Grantor Retained Annuity Trusts (GRATs) and Intentionally Defective Grantor Trusts (IDGTs) typically give the grantor the power to substitute assets of equivalent value, exercisable in a non-fiduciary capacity. This is commonly referred to as a “swap” power. The power to “reacquire the trust corpus by substituting other property of equivalent value” causes the trust to be treated as a grantor trust for income tax purposes. IRC Section 675(4)(c).

In Revenue Ruling 2008-22, the IRS held that, when a grantor has a power of substitution and such power is held in a non-fiduciary capacity, the trust property will not be includable in the grantor’s gross estate under IRC Section 2036 (transfers with retained life estate) or IRC Section 2038 (revocable transfers), so long as the trustee has a fiduciary obligation (provided either in the trust agreement or under local law) to ensure that the properties acquired and substituted by the grantor are, in fact, of equivalent value. In addition, the trustee must determine that the power cannot be exercised in a manner that would shift benefits among the beneficiaries of the trust.

However, Revenue Ruling 2008-22 did not address the consequences of whether the grantor’s retention of a swap power over a life insurance policy would be viewed as an “incident of ownership” under IRC Section 2042. Fortunately, this issue was resolved favorably by the IRS in Revenue Ruling 2011-28. That ruling concludes that the retained substitution power will not cause inclusion of the death proceeds in the grantor’s estate under IRC Section 2042, so long as (1) the grantor cannot serve as trustee, (2) the trustee has a fiduciary obligation to ensure that the substituted assets are of equivalent value, and (3) the substitution power cannot be exercised in a manner that shifts benefits among the trust beneficiaries.

Besides being a safe way to create grantor trust status, a swap power gives the grantor the absolute right to reacquire a trust asset, provided “equivalent value” is paid to the trust. Therefore, the grantor does not have to convince the trustee to sell the asset to him or her. Following are some common situations where exercising the swap power can be helpful:

1.  The asset in the GRAT or IDGT has declined in value. By reacquiring the asset from that low point and transferring it to a new GRAT (or selling it to a new IDGT), the future appreciation can be transferred.

2. The asset has grown substantially in value. By swapping it for cash (or a less volatile asset), the success of the GRAT or IDGT can be assured. An added benefit is that the asset will receive a stepped-up basis at the grantor’s death (thereby avoiding the 20% capital gains tax, the 3.8% net investment income tax and possibly, state income taxes).

3. To swap a life insurance policy with another policy containing more favorable provisions. Thus, outdated and/or expensive policies no longer have to be an expensive irrevocable mistake. It should be noted that determining the proper value of a life insurance policy may be problematic, particularly when the insured is in poor health.

4. To address changed client goals and/or liquidity needs.

Finally, can the grantor swap assets for his/her promissory note? It appears so. While notes from a GRAT cannot be used to satisfy annuity payments, with a swap power the note is to the GRAT. Perhaps the biggest problem with using a note is determining what interest rate to use. Using a market rate (e.g., prime plus) instead of the Applicable Federal Rates (AFR) increases the wealth transferred to the GRAT or IDGT. But this could result in the IRS arguing that the grantor gave an asset to the GRAT worth more than the asset received. If so, that is a prohibited additional contribution to the GRAT (or an additional gift to the IDGT that may have gift and GST tax implications). On the other hand, is using the AFR really something of equivalent value, particularly in light of the historically low AFRs? Therefore, the conservative approach is to avoid promissory notes.