Family Trust Company (“PTC”) being appointed to serve as a trustee of a trust. The issue was whether a grantor trust would result.

There were two factual scenarios presented. The PTC provided in our documentation adheres to both situations, the first with a PTC statute and the second without.

Factual Situation Common to both Situations:

  1. A and B are husband and wife;
  2. C, D, and E are their children, all of whom are married and have children; and
  3. “Family” refers to A, B, C, D, and E, their children, the spouses and former spouses of the children, and each other descendant of A and B (both now living and future) and the spouses and former spouses of such descendants.
  4. A and B established separate irrevocable trusts for each of their children and grandchildren;
  5. C, D, and E established irrevocable trusts for their respective descendants;
  6. Each child or grandchild of A and B is the primary beneficiary of the trust established for that child or grandchild;
  7. Each trust receives contributions only from the person who created the trust; and
  8. All grantors and beneficiaries are United States persons and no trust is a foreign trust.

Each instrument:

  1. has a discretionary distribution provision;
  2. provides the primary beneficiary with the testamentary power to appoint the trust corpus to or for the benefit of one or more members of Family (other than the primary beneficiary) and/or one or more organizations described in IRC §§ 170(c), 2055(a) and 2522(a);
  3. provides that the grantor, or the primary beneficiary if the grantor is not living, may appoint a successor trustee other than himself or herself if the current trustee either resigns or is no longer able to fulfill the duties of trustee; and
  4. provides that the trust will terminate, in all events, no later than 21 years after the death of the last to die of certain designated individuals living at the time of the creation of the trust.

The PTC must create a Discretionary Distribution Committee (DDC) and delegate to the DDC the exclusive authority to make all decisions regarding discretionary distributions from each trust. DDC provides that no member may participate in the activities of the DDC regarding any trust (i) of which that DDC member or his or her spouse is a grantor or a beneficiary; or (ii) with a beneficiary to whom that DDC member or his or her spouse owes a legal obligation of support. Only officers and managers of the PTC may participate in decisions regarding personnel of the PTC and nothing in the PTC’s governing documents may override a more restrictive provision in a trust. No family member may enter into any reciprocal agreement, express or implied.

Finally, the PTC’s governing documents provide for the creation of an Amendment Committee, a majority of whose members are not related or subordinate to any shareholder of the PTC. This committee has sole authority to make changes to the PTC’s governing documents regarding the creation, function, or membership of the DDC or of the Amendment Committee itself.

The conclusion is that grantor trust status was not imputed to any of the trusts.

CONCLUSION

The discretionary distribution clause using a PTC provides the ultimate in asset protection, while allowing the family to choose the type of trust best for them: grantor or non-grantor. The election is not final at inception. Consider, for example, the ability to “toggle” between grantor and non-grantor trusts. This requires an understanding IRS Notice 2007-73 and the reporting obligations provides in that notice.

There are many ways in which to structure non-grantor trusts to minimize income taxes, state and federal, but these must be tempered by the effects on the persons establishing the trusts. One of the more interesting alternatives to income tax planning using is the use of non-grantor trust with incomplete gifts, which reduce state income taxes, but which do not preclude estate tax assessments against the grantor on trust corpus at death. These are the ING trusts - incomplete gift non-grantor trusts - in Wyoming, a “WING.”