United States: Basis Of Grantor Trust Assets At Death: What Treasury Should Do

Two years have passed since Treasury and the IRS first announced that they were working on guidance relating to the basis of grantor trust assets at death.1 The project is apparently approaching completion — although Treasury's 2017-2018 priority guidance plan omitted projects not expected to be completed by the end of plan year, the basis of grantor trust assets at death remains on the list.2 Guidance, in other words, was expected to be issued by the end of June.

It is not surprising that Treasury remains committed to settling once and for all how the basis of grantor trust assets is determined after the grantor's death. Irrevocable grantor trusts, as described below, have become perhaps the premier vehicle whereby affluent Americans pass wealth free of gift and estate tax to the next generation. On top of their considerable estate tax planning benefits, grantor trusts may even qualify for a step-up in basis at death,3 at least according to some attorneys and tax scholars.4 At the same time, the IRS has vehemently rejected the theory that grantor trust assets receive a basis step-up at death.5 The guidance project apparently aims to establish that grantor trusts do not receive tax-free step-up in basis when the grantor dies.

Yet Treasury and the IRS face significant technical obstacles to achieving their objective. For better or worse, the IRS's own prior rulings and regulations have interpreted the code in a way that leaves no obvious solution to the problem of how the basis of grantor trust property is determined at death. Further, any subregulatory guidance risks inadvertently contradicting prior guidance. To avoid that outcome, Treasury and the IRS might need to reassess and possibly revoke decades-old rulings.

Fortunately, there is a way out. Section 1015(b) is an ancient and seldom-cited section of the code. But though the law may sleep, it is not dead: By its terms, section 1015(b) provides an answer to the vexed question of how the basis of grantor trust assets is determined after death. Specifically, under section 1015(b), the assets of a grantor trust after death have the same basis, once grantor trust status is turned off, as they had before death. In other words, consistent with the IRS view that grantor trusts do not qualify for a step-up in basis at death, section 1015(b) imposes a carryover basis.

Moreover, if Treasury and the IRS do rely on section 1015(b) to determine the basis of grantor trust assets at death, prior guidance would not need to be revoked or revised. Indeed, the IRS would merely have to reiterate the position it has already taken in an earlier ruling, Rev. Rul. 2008-41, 2008-30 IRB 170, and apply it in a different but analogous context. For those reasons, we argue, Treasury and the IRS should issue a revenue ruling holding that section 1015(b) governs the basis of trust property after an irrevocable grantor trust converts to a non-grantor trust at the death of the grantor.

I. Advantages of Irrevocable Grantor Trusts

A grantor trust is a trust that is treated as owned by the grantor or another person for income tax purposes under the rules of sections 671 through 679. Importantly, a gift can be considered complete for gift and estate purposes but still be treated as incomplete for income tax purposes. A wealthy individual, for example, can make a gift6 to an irrevocable trust that will not be included in the donor's gross estate at death under one of the estate tax "string" sections.7 As a result, all future investment returns on trust property from the date of the gift pass free of gift and estate tax.8

Even though the trust property passes outside the donor's gross estate for estate tax purposes, the trust can still be drafted as a grantor trust that is treated as owned by the donor for income tax purposes. For example, the grantor may retain the power (in a nonfiduciary capacity) to substitute property of an equivalent value9 or may give a non-adverse person a power to make loans to the grantor for less than adequate interest or security.10 Other techniques for triggering grantor trust status include designating the donor's spouse as a permissible beneficiary of the trust,11 granting a power to expand the class of beneficiaries,12 appointing a related or subordinate party as trustee,13 or having the trust acquire life insurance policies on the grantor's life whose premiums can be paid out of the income or principal of the trust.14 Even merely borrowing from the trust (or having the grantor's spouse borrow from the trust15) at some point during the year may cause grantor trust status for the entire year.16

With grantor trust status achieved, several estate tax planning techniques become possible. Perhaps the most powerful is simply the donor's obligation under the code to pay the tax on the grantor trust's income. The shift of tax liability from the trust to the donor allows the trust to earn tax-free returns during the donor's lifetime, even as the donor's own estate is depleted. Despite the significant — oftentimes massive — transfers of wealth that thereby occur, the donor is not treated as having made additional gifts to the trust for gift tax purposes.17

Another technique is to sell assets that will earn returns that exceed those earned on the consideration received. For example, the donor could sell assets to an irrevocable grantor trust in exchange for a promissory note bearing interest at no more than the applicable federal rate. If the value of the property transferred by the donor is equal to the value of the property received (that is, the note), no gift occurs for gift tax purposes.18 Further, under section 7872, the value of the note is not discounted to reflect the relatively low interest rate.19 Thus, the sale succeeds in passing wealth to the trust free of gift and estate tax as long as the assets earn returns that exceed the low interest rate.

Meanwhile, the IRS has for decades taken the position that grantor trusts are ignored for all income tax purposes.20 The sale, therefore, is ignored for income tax purposes and the grantor recognizes neither gain on the sale nor interest income on the note.21 In short, through a sale to a grantor trust, a wealthy individual can freeze the value of property transferred to a trust and cause future investment returns (above a relatively low interest rate) to pass to descendants, all without gift, estate, or income tax cost.

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1. See Treasury 2015-2016 priority guidance plan.

2. See Treasury 2017-2018 priority guidance plan and quarterly updates.

3. As discussed below, section 1014(a) generally provides that property acquired or passing from a decedent receives a basis equal to its fair market value on the date of the decedent's death or the alternate valuation date, if the estate tax alternate valuation date election is made. As most property tends to appreciate, and well-advised taxpayers typically realize losses before death, the fresh basis at death under section 1014(a) is commonly referred to, including in this article, as a basis "step-up."

4. Jonathan G. Blattmachr, Mitchell M. Gans, and Hugh H. Jacobson, "Income Tax Effects of Termination of Grantor Trust Status by Reason of the Grantor's Death," 97 J. Tax'n 149 (2002).

5. ECC 200937028.

6. Reg. section 25.2511-2. A gift is complete for gift tax purposes if the donor "has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or for the benefit of another." Reg. section 25.2511-2(b).

7. Sections 2035-2039 and 2041.

8. The code gives the IRS no mechanism for taxing future outsized returns earned by the donee of the gift. See reg. section 25.2511-2(a) ("The gift tax is not imposed upon the receipt of the property by the donee, nor is it necessarily determined by the measure of enrichment resulting to the donee from the transfer.").

9. Section 675(4); see also Rev. Rul. 2008-22, 2008-16 IRB 796.

10. Section 675(2).

11. Section 677(a)(1).

12. Such a power, combined with trustee discretion to make distributions, may cause grantor trust status under section 674(a) by negating the otherwise broad exception of section 674(c).

13. Like a power to add to the class of beneficiaries, the appointing of a related or subordinate party as trustee may cause grantor trust status under section 674(a) by negating the otherwise broad exception of section 674(c).

14. Section 677(a)(3); Rev. Rul. 66-313, 1966-2 C.B. 245.

15. Section 672(e).

16. Rev. Rul. 86-82, 1986-1 C.B. 253.

17. Rev. Rul. 2004-64, 2004-2 C.B. 7.

18. Section 2512(b); reg. section 25.2512-8.

19. See LTR 9535026 (holding that the value of secured notes bearing interest at the rate prescribed by section 7872 of the code was equal to the value of the property transferred); cf. LTR 9644053 (holding that a secured right to an annuity was equivalent in value to the property transferred); see also reg. section 25.2504-2(d), Example 3; Frazee v. Commissioner, 98 T.C. 554, 590 (1992); True v. Commissioner, T.C. Memo. 2001-167. But see Dallas v. Commissioner, T.C. Memo. 2006-212 (valuing promissory notes with self-canceling provisions at less than the value of the property sold).

20. ILM 201343021 ("We conclude that a trust that is treated as a grantor trust is ignored as a separate entity apart from the owner for all federal income tax purposes."); Rev. Rul. 85-13, 1985-1 C.B. 184; Rev. Rul. 2007-13, 2007-1 C.B. 684. Cf. reg. section 1.1001-2(c), Example 5 (stating that the grantor of a grantor trust "is treated as the owner of the entire trust"); but see Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984).

21. Rev. Rul. 85-13.

Originally published by Tax Notes.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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