By Danielle
T. Zaragoza, Esq. and Sonja
K. Johnson, Esq.
A so-called "grantor trust" is a trust that is disregarded
for income tax purposes. Because the
income and gratuitous transfer tax laws are not completely consistent with each
other, it is possible for an irrevocable trust to be a grantor trust for income
tax purposes but not for gratuitous transfer tax purposes. In a grantor trust, the grantor is taxable
with respect to the trust's taxable income, which results in a tax-free gift by
the grantor to the trust each year in the amount equal to the income tax
liability attributable to the trust's taxable income. This grantor trust feature also enables the grantor
to deal with the trust on an arm's length basis without adverse income tax consequences,
which can further enhance the value of the trust.
For instance, a popular technique to leverage the income
tax benefits of a grantor trust is for the grantor to sell property to the trust
in exchange for a promissory note of equivalent value. Both the sale of property and loans to and
from the trust and the grantor are disregarded by the IRS for income tax
purposes and the grantor would not recognize any gain or loss.1 If the net income from, and appreciation in
value of, the property sold to the trust is greater than the interest payable
with respect to the note, the value of the trust can be further enhanced. However, the result may be that the trust's only
substantial asset is property that is subject to a note. This raises a question about the potential
income tax consequences to the grantor if the trust distributes almost all of
its assets, including property subject to the note to beneficiaries.
The capital gain tax
consequences of a distribution from a grantor trust of debt and assets pledged
as security for that debt are not directly covered by the Internal Revenue Code
(the "Code") or Regulations. However, we can look for guidance as to how such distributions
from a grantor trust may be treated by examining Internal Revenue Service ("IRS")
rulings and Regulations regarding capital gain tax consequences of (a) the
termination of grantor trust status during the grantor's lifetime by the grantor
renouncing specific grantor trust powers and (b) the termination of a grantor
trust itself and a final distribution of trust assets and liabilities to the
trust beneficiary.
Capital
Gain Triggered by Renunciation of Grantor Trust Powers
The grantor of a grantor trust is considered to own the
trust property, and to be liable for the trust's debts, for as long as the
trust remains a grantor trust. A grantor
usually retains the right, either in the trust
instrument or by state law, to renounce the powers that cause a trust to be a
grantor trust. If a grantor opts to
renounce those grantor trust powers, the trust's assets and liabilities will
cease to be treated as owned or owed by a grantor for income tax purposes. When this renunciation occurs for income tax
purposes the grantor is treated as disposing of the trust's property and
liabilities.
The renunciation of grantor trust powers is considered a
triggering event for recognition of capital gain. Treasury Regulations Section 1.1001-2(a) provides generally
that "the amount realized from a sale or other disposition of property includes
the amount of liabilities from which the transferor is discharged as a result
of the sale or disposition." Applying
this general gain recognition rule to the
context of grantor trusts, Example 5 of Treasury Regulations
Section 1.1001-2(c) sets forth an example in which an individual ("C")
contributes partnership ("P") interests to a grantor trust ("T") and then later
renounces the powers that had caused T to be a grantor trust. Upon such renunciation, the example explains,
"C is considered to have transferred ownership of the interest in P to T, now a
separate taxable entity, independent of its grantor C. On the transfer, C's share of partnership
liabilities ... is treated as money received."2 In computing the amount of such gain, the
grantor's basis is adjusted upward for any losses and/or downward for any gains
that the grantor claimed with respect to the trust property (since any such
losses or gains would have been attributable to the grantor while the trust was
a grantor trust).
Capital
Gain Triggered by Trust Termination (During Grantor's Lifetime)
The termination of a grantor trust during the grantor's
lifetime is also a triggering event for capital gain recognition. In Technical Advice Memorandum ("TAM") 200011005, the IRS
examined the capital gain tax consequences when a grantor trust terminated and
distributed certain assets and associated liabilities to a remainder
trust. The grantor in TAM 200011005 created a grantor
retained annuity trust ("GRAT") for the benefit of certain family members. The GRAT borrowed money from a third party to
pay the annuity amounts. At the end of
the GRAT term, the loans were outstanding.
The GRAT terminated and distributed its property to non-grantor trusts
for the benefit of the grantor's family members, subject to the outstanding
debt. In that case, the IRS concluded
that the termination of the trust should be treated as a disposition by the grantor
for income tax purposes and that the grantor had an amount realized under Reg.
1.1001-2(a) on the disposition equal to the outstanding debt. Since his basis in the property was
negligible, a large portion of the amount realized was subject to income tax.
Capital Gain Consequences When Grantor Trust Status Terminates
Upon Death of Grantor
The income tax consequences
are much less clear when a grantor trust has outstanding liabilities and the
grantor trust status is terminated due to the death of the grantor. Commentators have proposed each of the
following possibilities:
(i) Deemed sale immediately prior to death. The grantor recognizes gain on the excess, if
any, of the note amount over the grantor's adjusted basis in the assets. The trust takes a basis equal to the
grantor's adjusted basis plus any gain recognized.
(ii) Deemed sale immediately after death. The grantor's estate recognizes a loss on the
excess of the fair market value of the assets at the grantor's death over the
note amount (or gain on the reverse, if the note amount exceeds the value of
the assets at the grantor's death).
Again, the trust takes a basis of the note amount. (Or alternatively, if the transaction is
considered a part-gift/part-sale, the estate does not recognize a loss, and the
trust takes a basis equal to the fair market value of the assets at the
grantor's death.)
(iii) Testamentary transfer.
The grantor's death does not trigger gain, and the trust takes a
stepped-up basis equal to the fair market value of the assets at the time of
the grantor's death.
(iv) Transfer in trust.
The grantor's death does not trigger gain, but the trust takes a
carry-over basis equal in value to the grantor's adjusted basis in the
assets. Thus, all appreciation on the
assets is recognized on the trust's later sale of the assets.
(v) No transfer. The
grantor's death does not trigger gain or create a stepped-up basis in the
assets because it simply marks the end of the income tax "fiction" that the
assets are owned by the grantor. Thus,
all gain or loss on the assets (as measured against the adjusted basis at the
grantor's death) is recognized on the trust's later sale of the assets.
A closer examination of the operation of each of these
approaches reveals that, despite the clear treatment of a lifetime renunciation
of grantor trust powers as a sale, the deemed-sale approach is rather illogical
in the context of a grantor's death. A
sale that occurs before death makes little sense because (absent a renunciation
of powers) grantor trust status would not have terminated by such time, and
therefore a transfer between the grantor and trust would not be recognized for
income tax purposes. A sale following
death is also problematic, as it seemingly requires the estate to recognize
gain or loss on the sale of assets that never pass through it; moreover, this
concept appears contrary to established precedent regarding the time at which
transfers from a decedent are measured.
Perhaps most importantly, however, there is no statutory or regulatory
authority supporting the extension of the "deemed sale" concept (which is
specifically carved out in the Treasury Regulations with respect to lifetime
renunciations of grantor trust powers) to the context of a grantor's death.
However, even if it were certain that a "deemed sale"
approach would not apply, the overall income tax consequences following the
death of a grantor could still vary substantially because the remaining
approaches have such different tax consequences. The "testamentary transfer" approach grants
the trust a stepped-up basis in its assets, while the "transfer in trust" and "no
transfer" approaches do not.
Capital Gain (Potentially) Triggered by Distribution
of Trust Assets and Liabilities
Given the uncertainty about the
income tax consequences when a grantor trust has outstanding liabilities and
the grantor trust status is terminated due to the death of the grantor, it is
worth examining the income tax consequences to the grantor if the grantor trust
makes a distribution of the liabilities without terminating the trust and lets
the grantor trust status terminate upon the death of the grantor at a later
date. For
example, assume that Trust X is a grantor trust as to A, Trust X owns stock in
Co. which was purchased with a loan from B, and the Co. stock is pledged as
security for the loan. What are the
income tax consequences to A if Trust X distributed the Co. stock subject to
the promissory note to B?
In this example, prior to any
distribution, for income tax purposes it is as if (i) A owns the Trust X assets
(Co. stock) and (ii) B loaned A cash in exchange for a promissory note
secured by the Co. stock. It is
clear from the Treasury Regulations that if A were to renounce the powers that
cause Trust X to be a grantor trust, the "transferred" liabilities (i.e. the
amount that Trust X owes on the promissory note) would be treated as having
been received by A in exchange for the Co. stock. A's basis in computing any gain would be equal
to A's basis in the Co. stock.
Similar to the example above, the debt in TAM 200011005
was the result of money borrowed by the trustee. The IRS concluded that the transaction was "substantially
similar" to the one posited in Example 5 of Treasury Regulations
Section 1.1001-2(c) and that, as a result, the grantor had to recognize
gain on the excess of the debt over basis. Based on the
rationale presented in TAM 200011005, it is reasonable to conclude that, if a grantor
trust distributes substantially all of its assets subject to its liabilities,
even if the grantor trust is not terminated, the grantor will be deemed to have
transferred such assets and be discharged of such liabilities. Therefore, it is
possible that making such a transfer would be a triggering event for recognition
of capital gain to the grantor.
If so, the result is that the amount of discharged liabilities may be
treated as gain, an amount received in exchange for the assets.
[1] See Rev. Rul. 85-13, 1985-1 Cum. Bull. 184.
[2] See
also Madorin v. Comr., 84 T.C. 667 (1985) [enhanced version available to lexis.com subscribers] and
Rev. Rul. 87-61, 1987-2 C.B. 219, which similarly found
that when a grantor trust ceased to be a grantor trust during the lifetime of
the grantor, the grantor was considered to have transferred the trust assets to
the newly independent trust for income tax purposes, and therefore required the
grantor to recognize gain with respect to the trust's liabilities.
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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 2011 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.
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