Editor: Howard Wagner, CPA
A client may want to own a certain asset that is held inside the client's irrevocable trust. What are commonly referred to as "swap powers" often provide the flexibility needed to achieve the client's wish without adverse income, estate, or gift tax consequences. Many irrevocable trusts include such a power allowing the grantor to substitute nontrust assets for trust-owned assets (Sec. 675(4)).
The inclusion of swap powers is a common method of qualifying a trust as a grantor trust for income tax purposes while still removing assets from the grantor's taxable estate. A swap power allows the settlor (or someone without a beneficial interest in the income or assets of the trust) to transfer personally owned assets into a trust in exchange for trust assets of equivalent value. However, regardless of its original intent, the power may provide many other valuable planning opportunities. While this discussion focuses on the use of swap transactions, the client's estate planning counsel should be consulted before completing a swap transaction.
When exercising swap powers under Sec. 675, the trustee must be under a fiduciary obligation to ensure that the assets substituted or swapped are of equivalent value (see Rev. Rul. 2008-22). The transaction may not leave beneficiaries of the trust in a better or worse economic position. The trustee should document the value of the transferred assets to show they are of equivalent value for each swap transaction. Trading ABC publicly traded securities for XYZ publicly traded securities of equal value held in a trust containing these provisions would be an appropriate swap transaction, since publicly traded securities have a readily ascertainable fair market value. However, for non—publicly traded assets, which are most often the subject of a swap transaction, appraisals or business valuations are essential to ensure assets being exchanged are of equivalent value.
Beyond determining equivalent value, trustees must evaluate other characteristics of the assets. For example, if closely held stock is being exchanged for trust assets, it is important to make sure the voting rights are held by the trust and not the settlor. If the settlor retains the voting rights for the property transferred to the trust, the settlor's taxable estate would include the assets received in the swap plus the stock transferred to the trust (Sec. 2036(b)). This effectively negates the purpose of making a gift.
The timing of a swap of trust assets can be important for estate planning purposes. For instance, a grantor or the grantor's spouse might be diagnosed with a terminal illness. This taxpayer may find it beneficial to exercise a swap power to reacquire an asset for which a step-up in basis is desirable. This might be as simple as having a grantor swap high-basis assets to the trust in exchange for low-basis assets. Whether or not the grantor or the grantor's spouse is in a deathbed scenario, this power is exercised in a nonfiduciary capacity. Thus, the person exercising the power does not need the trustee's consent to complete the swap transaction; however, legal counsel should be consulted.
Assume the grantor trust status for income tax purposes is going to be terminated (which could be motivated by many different reasons that are beyond the scope of this discussion). Assume further that any sale of publicly traded securities owned by the soon-to-be nongrantor trust would result in a capital loss. Since capital losses do not flow to the settlor or a beneficiary in a nongrantor trust, the trust may not be able to take advantage of the capital loss.
If the grantor has capital gains, substituting another asset for those publicly traded securities prior to termination of the grantor status could be wise income tax planning. Had the capital losses remained owned by a nongrantor trust that did not have an opportunity to generate future capital gains, those capital losses could end up trapped inside the trust.
In addition to income tax planning, contributing rapidly appreciating assets to a trust is an appropriate estate planning technique to remove future appreciation from a taxable estate. If the original assets that funded the trust have not appreciated as expected or have "run their course" and are now expected to level off or even decline in value, it may be wise to swap different assets into the trust that have a higher future potential for appreciation. The opposite may be true if, due to the fact the estate lifetime exemption amount doubled under the law known as the Tax Cuts and Jobs Act, P.L. 115-97, there is no longer any concern about estate tax inclusion.
On its face, the exercise of swap powers is not a taxable gift, provided the properties exchanged are of equivalent value. Nevertheless, it may be prudent to report the swap on a gift tax return at zero value, which will start the statute of limitation on challenges to the reported values, provided that adequate supporting documentation of the valuation is included.
Clearly, a swap power provision can add flexibility to an irrevocable trust for the grantor's investment, income tax, and estate tax planning. This useful tool is often forgotten after the trust agreement is signed and tucked away for safekeeping in the grantor's desk drawer. However, now may be the time to review trusts and search for the power, which is often buried in boilerplate provisions. Find it, and a wide range of valuable options may become available to your client.
Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Crowe LLP.