What Is Section 673 and How Does It Apply to Reversionary Interests?

Section 673 of the Internal Revenue Code addresses reversionary interests in trusts, specifically when a grantor retains rights that could result in being treated as the owner for tax purposes. This provision determines whether trust income is taxed to the grantor rather than the trust or its beneficiaries.

Understanding its application requires examining when a reversionary interest exists and how its value affects taxation.

Conditions for Reversionary Interests

A reversionary interest exists when trust assets or income may return to the grantor after a certain period or event. Section 673 considers the likelihood and timing of this reversion in determining tax treatment.

If the reversionary interest exceeds 5% of the trust’s value at the time of creation, the grantor is considered the owner for tax purposes. This calculation relies on IRS actuarial tables, which estimate the probability of the reversion based on the grantor’s age and the time before assets could revert. If the reversion depends on an uncertain event, such as a beneficiary’s death, the IRS may use alternative valuation methods to determine if the 5% threshold is met.

Certain reversions are disregarded. If assets return to the grantor only after the death of a beneficiary who is at least 21 years old, the reversionary interest is ignored for tax purposes. This prevents estate planning structures from unintentionally triggering grantor trust status. Similarly, if the reversion depends on an unlikely event, such as a beneficiary voluntarily giving up their rights, the IRS may determine that no meaningful reversionary interest exists.

Criteria for Grantor Relationship

For a trust to be classified as a grantor trust under Section 673, the grantor must retain powers or interests that indicate ongoing control. The IRS evaluates whether the grantor has substantive rights that influence the trust’s administration or economic outcomes, determining whether income, deductions, and credits should be reported on the grantor’s tax return.

A key factor is control over distributions. If the grantor can direct how income or principal is distributed—either directly or through a related party—the IRS may conclude they still hold effective ownership. This applies even if the grantor does not personally receive distributions but can allocate funds among beneficiaries in a way that serves their interests.

Another factor is the power to substitute trust assets. If the grantor retains the right to exchange trust property for assets of equivalent value, this suggests continued control. Courts have upheld this interpretation when the grantor had the unilateral ability to alter the trust’s holdings, maintaining ownership despite legal title being transferred.

Determining the Reversion’s Value

Calculating the value of a reversionary interest requires analyzing the present worth of assets that may return to the grantor. The IRS uses actuarial principles to assess whether the reversionary interest represents a significant portion of the trust’s value.

One primary method for determining present value is applying IRS-prescribed discount rates under Section 7520. These rates, updated monthly, reflect prevailing interest conditions and impact valuations of future interests. A higher discount rate lowers the present value of a reversionary interest, while a lower rate increases it. The grantor’s age and life expectancy, as outlined in IRS mortality tables, further refine the calculation. If the trust specifies that assets revert only after a fixed number of years, valuation incorporates the probability of the grantor surviving that period.

Trust structure also affects valuation. If the trust allows discretionary distributions that deplete principal, the potential value of the reversion may decline. If the trust holds volatile assets like stocks or real estate, the IRS may require additional analysis to ensure valuation reflects economic conditions. Courts have ruled in cases where the IRS challenged undervalued reversions, emphasizing the importance of accurate financial models over speculative assumptions.

Classification Under the Code

The classification of a reversionary interest under Section 673 depends on whether the trust structure results in the grantor being treated as the owner for tax purposes. The IRS evaluates the trust’s overall design and the extent to which the grantor retains economic benefits.

A key distinction exists between revocable and irrevocable trusts. While a reversionary interest may exist in both, irrevocable trusts require closer assessment to determine if the grantor’s retained interest meets the threshold for ownership. If the trust agreement allows the grantor to influence investment decisions or administrative functions, this further supports classification as a grantor trust. The IRS has scrutinized trusts where the grantor’s retained powers extend beyond a passive reversion, particularly when those powers enable indirect access to trust income or assets.

Interplay With Similar Provisions

Section 673 interacts with other provisions governing grantor trusts, sometimes leading to overlapping tax treatments. Understanding these relationships is necessary for structuring trusts to align with tax planning objectives while complying with IRS regulations.

Section 674: Control Over Beneficial Enjoyment

Section 674 applies when the grantor retains control over how trust income or principal is distributed. Even if a reversionary interest under Section 673 does not exceed the 5% threshold, the trust may still be classified as a grantor trust if the grantor can direct distributions, either directly or through a related party. This is particularly relevant when the grantor appoints a trustee with discretionary authority who is a close relative or business associate. The IRS examines these arrangements to determine whether the grantor has indirect control over the trust’s financial benefits, which could result in income being taxed at the grantor’s individual rate rather than the trust’s higher tax brackets.

Section 675: Administrative Powers

Section 675 focuses on retained administrative powers that indicate ongoing control over trust assets. If the grantor can substitute assets of equivalent value, borrow from the trust without adequate security, or influence investment decisions, the trust may be classified as a grantor trust regardless of the reversionary interest. This provision is often used in estate planning to create intentionally defective grantor trusts (IDGTs), where the grantor is taxed on trust income while allowing trust assets to grow outside their taxable estate. The IRS evaluates whether these retained powers provide the grantor with meaningful economic benefits, which can override classification under Section 673.

Section 676: Power to Revoke

Section 676 applies when the grantor retains the ability to revoke the trust and reclaim its assets. Unlike Section 673, which focuses on future reversionary interests, this provision deals with immediate control. If a trust is revocable, the IRS automatically treats it as a grantor trust, making Section 673’s 5% threshold irrelevant. This distinction is important for estate planning, as revocable trusts offer flexibility but do not provide the same tax advantages as irrevocable structures designed to shift income or assets to beneficiaries.