Upon repeal of the federal estate tax laws, many estate
planners were forced to take a closer look at specific sections of the Internal
Revenue Code affected by repeal. One
provision that has received particular attention is section
2511(c), which became effective on January 1, 2010, and reads:
Treatment of Certain Transfers in Trust. Notwithstanding any other provision of this
section and except as provided in regulations, a transfer in trust shall be
treated as a transfer of property by gift, unless the trust is treated as wholly owned by the donor or
the donor's spouse under subpart E of part I of subchapter J of chapter 1.
Legislative Intent and Purpose of Section 2511(c)
The gift tax and estate tax are related parts of the
federal transfer tax system. If there
was no gift tax, taxpayers could simply give away their assets during life and
avoid the estate tax at death. In 2010, while
there is no estate tax, there is no need to have a gift tax as a backstop to
the estate tax. However, the gift tax
was retained in 2010 to discourage high income tax bracket taxpayers from
shifting income tax liability to individuals or trusts in lower income tax
brackets. If a transfer to a trust could
be incomplete for gift tax purposes, because the grantor retains certain
powers, but complete for income tax purposes, because the trust was not a
grantor trust, then it seems that a high income tax bracket taxpayer could
avoid gift tax and shift the income tax liability to lower bracket taxpayers. Section 2511(c) responds to this income tax
shifting possibility by treating all transfers to trusts as gifts, and thus
subject to gift tax, unless the trust is wholly owned by the grantor or the
grantor's spouse. If a trust is wholly
owned by the grantor or the grantor's spouse the income of the trust remains
taxable to the grantor or the grantor's spouse under sections 671-679 of the
Internal Revenue Code.
What Does 2511(c) Mean and Why Does It Raise
Concerns For Estate Planners?
Prior to January 1, 2010,
it was possible for an irrevocable trust to be a grantor trust for income tax
purposes but not for gratuitous transfer tax purposes, because the income and
gratuitous transfer tax laws are not completely consistent with each
other. For example, a dynasty trust can
be drafted as a grantor trust for income tax purposes but not for gratuitous
transfer tax purposes. This grantor
trust feature can make a dynasty trust even more valuable than otherwise for
estate planning purposes, because the value of the trust is not reduced by the
income taxes attributable to its taxable income at least while the grantor is
alive. Instead, the grantor is taxable
with respect to the trust's taxable income, which results in what amounts to a
tax-free gift by the grantor to the trust each year in an amount equal to the
income tax liability attributable to the trust's taxable income.1 Such a trust is sometimes referred to as an intentionally
defective grantor trust (IDGT). Another type of irrevocable grantor trust sometimes used in
estate planning is a grantor retained annuity trust (GRAT).
Read literally section 2511(c) could be interpreted to
mean that any transfer to a wholly owned grantor trust in 2010 is not a gift
for federal gift tax purposes. This
provision raised concern among estate planners that a gift to a wholly owned
grantor trust will not be treated as a gift, even if it would otherwise be
treated as a gift under Chapter 12 (the federal gift tax rules), and whether or
not such a transfer to a trust could trigger a gift at some later time. For instance, does section 2511(c)
provide that transfers to GRATs, IDGTs, or other wholly owned grantor trusts in
2010 are not treated as a gift, and therefore not subject to the gift tax at
the time of transfer? If so, does section
2511(c) also mean that when the property is distributed out of a wholly owned
grantor trust or such trust is no longer a grantor trust (e.g., when the grantor
dies, or the grantor trust powers are released or terminated) a gift is deemed
to have occurred at that time? If that
is the meaning of section 2511(c) then much of the transfer tax planning benefits
of GRATs, IDGTs and other wholly owned grantor trusts would be eliminated.
IRS Provides Guidance in Response to "Inaccurate
Interpretations"
The IRS
issued "Guidance for Persons Making Transfers in Trust After December 31, 2009"
in Notice 2010-19 which attempts to clarify that the above interpretation is
incorrect and that gifts to grantor trusts during 2010 may be completed gifts
using the same criteria as were in effect on December 31, 2009. Notice 2010-19 provides the following as
background:
Section 2511(a) generally provides that the gift
tax shall apply to transfers in trust or otherwise, whether direct or indirect.
Under § 25.2511-2(b) of the Gift Tax Regulations, a gift is complete when
the donor parts with sufficient dominion and control as to leave in the donor
no power to change its disposition.
Section 2511(c) provides that, notwithstanding any
other provision of section 2511 and except as provided in regulations, a
transfer in trust shall be treated as a transfer of property by gift unless the
trust is treated as wholly owned by the donor or the donor's spouse under
subpart E of part I of subchapter J of chapter 1.
The Joint Committee on Taxation's explanation of section
2511(c) provides that certain transfers in trust are treated as transfers of
property by gift even though such transfers would have been regarded as
incomplete gifts, or would not have been treated as transfers under the gift
tax provisions in effect prior to 2010. Joint Committee on Taxation, Technical
Explanation of the "Job Creation and Worker Assistance Act of 2002"
(JCX-12-02), March 6, 2002.
The Notice 2010-19 then
provides the following interim provisions as guidance:
Some taxpayers may
have inaccurately interpreted section 2511(c) as excluding from the gift tax
transfers to a trust treated as wholly owned by the donor or the donor's spouse
under subpart E of part I of subchapter J of chapter 1, even though those
transfers would otherwise be taxable under Chapter 12. The provisions of Chapter 12 regarding the
substantive law applicable to the gift tax were not amended by EGTRRA, and
those provisions continue to apply to all transfers made by donors during 2010.
Section 2511(c) is
an addition to those substantive law provisions and is applicable to transfers
made in 2010. Section 2511(c) broadens
the types of transfers subject to the transfer tax under Chapter 12 to include
certain transfers to trusts that, before 2010, would have been considered
incomplete and, thus, not subject to the gift tax.
Accordingly, each
transfer made in 2010 to a trust that is not treated as wholly owned by the
donor or the donor's spouse under subpart E of part I of subchapter J of
chapter 1 is considered to be a transfer by gift of the entire interest in the
property under section 2511(c). The
provisions of Chapter 12 as in effect on December 31, 2009, continue to apply
(both before and during 2010) to all transfers made to any other trust to
determine whether the transfer is subject to gift tax.
Notice 2010-19 appears to clarify
that transfers to a trust that would otherwise be treated as a gift, and
subject to gift tax, would not be excluded from gift tax merely because the
transfer would otherwise escape tax under section 2511(c). Therefore, transfers to GRATs, IDGTs and
other wholly owned grantor trusts in 2010 could be completed gifts and are not
necessarily incomplete under section 2511(c).
However, Notice 2010-19 goes further and "broadens the types of transfers
subject to [gift tax] to include certain transfers to trusts that, before 2010,
would have been considered incomplete and, thus not subject to gift tax."
(Unintended?) Consequences of Section 2511(c)
and Notice 2010-19
Under the IRS's interpretation
of section 2511(c) in Notice 2010-19, it is impossible to make an incomplete
gift to a non-grantor trust during 2010.
Notice 2010-19 interprets section 2511(c) to mean that a gift to a
non-grantor trust would be a gift of the "entire interest" to the trust. This raised new concerns for the charitable
estate planning community about the use of charitable remainder trusts (CRTs). CRTs do not allow taxpayers to shift income
tax liability to a lower bracket taxpayer in the manner that
section 2511(c) was intended to preclude.
However, CRTs are not specifically excluded from the application of
section 2511(c) by its terms or by Notice 2010-19.
A common practice is for a
donor to establish a CRT and retain a unitrust or annuity interest for the
donor's lifetime with a charity to receive the remainder of the trust upon the
donor's death. Prior to section 2511(c)
the value of the interest retained by the grantor was not subject to gift tax
because the grantor had not transferred that interest and no gift was deemed to
occur. The value of the remainder
interest transferred to the charity qualifies for the gift tax charitable
deduction under section 2522. Because a
CRT is not a grantor trust, a reasonable interpretation of section 2511(c) and
Notice 2010-19 may be that the entire value of the property transferred to the
CRT, including the value of the interest retained by the grantor, is considered
to be a transfer by gift. If that is the
case, the donor may be deemed to have made a taxable gift of the entire
interest transferred to the CRT, including the interest retained by the
grantor, with only part of the gift eligible for the gift tax charitable
exclusion.
As it stands, section 2511(c)
appears to apply to CRTs. The result of
such application is that there is some uncertainty regarding whether CRTs are a
viable method for making charitable gifts in 2010, a likely unintended
consequence. Therefore, members of the
charitable planning community, including the American Council on Gift Annuities
and the Charitable Planning Group of the ABA Real Property Trusts & Estate
(RPTE) Section have requested that the IRS issue another notice to clarify that
section 2511(c) either does not apply to CRTs, or that section 2511(c)
does not treat the value of any interest retained by the donor as a completed
gift. As of this writing, no such
guidance has been issued. Hopefully, the
IRS will clarify this CRT issue before issuing final regulations confirming the
conclusions set forth in Notice 2010-19 and/or before January 1, 2011, when the
temporary repeal of the federal estate tax laws, including section 2511(c), will
sunset.
* *
*
Morrison & Foerster's Trusts and Estates group
provides sophisticated planning and administration services to a broad variety
of clients. If you would like additional
information or assistance, please contact Patrick McCabe at (415) 268-6926 or
PMcCabe@mofo.com.
© Copyright 2010 Morrison & Foerster LLP. This article is published with permission of
Morrison & Foerster LLP. Further
duplication without the permission of Morrison & Foerster LLP is
prohibited. All rights reserved. The views expressed in this article are those
of the authors only, are intended to be general in nature, and are not
attributable to Morrison & Foerster LLP or any of its clients. The information provided herein may not be
applicable in all situations and should not be acted upon without specific
legal advice based on particular situations.
[1] Rev. Rul. 2004-64, 2004-2 CB 7.