Swap powers in your irrevocable trust: How do you properly exercise them?

What is a swap power and why do you care?

A “swap power” is also called a “power to substitute.” It is a special right reserved to you (or someone else) in a trust you create while you are alive. This right gives you the power to swap an asset of yours, say cash, for an asset held in the trust you created. Why would you want to include a swap power in a trust you create?

1. A swap power should characterize the trust as a grantor trust. For income tax purposes that means that you would report trust income on your personal income tax return and pay the tax on trust income, even though that income is received by the trust and even if you have no right to get at the income. While that might not sound like a great deal, it really is. Grantor trust status allows you to transact business with the trust without income tax consequences. Be careful, however; the Biden Administration may change the benefits of these types of trusts.
2. A swap power gives you the right to switch properties. Say you transferred an interest in your family business to an irrevocable trust and the trust provides that your son who at the time was running the business would ultimately inherit the business. Subsequently your son decided the family business was not his future, but your daughter has become active in the business. If you can, swap the business out of the trust for cash. Once you have ownership of the business back in your name you can bequeath it however you feel appropriate regardless of the terms of the trust.

Bottom line is that grantor trust status can provide valuable flexibility and a swap power may just be the ticket to that benefit.

Who can hold a swap power?

Generally, the person setting up the trust (the “settlor” or “grantor”) would hold the swap power under the terms of the trust. More technically, any person who is designated in the trust document and who acts in a nonfiduciary capacity (i.e., not a trustee) can hold this power. Whoever is appointed should have no fiduciary ties to the trust.

If you are planning a new trust with a swap power, you might also address what happens if you are incapacitated. For example, the trust might provide that if you are incapacitated the agent under your durable power of attorney can instead act. If that is done be sure that you have a durable power of attorney (names an agent to handle legal and financial matters if you cannot) and that the document gives the agent the right to exercise your swap power if you are disabled. Other mechanisms might be integrated into the trust document to name successor power holders.

What does the person holding the power have the right to do?

A swap power gives you (or the other person holding the power) the right to substitute your assets for trust assets. More technically, it is the right to reacquire the trust property (corpus) by swapping (substituting) other property of an equivalent value.

Will the swap power cause trust assets to be included in your estate?

Your holding a swap power should not cause inclusion of the trust assets in your gross estate for estate tax purposes. This is because the right to swap assets does not enable you to consummate additional wealth transfers to reduce your estate. If you swap highly appreciated Apple stock worth $100,000 you have to transfer into the trust $100,000 of another asset, say cash, so there cannot be any wealth transfer if you properly exercise the power.

Key IRS authority

The IRS issued Revenue Ruling 2008-22 that provides important guidance on using a substitution power. If you set up the trust (you were the grantor) and you retained the power, exercisable in a nonfiduciary capacity, to acquire property held in the trust by substituting other property of equivalent value, the trust assets should not be included in your taxable estate. The IRS Ruling explains that the substitution power will not, alone, cause the value of the trust corpus to be includible in the grantor’s gross estate.

But it sets forth a number of requirements on the Trustee:

• The trustee has to have a fiduciary obligation (under local law) to confirm that the properties acquired and substituted by you are in fact of equivalent value.
• The trustee must have under the trust agreement a duty to act impartially in investing and managing the trust assets, taking into account any differing interests of the beneficiaries.
• Under local law and without restriction in the trust instrument, the trustee must have the discretionary power to acquire, invest, reinvest, exchange, sell, convey, control, divide, partition, and manage the trust property in accordance with the standards provided by law.

The Ruling also sets forth a number of requirements on you as the holder of the swap power:

• The substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries.
• The power is exercisable by you in a nonfiduciary capacity, without the approval or consent of any person acting in a fiduciary capacity.
• You must certify in writing that the substituted property (e.g., cash) and the trust property for which it is substituted, are of equivalent value.

How to exercise a swap power

If you are going to exercise a swap power, be certain to comply with the terms of the power held in the trust and the requirements of Revenue Ruling 2008-22. Both you and the trustee should document that you have complied with each of the above requirements. As to confirming that the properties swapped are of equivalent value, if either or both properties are not marketable (e.g., an interest in a real estate rental property) have qualified appraisals completed. Be certain to save all of the corroborating documentation as part of the permanent trust records. Also, consider whether the swap should be disclosed on your gift tax return as a non-gift transaction. If the swap is adequately disclosed on the gift tax return it may serve to toll the statute of limitations for a later IRS audit.

This article was written by Martin Shenkman from Forbes and was legally licensed through the Industry Dive publisher network. Please direct all licensing questions to legal@industrydive.com.

The contents in this article are being provided for educational and informational purposes only. The information and comments are not the views or opinions of Union Bank, its subsidiaries or affiliates.