We will be holding a free 30-minute webinar on the use of grantor trusts on Monday, April 10, 2023 at 4:00 PM EST. Please click here to register. I wish to thank Stetson University College of Law students Jason McCosby and Peter Farrell for their assistance in writing this article.}
Estate tax planning experts and many affluent taxpayers are aware of the multiple advantages of what are known in the technical jargon as “Intentionally Defective Grantor Trusts” (IDGTs), which are irrevocable trusts that are intentionally drafted to trigger grantor status. This means that all income and deductions of the trust for federal income tax purposes are considered to be income and deductions of the grantor. This type of trust is also known as “disregarded.”
Grantor trust status can result from any one of a number of provisions within the trust, including allowing the grantor to replace trust assets with assets of equal value, allowing the grantor to borrow from the trust without adequate collateral, allowing the trust to pay premiums on life insurance on the grantor=s life from the income of the trust, allowing someone to add beneficiaries to the trust, or having a foreign trustee if the trust benefits one or more individuals who reside in the United States and the grantor resides in the United States. The above features will typically not cause the trust to be considered as owned by the grantor for federal estate and gift tax purposes.
Three benefits provided by grantor trusts have recently been in the crosshairs of Democratic Senators Bernie Sanders, Elizabeth Warren, and others in their battle to limit tax avoidance by the Aultra-wealthy.@ The Treasury Department just took steps to strike down one of the benefits in a Revenue Ruling issued on March 29, 2023, just days after the senators sent their proposals in a letter to the Treasury Secretary.
With Republicans in control of the House of Representatives, it was unlikely that any of these proposals would be enacted by legislation during the 118th Congress. Tax legislation has to start from the Ways and Means Committee of the House of Representatives, which is controlled by Republicans at this time, and some Democrats in the Senate, including Joe Manchin and Kyrsten Sinema, have been resistant to anti-wealth tax legislation. It seemed unlikely that Congress and the President would pass a law raining on the IDGT parade unless a blue storm comes through in 2024 and Democrats take control of the House.
This is why the Democratic senators instead urged the Treasury Department to exercise the full extent of its regulatory authority to limit what the senators view as unfair tax tricks employed by billionaires, multi-millionaires, and their Aelite lawyers@[1] to avoid paying income and estate taxes.
Senators Bernie Sanders, Elizabeth Warren, Sheldon Whitehouse, and Chris Van Hollen=s March 20, 2023 letter[2] requested that the IRS change its previous rulings and methodology to eliminate three grantor trust benefits.
1. They asked the Treasury Department to revoke its Revenue Ruling that provided that the transfer of assets between a grantor and grantor trust is a non-taxable event and the sale of assets to an Intentionally Defective Grantor Trust therefore triggers income tax.
2. They also asked the Treasury Department to clarify that the assets held by an Intentionally Defective Grantor Trust are not entitled to an income-tax basis adjustment to the fair market value of the assets on the death of the grantor.
3. Finally, the senators requested that the IRS confirm that when a grantor pays income taxes that are attributable to trust income, those payments are subject to the gift tax.
The letter concluded with a request that the Treasury Department provide answers to a series of questions before April 3, 2023.[3] These include the Treasury=s estimate of how much money is currently held in grantor trusts, its plans to take administrative action to address tax avoidance through grantor trusts, and its estimate of how much tax revenue could be raised from changing the rules related to grantor trusts.
In testimony before the Senate Appropriations Financial Services and General Government Subcommittee on March 22, 2023, Senator Van Hollen asked Secretary Yellen about the letter and whether the Treasury Department would Atake a look@ at their grantor trust proposals.[4] In her response, the Secretary pointed to the similar proposals in the Department=s 2024 Green Book to Aclamp down on that type of abuse.@[5]
Coincidentally, perhaps, and only nine days after they signed their letter, the Department issued a Revenue Ruling on March 29, 2023, formally eliminating the first enumerated tax advantages by holding that assets that are not part of an estate for estate tax purposes do not receive a basis adjustment when the grantor dies. While some Revenue Rulings provide that tax positions taken before the issuance of the Revenue Ruling may be “grandfathered” this Revenue Ruling does not do so, and thus implies that an income-tax basis adjustment will not be available notwithstanding that the IRS waited until 2023 to take and publish this position.
Tax Advantage 1: Whether the Transfer of Assets Between a Grantor and a Grantor Trust Is a Taxable Event for Federal Income Tax Purposes
The first enumerated tax advantage of grantor trusts that the senators requested be eliminated is the treatment of transfers of assets between a grantor and grantor trust as non-taxable events. Taxpayers can make a gift to such a trust to remove assets from his or her estate for estate tax purposes and at the same time sell assets to the trust for a low-interest-rate promissory note. This allows for the assets of the trust to grow and generate income that is normally at a significantly higher rate than the interest rate paid on the note. There is no income tax incurred on the sale of appreciated assets to such a trust unless or until those assets are sold by the trustee. The grantor of the trust can swap cash or bonds that have a high income tax basis for appreciated stocks or real estate before death in order to get a fair-market-value income tax basis on those assets.
By way of background, even though a trust is disregarded for federal income tax purposes, the tax law was not clear until 1985 that the transfer of assets in exchange for a note or other consideration between a grantor and a disregarded trust would not trigger income tax.
The Tax Court initially took the position that such a transfer would trigger income tax. The Tax Court held in its 1984 opinion Rothstein v. United States[6] that a grantor trust is a separate taxable entity from the grantor, even though they are both disregarded for income tax purposes. Therefore, according to the Rothstein case, transactions between a grantor and a grantor trust were taxable events. President Ronald Reagan appointed Donald Regan as Treasury Secretary in 1981 and I conjecture that Regan may have been personally involved to convince the IRS to go against the Tax Court=s holding in Rothstein. The Rothstein analysis was rejected by the IRS when it issued Revenue Ruling 85-13[7] in 1985, which provided that such transfers are not taxable events because the grantor is the owner of the trust property. The IRS explicitly stated that it would not follow Rothstein:
The court’s decision in Rothstein, insofar as it holds that a trust owned by a grantor must be regarded as a separate taxpayer capable of engaging in sales transactions with the grantor, is not in accord with the views of the Service. Accordingly, the Service will not follow Rothstein.[8]
The IRS continues to treat the grantor and grantor trust as a single entity for income tax purposes when the transfers are made between the grantor and the grantor trust. Therefore, under current law the transfer of assets between a grantor trust and its grantor are not subject to income tax. An individual can transfer rapidly-appreciating assets to a grantor trust in exchange for a low-interest promissory note in order to reduce federal estate taxation and pay the income tax from the income and sale of the appreciated asset to further reduce the grantor=s estate.
The letter from the senators to Janet Yellen strongly requests that Revenue Ruling 85-13 be revoked and that Rothstein be followed instead:
Revoking Revenue Ruling 85‑13 and following Rothstein, with appropriate exceptions to prevent disruption of business operations conducted for legitimate non‑tax reasons, provides a more sensible tax framework for grantor trusts.
In light of the below-referenced recent Tax Court cases regarding conservation easements, making such a change may possibly require a full regulatory procedure in accordance with the Administrative Procedure Act=s notice and comment procedures if the change is considered to be legislative in nature. This process typically takes years. In a set of consolidated cases decided in 2022, the Tax Court held that an IRS notice requiring the disclosure of syndicated conservation easement transactions on tax returns was invalid because it did not follow the proper notice and comment procedures.[9] The IRS has been put on notice that it cannot issue or change notices or rulings without following the proper steps because they have the strength of a regulation.
Tax Advantage 2: Whether Assets That Are Not Part of an Estate for Estate Tax Purposes Receive an Income-Tax Basis Adjustment When the Grantor Dies
The second tax advantage that the senators have now largely eliminated because of the newly-issued Revenue Ruling involves a debate among tax experts regarding whether property transferred to an irrevocable grantor trust receives a basis adjustment after the grantor=s death if the property was not included in his or her gross estate. Some tax experts (including this author) believe that the assets held in such a trust should receive a new fair-market-value income-tax basis on the death of the grantor, even though the assets are outside of the grantor’s estate for federal estate tax purposes, but most tax authorities believe to the contrary.
IRC ‘1014(a) allows for a decedent’s property to be passed on with an adjusted basis. The new owner takes the property at its value on the date of the decedent’s death if the transfer is allowable within the section.[10] If a transfer does not meet these requirements, and the new owner has not purchased the asset at fair market value, he generally takes the property subject to the prior owner’s basis. In such a case, if the new owner takes the property and disposes of it, he would owe tax on all of the asset’s appreciation from the time of the prior owner’s purchase.
For example: Doug Decedent buys 10 shares of XYZ stock at $1 per share. Doug Decedent holds these shares for 60 years, until they are valued at $1,000 per share. Doug Decedent dies, resulting in Benny Beneficiary receiving the shares. If the transfer qualifies under ‘1014(a), Benny Beneficiary gets those shares at the same basis as if he bought them today. He would not pay tax on any gains if he immediately sold the shares ($10,000 basis, $10,000 sale price, $0 gain). If, however, the transfer did not qualify, Benny Beneficiary would take these shares with Doug Decedent’s basis ($10). If he sold them at fair market value ($10,000), he would realize a taxable gain ($9,990). From this we can see how important it is for clients to protect their assets, and future recipients of them, by preserving the valuable opportunity that ‘1014(a) gives for assets to receive a basis adjustment at the owner’s death.
The senators requested that the Treasury clarify that Intentionally Defective Grantor Trusts are not entitled to this basis adjustment:
The Treasury Department should use its regulatory authority to issue a regulation or revenue ruling confirming the consensus view that IDGT assets that are not part of an estate for estate tax purposes do not receive stepped‑up basis when the grantor dies. The IRS has already taken this logical position in informal guidance (Chief Counsel Advice 200937028), but some aggressive practitioners continue to advise clients that trustees or beneficiaries can claim stepped‑up basis for assets in an IDGT when the grantor dies, thus eliminating capital gains tax liability. Treasury should stop this aggressive tax avoidance technique by clarifying that assets in an IDGT do not receive stepped‑up basis when the grantor dies.[11]
Just nine days after they sent their letter, the Treasury Department issued Revenue Ruling 2023‑2. The ruling held that assets within an irrevocable grantor trust should not receive a basis adjustment on the death of the grantor because the assets were not acquired or passed from the decedent to the beneficiary for purposes of IRC ‘ 1014(a)
The Revenue Ruling was based upon the following facts:
In Year 1, A, an individual, established irrevocable trust, T, and funded T with Asset in a transfer that was a completed gift for gift tax purposes. A retained a power over T that causes A to be treated as the owner of T for income tax purposes . . . . A did not hold a power over T that would result in the inclusion of T=s assets in A=s gross estate . . . . By the time of A=s death in Year 7, the fair market value (FMV) of Asset had appreciated. At A=s death, the liabilities of T did not exceed the basis of the assets in T, and neither T nor A held a note on which the other was the obligor.
The seven types of property that are entitled to this basis adjustment at a decedent’s death are defined in IRC § 1014(b).[12] The Revenue Ruling held that none of the seven property types apply to property owned by an irrevocable grantor trust upon the death of the grantor.
According to Revenue Ruling 2023-2 such an asset is not bequeathed (“giving property[,] usually personal property or money[,] by will”), devised (“giving property, especially real property, by will”), or inherited (“received from an ancestor under the laws of intestacy or property that a person receives by bequest or devise”) (therefore not §1014(b)(1) property). The grantor did not retain a power to revoke or amend the trust, and did not hold a power of appointment over the trust asset (therefore not §§1014(b)(2), (3), and (4) property). The asset was not community property (§1014(b)(5) property) and it is not included in the grantor’s gross estate (§§1014(b)(6) and (7) property).
Transfers to an irrevocable trust are considered to be “completed gifts” at the time of the transfer. If a grantor does not hold a beneficial interest in or certain decision‑making provisions that would require the trust asset to be included in the grantor’s gross estate (a “retained power”) the beneficiary is not “inheriting” these assets from the grantor on the grantor’s death. Rather, the beneficiary is receiving the assets from the trust, which does not constitute the assets being “bequeathed” or “devised” by the grantor. Therefore, the asset does not receive a basis adjustment, and the beneficiary’s basis in the assets is the same as the decedent’s basis in the assets at his or her death.
This ruling forces grantors to decide which is more valued: removal of the asset from the gross estate or a basis adjustment for the eventual recipient of the asset.
Tax Advantage 3: Whether the Payment of Income Tax on the Income of the Trust by the Grantor Is Considered to Be a Gift for Estate and Gift Tax Purposes
Pursuant to IRS Revenue Ruling 2004‑64, the payment of the grantor’s personal income taxes on income attributable to income of a grantor trust by reason of the income being reported on the Form 1040 Income Tax Return of the grantor is not considered to be a gift to the trust.
Revenue Ruling 2004‑64 held the following:
When the grantor of a trust, who is treated as the owner of the trust . . . , pays the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, the grantor is not treated as making a gift of the amount of the tax to the trust beneficiaries. If, pursuant to the trust’s governing instrument or applicable local law, the grantor must be reimbursed by the trust for the income tax payable by the grantor that is attributable to the trust’s income, the full value of the trust’s assets is includible in the grantor’s gross estate under section 2036(a)(1). If, however, the trust’s governing instrument or applicable local law gives the trustee the discretion to reimburse the grantor for that portion of the grantor’s income tax liability, the existence of that discretion, by itself (whether or not exercised) will not cause the value of the trust’s assets to be includible in the grantor’s gross estate.
The letter from the senators strongly urges the IRS to revoke this Revenue Ruling and instead follow its holding from a 1994 Private Letter Ruling:
Revenue Ruling 2004‑64 holds that gift tax would not apply to a grantor=s payment of income tax attributable to trust income, which effectively allows grantors to make additional, tax‑free gifts to the trust beneficiaries. By contrast, a 1994 Private Letter Ruling (PLR 9444033) held that a grantor=s payment of income tax attributable to trust income would incur gift tax, which is the result that would presumably follow if Revenue Ruling 2004‑64 were revoked. The IRS should revoke Revenue Ruling 2004‑64 and confirm that when a grantor pays income taxes that are attributable to trust income, those payments are subject to the gift tax. This change would eliminate an unwarranted tax avoidance opportunity for wealthy grantors.
While there are many aspects of the federal tax law that Bernie Sanders, Elizabeth Warren, and others want to change, they are clearly applying a laser focus and a scalpel[13] to the grantor trust. Given the swiftness in which the Treasury Department issued Revenue Ruling 2023-2, taxpayers who would benefit from the Asale to Intentionally Defective Grantor Trust for promissory note@ technique or payment of income tax attributable to income of a grantor trust not being considered a gift to the trust should take advantage of these remaining tax advantages without delay. It is a general principle of tax history that arrangements in place at the time a new law is passed will typically be grandfathered. This gives even more incentive for taxpayers to make the best use possible of grantor trusts while they still can.
For trusts that are not fully revocable by the deemed owner, the proposal would treat the transfer of an asset for consideration between a grantor trust and its deemed owner or any other person as one that is regarded for income tax purposes, which would result in the seller recognizing gain on any appreciation in the transferred asset and the basis of the transferred asset in the hands of the buyer being the value of the asset at the time of the transfer.