Revenue Ruling 79-35: Trustee Removal and Estate Tax

Revenue Ruling 79-35 from the Internal Revenue Service (IRS) created significant concern in trust and estate planning. The ruling addressed the ability of a trust’s creator, the grantor, to remove a trustee and appoint a new one, treating this power as a substantial right of control.

The ruling suggested that holding the authority to change a trustee could cause the trust’s assets to be included in the grantor’s taxable estate upon death. This interpretation caused uncertainty for individuals seeking to create tax-efficient structures for their beneficiaries.

The Mandate of Revenue Ruling 79-35

Revenue Ruling 79-35 addressed a scenario where a grantor of an irrevocable trust retained the power to remove a corporate trustee at any time, without cause, and appoint another. The terms of the trust explicitly prevented the grantor from appointing themselves as the trustee. Despite this limitation, the IRS determined that the value of the assets held in the trust must be included in the grantor’s gross estate for federal estate tax purposes.

This conclusion was based on Internal Revenue Code Sections 2036 and 2038. The reasoning was that an unrestricted power to replace a trustee was equivalent to holding the trustee’s powers. If a trustee had broad discretion over distributions, the IRS argued that the grantor, by being able to substitute trustees, effectively retained control over those decisions and had not fully relinquished control.

The Reversal Under Revenue Ruling 95-58

After years of criticism, the IRS issued Revenue Ruling 95-58, which explicitly revoked the earlier mandate of Revenue Ruling 79-35. This new ruling allows grantors to hold a removal and replacement power over a trustee without adverse tax consequences.

Under the standard in Revenue Ruling 95-58, a grantor’s power to remove a trustee and appoint a successor will not, on its own, cause the trust’s assets to be included in their gross estate. This holds true even if the trustee possesses broad discretionary powers over distributions, as the power to replace a trustee does not automatically mean the grantor has retained the trustee’s powers.

This change came with a condition that serves as a safe harbor for taxpayers. The protection is contingent on the grantor’s power being limited to appointing a successor trustee who is not a “related or subordinate party” to the grantor.

Defining a Related or Subordinate Party

To comply with the safe harbor in Revenue Ruling 95-58, it is necessary to understand the definition of a “related or subordinate party.” The ruling borrows its definition from Internal Revenue Code Section 672, which provides a list of individuals and entities considered to be under the grantor’s influence.

The term encompasses several categories. A related or subordinate party includes:

• The grantor’s spouse, if living with the grantor
• The grantor’s father, mother, descendants, brothers, and sisters
• An employee of the grantor
• A corporation in which the stock holdings of the grantor and the trust are substantial from the viewpoint of voting control
• A subordinate employee of a corporation in which the grantor is an executive

By avoiding the appointment of any successor trustee fitting these descriptions, a grantor can retain the power to remove and replace a trustee without risking the inclusion of trust assets in their estate.