Morrison & Foerster LLP: Distribution of Liabilities from a Grantor Trust Likely Causes the Grantor to Recognize Gain

Morrison & Foerster LLP: Distribution of Liabilities from a Grantor Trust Likely Causes the Grantor to Recognize Gain

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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