II. Taxation of Transfers During Life and at Death
A transfer of property may be classified, on one hand, as a sale if the transferor receives consideration in exchange for the transferred property, or, on the other hand, as a gratuitous transfer if there is no consideration. Generally speaking, a sale is a taxable event for income tax purposes, and the transferor’s gain or loss is equal to the difference between the amount realized and the adjusted basis of the transferred property. In contrast, a gratuitous transfer generally is not treated as a taxable disposition for income tax purposes. The transferor realizes no gain or loss, and the value of the transferred property is excluded from the recipient’s gross income. Instead, such transfers are subject to a separate system of gift and estate taxation with its own rates and exemptions. Among gratuitous transfers, the Code further distinguishes lifetime gifts from testamentary transfers occurring at the transferor’s death, subjecting the former to gift tax and the latter to estate tax. Moreover, for income tax purposes, the recipient of a lifetime gift generally takes a carryover basis in the transferred property, while property passing from a decedent generally has a basis in the recipient’s hands equal to its value at the transferor’s death.
Taxpayers thus face two fundamental tradeoffs in planning the structure of property transfers. First, to the extent the transferor receives consideration, the transaction may give rise to taxable gain for income tax purposes, but the consideration will reduce the amount of any taxable gift for gift and estate tax purposes. Second, if a gratuitous transfer is completed while the transferor is alive, any unrealized appreciation in the transferred property will be preserved through a carryover basis in the recipient’s hands, whereas a transfer occurring at the transferor’s death may expunge any potential taxable gain through a stepped-up basis. The distinction between lifetime and deathtime transfers may be further complicated if property is transferred in trust. A grantor may retain a range of interests and powers that cause the transfer of property in trust to be treated as wholly or partially incomplete for gift and estate tax purposes. If the completed transfer is postponed until the grantor’s death, the property will generally be included in the grantor’s gross estate. Meanwhile, to the extent the transfer remains incomplete, the grantor may continue to be treated as the owner of the trust property for income tax purposes. The gift tax and income tax provisions concerning the timing and extent of completed transfers in trust differ materially. Consequently, a trust may be structured to incur an immediate gift tax and remove the transferred property from the grantor’s gross estate, even though the grantor continues to be treated as owning the trust property for income tax purposes. Conversely, a trust may be recognized as a separate taxable entity capable of entering into taxable transactions with the grantor for income tax purposes, even though the property will eventually be subject to estate tax at the grantor’s death.
A. Grantor Trust Status
A longstanding source of controversy in the income tax area involves the treatment of income from property held in trust. For many years the primary concern focused on the use of trusts to shift income from a high-bracket grantor to low-bracket beneficiaries. The original versions of sections 676 and 677, enacted in 1924, attributed trust income to the grantor if the grantor retained a power to revoke the trust or a discretionary power to distribute or accumulate income for the grantor’s own benefit. These provisions were framed as narrow exceptions to the general rule recognizing a trust as a taxable entity separate from the grantor, and their inadequacy quickly became apparent. As grantors resorted to short-term trusts and nonbeneficial powers outside the scope of the primitive grantor trust provisions, the courts responded by treating the grantors as constructive owners of trust income under the predecessor of section 61, culminating in the Supreme Court’s 1940 Clifford decision. In the aftermath of that decision, the Treasury issued comprehensive regulations which formed the basis for the grantor trust provisions enacted in 1954. Those provisions, codified in sections 671-678, remain essentially intact under current law and constitute the exclusive statutory foundation for treating the grantor as the owner of trust income based on retained dominion and control.
The taxable triggers for grantor trust status appear in sections 673-677. These provisions enumerate the beneficial interests and powers which may cause a grantor to be “treated as the owner” of all or part of the trust for income tax purposes, including retained rights to receive present or future distributions, powers affecting beneficial enjoyment, and specified powers of administration. These provisions determine whether (and to what extent) a transfer in trust is effective to shift trust income from the grantor to the trust and its beneficiaries under the conduit rules; in that sense, the grantor trust provisions are analogous to the rules determining whether a transfer in trust is complete for gift tax purposes. In keeping with their original mission of limiting opportunities for income shifting, however, the grantor trust rules cast a much broader net than their gift tax counterparts. For example, the grantor trust provisions apply not only to interests and powers retained by the grantor personally but also to those held by the grantor’s spouse. Indeed, tax-sensitive powers may trigger grantor trust status even if they are exercisable solely by a third person (or jointly with the grantor or the grantor’s spouse) without the consent of an adverse party. Thus, it is a relatively simple matter, if desired, to establish a trust that will be treated as a grantor trust for income tax purposes but will give rise to a completed gift for gift tax purposes. This will occur, for instance, if a nonadverse party holds a broad power to add beneficiaries or if the grantor retains a nonfiduciary power to recover trust property by substituting other property of equal value. Furthermore, neither of these powers will cause the trust property to be included in the grantor’s gross estate.
If a trust qualifies as a grantor trust under sections 673-677, section 671 provides that the trust’s “items of income, deductions, and credits” must be “included in computing the [grantor’s] taxable income and credits.” While this provision clearly operates to attribute the income of a wholly-owned grantor trust to the grantor as deemed owner, it fails to specify whether the trust is recognized as an entity separate from the grantor or is simply disregarded for income tax purposes. The leading authority for a literal reading of section 671 as a narrow income-attribution provision (rather than simply ignoring the trust’s existence) is Judge Friendly’s opinion in Rothstein v. United States, which involved a grantor’s basis in stock that he purchased from a grantor trust for an unsecured installment note. When the grantor redeemed the stock shortly afterward, he claimed a cost basis in the stock equal to the principal amount of his note. Rejecting “what might otherwise seem the sensible general principle that a taxpayer may not have meaningful dealings with himself,” Judge Friendly interpreted section 671 as requiring that the income of the grantor and the trust be computed “in the normal fashion, the trust being treated as a fully independent tax-paying entity,” and that the trust’s items be included in computing the grantor’s taxable income: “[section] 671 dictates that, when the grantor is regarded as ‘owner,’ the trust’s income shall be attributed to him–this and nothing more.”
Alternatively, the income-attribution rule of section 671 may be viewed merely as a specific application of a more expansive view of the grantor trust provisions. Under this view, the grantor of a wholly-owned grantor trust is treated as owning the trust property, and, accordingly, the trust is not recognized as a taxable entity separate from the grantor for income tax purposes. Applying this approach in Revenue Ruling 85-13, the Service disregarded a purported sale transaction between a grantor and a grantor trust and announced that it would not follow the contrary holding of Rothstein. More broadly, the Service’s approach suggests that a wholly-owned grantor trust should generally be treated as the grantor’s alter ego for income tax purposes. This approach stops well short of a categorical rule disregarding grantor trusts across the board, but it appears to produce sensible results (and avoid unreasonable results) in most cases involving the grantor’s income tax liability, and it has been widely accepted by courts and commentators as a rule of thumb.
The grantor trust provisions were originally enacted to curb income shifting, and for many years grantors assiduously sought to create trusts that would be respected as separate taxpaying entities and avoid unwanted attribution of trust income under section 671. Ironically, the central mission of the grantor trust provisions has been overtaken by other income tax developments since 1986, and grantor trusts have become increasingly attractive as vehicles for minimizing the combined burden of income, gift, and estate taxes.
B. Gift and Estate Taxes
Gift and estate taxes are imposed on cumulative taxable transfers made by an individual transferor during life and at death. Although formally distinct, the gift and estate taxes are linked by a common rate schedule and a unified credit. As a result, the first $10 million (indexed for inflation) of taxable transfers, whether made during life or at death, are effectively exempt from tax, and any subsequent taxable transfers are taxed at a flat 40% rate. Ideally, in a system with a consistently defined tax base, a constant tax rate, and a uniform rate of return on investments, a gift tax imposed during life would be equivalent in present value terms to an estate tax imposed at death, and the timing of taxable transfers would therefore be a matter of indifference to a rational taxpayer. Current law, however, taxes lifetime gifts more leniently than deathtime transfers in several respects. For example, the annual per-donee exclusion (currently $17,000) and the unlimited exclusion for qualified educational and medical payments allowed for lifetime gifts have no counterpart in the estate tax. Furthermore, amounts used to pay gift tax are excluded from taxable gifts, while the estate tax payable at death is included in the taxable estate, resulting in a preferential effective tax rate for lifetime gifts. General and special valuation rules also encourage taxpayers to make lifetime gifts of partial or fragmented interests in property, tailoring transfers to take advantage of valuation discounts and minimizing the total amount of taxable gifts. Because property is generally taken into account at its fair market value when the transfer becomes complete, the Code provides a powerful incentive to transfer rapidly appreciating property, often in trust, as soon as possible in order to remove future appreciation from the transferor’s gross estate.
A transfer of property is generally treated as complete for gift tax purposes when the transferor relinquishes dominion and control, retaining no power to change beneficial enjoyment of the property. This expansive, open-ended standard is further refined in regulations and judicial decisions which allow well-advised transferors considerable flexibility to delay or accelerate the completion of a taxable gift when property is transferred in trust. The simplest example of an incomplete transfer is a garden variety revocable trust that remains subject to the grantor’s unrestricted control. Even if the trust is irrevocable, the grantor can avoid a completed gift by retaining an unrestricted power, either as trustee or in a personal capacity, to shift beneficial enjoyment of income and corpus among other beneficiaries. In either case, if the grantor continues to hold the power until death, the remaining trust property will be included in his or her gross estate. Suppose instead that the grantor wishes to report an immediate taxable gift and avoid estate tax exposure while retaining a power as trustee over beneficial enjoyment of the trust property. This can be accomplished as long as the grantor’s retained fiduciary power is limited by a “fixed or ascertainable standard” and cannot be exercised for the grantor’s own benefit. Alternatively, the grantor could confer an unrestricted discretionary power on another person as trustee (e.g., a spouse, relative or close friend) who would be reliably responsive to the grantor’s wishes. As long as the grantor retained no rights to receive distributions or direct the trustee, the transfer would be complete for both gift and estate tax purposes. If a grantor retains a power over trust property that prevents the transfer from being complete for gift tax purposes, it is virtually certain that the same power, if held at death, will cause the underlying property to be included in the grantor’s gross estate. The converse, however, is not true. A retained power over trust property that does not prevent a completed gift may in some cases subject the property to estate taxation. To this extent, the gift and estate taxes remain imperfectly correlated.
The amount of a transfer subject to gift tax is generally measured by the value of the transferred property, reduced by any money’s-worth consideration received by the transferor. Accordingly, if the transferor receives consideration equal to the value of the transferred property there should be no taxable gift. If the consideration falls short, only the excess value of the transferred property is subject to gift tax. The consideration offset thus serves not only to measure the amount of the taxable transfer but also to reinforce the basic concept that a sale or exchange of property for inadequate consideration generally gives rise to a taxable gift. By focusing on the objective disparity between the value of the transferred property and the consideration received, the gift tax makes donative intent largely irrelevant in identifying a taxable gift. Nevertheless, the Regulations provide that a transfer is deemed to be made for adequate consideration if it is made “in the ordinary course of business” (i.e., if the transaction is “bona fide, at arm’s length, and free from any donative intent”). This safe harbor is necessary to ensure that ordinary business transactions are exempt from gift tax, even if one party benefits from an unequal exchange. Thus, the absence of donative intent remains relevant in distinguishing arm’s-length business transactions from gratuitous transfers. In theory, the sale of a closely held business interest between family members could qualify as an ordinary business transaction, but as a practical matter, it may be difficult to demonstrate that the transaction is free of donative intent if the seller fails to receive consideration at least equal to the value of the transferred property.
C. Recipient’s Income Tax Basis
A sale or exchange of property generally constitutes a taxable event for income tax purposes. The seller realizes gain (or loss) equal to the difference between the amount realized and the seller’s adjusted basis, and the buyer takes the property with a cost basis equal to the purchase price. If the property is a capital asset and was held for more than one year, any gain recognized by the seller is taxed at a favorable low rate.
In contrast, a gratuitous transfer is generally not treated as a taxable event for income tax purposes. In the case of property received as a gift from a living donor, any unrealized appreciation is preserved in the hands of the donee, who takes the property with a carryover basis under section 1015. The original version of the carryover basis provision, which applies equally to outright gifts and gifts in trust, was enacted in 1921 to put an end to the Treasury’s prior practice of allowing the donee a basis equal to the fair market value of the property at the time of the gift.
Although the 1921 Act added a carryover basis provision to prevent a tax-free basis step-up for appreciated property received as a lifetime gift, it did not extend the same treatment to property passing from a decedent. Instead, the 1921 Act codified the practice under prior law of providing a fresh basis for property “acquired by bequest, devise, or inheritance” equal to its fair market value at the transferor’s death. The original version of section 1014 also made the deathtime basis adjustment applicable to specified non-probate transfers that were included in the gross estate. Under current law, the operative provision is section 1014(a), which generally specifies a basis for property acquired from a decedent equal to its fair market value at the date of death. For this purpose, section 1014(b) enumerates the categories of property that are treated as acquired from a decedent, including property acquired by bequest, devise, or inheritance, as well as nearly all other property includible in the gross estate. By providing a stepped-up basis for appreciated property passing from a decedent, section 1014 in effect allows pre-death appreciation in property acquired from a decedent to escape tax entirely, in marked contrast to the tax deferral provided by the carryover basis rule for property acquired by gift.
The tax-free basis step-up for appreciated property acquired from a decedent has drawn uniformly harsh criticism. As a matter of tax policy, the unlimited deathtime gain exclusion is open to numerous objections: it imposes a high cost in foregone revenue; it produces starkly different tax consequences for similarly situated taxpayers; it favors high-income taxpayers who own a disproportionate share of appreciated capital assets; and it encourages investment in assets with high potential capital appreciation and discourages lifetime dispositions of those assets. Nor are these shortcomings counterbalanced by any clear or convincing justification for allowing permanent forgiveness of tax on unrealized gains at death. When the original versions of sections 1014 and 1015 were enacted in 1921, the former provision passed virtually unremarked, and the latter provision provoked only scattered opposition. The only explanation offered for the favorable treatment of property acquired from a decedent was that such property was already subject to an estate tax. It is true, of course, that there was no gift tax on the books in 1921, but the inadequacy of this explanation should have become obvious no later than the advent of the modern gift tax in 1932. In any event, the disparate income tax treatment of property transferred at death and property transferred by lifetime gift has been embedded in the Code for more than a century.
An important limitation on the tax-free basis step-up appears in section 1014(c), which makes section 1014(a) inapplicable to “property which constitutes a right to receive an item of income in respect of a decedent.” This provision ensures that items of income in respect of a decedent (IRD) which were not fully realized by a decedent (and hence not reportable on the final return) do not permanently escape taxation by receiving a deathtime basis step-up. Instead, items of IRD are taxed under section 691 to the decedent’s estate (or other recipient) when they are collected after the decedent’s death, with the same character they would have had in the decedent’s hands. While the denial of a stepped-up basis for IRD contrasts starkly with the treatment of other appreciated property acquired from a decedent, the dividing line is not always clear. There is no comprehensive statutory definition of IRD, and the Regulations indicate that IRD generally refers to items of gross income to which the decedent was “entitled” but which were not properly includible before death under the decedent’s method of accounting. In the typical case of a cash-basis decedent, IRD clearly embraces items of gross income (e.g., wages, interest, dividends, and rent) that were accrued but not received before death, as well as tax-deferred retirement benefits. The courts have also extended IRD treatment to a discretionary bonus declared and paid after an employee’s death to the decedent’s estate. Proceeds of an executory sales contract may constitute IRD if the transaction had progressed far enough that only formal or ministerial acts remained to be performed at the decedent’s death; the Regulations provide for a different result, however, if the sale was to be completed by the executor after the decedent’s death, even if terms were fixed by a binding contract entered into by the decedent while alive. In sum, the general concept of IRD appears to be sufficiently elastic to allow considerable flexibility in its application in various settings.
III. Deferred Payment Sales
A well-to-do transferor who wishes to pass on rapidly-appreciating property to younger generations often faces a series of estate planning tradeoffs. If the transferor simply holds on to the property until death, the full value of the property will be included in his or her gross estate and potentially subject to estate tax at a 40% rate. At the same time, the property will take a stepped-up basis in the recipient’s hands, eliminating income tax on any built-in gain at the transferor’s death. A lifetime gift would incur an immediate gift tax and forego a deathtime basis step-up. Thus, a gratuitous transfer, whether made during life or at death, is subject to gift or estate tax but is generally ignored for income tax purposes. Conversely, a sale of property for adequate money’s-worth consideration is not subject to gift or estate tax, but the transferor must recognize gain for income tax purposes. The primary estate planning goal of a sale is to limit the amount includible in the gross estate to the consideration received, excluding any post-sale appreciation in the transferred property.
A. Sale to a Nongrantor Trust
For a high-bracket transferor, a taxable sale of appreciated property to a nongrantor trust triggers an immediate income tax on the realized gain, probably at a maximum rate of 20%, but this may be a price worth paying to remove future appreciation from a 40% estate tax. The income tax burden may be further alleviated if the transferor defers reporting gain until payments are received under the installment method. If the transferor dies before receiving full payment of the purchase price, the outstanding note will be included in the gross estate, but it will not receive a stepped-up basis; the post-death payments will be taxed to the recipient as IRD.
In theory, a taxable sale to a nongrantor trust may be indistinguishable from an arm’s-length sale to an unrelated third party. The close relationship between the grantor (as seller) and the trust (as buyer), however, warrants a heightened level of scrutiny of the transaction, revealing three potential problems. The first issue concerns the gift tax valuation of the transferred property and the consideration received. To avoid a taxable gift, the transferor must receive money’s-worth consideration at least equal to the value of the transferred property. Both the value of the consideration and the value of the transferred property, however, may be uncertain. Reasonable methods and assumptions may support a range of plausible values, and taxpayers may be inclined to report a value at the lower end of the range for property such as a farm or a closely held business interest.
The risk of a taxable gift is exacerbated by unsettled questions concerning the gift tax value of consideration in the form of an installment note. For gift tax purposes, the value of a promissory note is generally presumed to be equal to its face amount (plus accrued interest), unless the terms of the note (e.g., interest rate or maturity date) or credit risk (e.g., insolvency or inadequate security) support a lower value. For income tax purposes, the provisions relating to deferred payment sales and loans specify safe harbor test rates to determine whether a note bears adequate stated interest. Although the deferred payment sales provisions apparently do not govern the valuation of notes for gift tax purposes, the Tax Court has upheld the Service’s use of the “applicable federal rate” to determine the present value of a note issued as consideration for property in a gift tax case under section 7872. Practitioners have little reason to object to the applicable federal rate as the test rate for determining the value of a note for gift tax purposes, since that rate is likely to be well below the market rate indicated by general valuation principles. Nevertheless, it is far from clear that section 7872 applies to a note bearing adequate stated interest at the applicable federal rate, and in the absence of definitive guidance, the Service conceivably might seek to use a higher market rate in valuing the note for gift tax purposes. Moreover, nothing in the statute or regulations precludes the Service from taking relevant factors other than the interest rate (e.g., credit risk) into account in determining the gift tax value of the note.
A related question arises if the transferor dies before receiving all payments due under the note. The estate tax regulations, mirroring the gift tax regulations, presume that the note is worth its face amount (plus accrued interest) unless the executor proves a lower value. Even if the note bore adequate stated interest when issued, a subsequent rise in the applicable federal rate (or a deterioration in the issuer’s creditworthiness) might cause the note to be worth less than its face amount at the transferor’s death. Again, in the absence of definitive guidance, it is not clear whether or how section 7872 may affect the valuation of the note for estate tax purposes.
Apart from valuation concerns, there is a risk that a sale of property to a trust for consideration in the form of an installment note may be recharacterized for tax purposes. The essential question is whether the form of the transaction as an exchange of property for a note should be respected or whether the transferor should instead be treated as having retained an interest in the property transferred to the trust. If the payments under the note are treated as a retained interest in the transferred property, the gift and estate tax consequences may be severe. The transferor’s right to payments under the note may be disregarded for gift tax purposes under section 2702, resulting in a taxable gift of the full value of the transferred property. Moreover, if the note was not fully paid during the transferor’s life, the deathtime value of the transferred property might be included in the transferor’s gross estate, frustrating the goal of the estate freeze. To avoid recharacterization as a retained interest under section 2036, the payments under the note should be independent of the income produced by the transferred property and should be a personal obligation of the transferee rather than being payable solely from the property or its income. It may be difficult to satisfy these requirements if the trust is newly created and has no significant assets other than the property received from the transferor. Even if the formalities of a sale are carefully observed, as a practical matter, the transferred property and its future income stream may be the trust’s only source of funds for principal and interest payments under the note. To prevent recharacterization as a transfer with retained interest and support the treatment of the note as bona fide debt, practitioners recommend that the transferor fund the trust with additional property to provide an “equity cushion” of at least ten percent of the value of the property sold for the trust’s note.
A transferor might attempt to avoid potential estate tax exposure by accepting a note providing for payments that would automatically terminate at the transferor’s death. To achieve the desired result, the note would have to provide for a premium, in the form of either a higher stated principal amount or an increased rate of interest, to compensate the trust for the mortality risk. The premium should be computed to ensure that the present value of the self-cancelling note is equal to the value of the transferred property. If the transferor dies before the note is fully paid, the unrealized gain will be accelerated for income tax purposes and reported either on the transferor’s final return or as IRD to the transferor’s estate. In contrast, if the transferor lives long enough to collect the payments in full, the self-cancelling feature will increase the total amount received by the transferor and the estate freeze will be correspondingly less effective. In either case, the self-cancelling feature involves additional complexity and uncertainty which must be weighed against its potential benefits.
A self-cancelling installment note is functionally similar to a private annuity, except that a note usually specifies a maximum fixed term while annuity payments usually continue until the transferor-annuitant’s death. A sale of property may have materially different tax consequences, however, depending on whether the deferred payment obligation issued in exchange for the transferred property is classified as an installment note or an annuity. In the latter case, the transferor is taxed on annuity payments under section 72, which allows ratable basis recovery and gain recognition over the transferor’s life expectancy and includes the residual amount as ordinary income. If the transferor dies prematurely, the transferor is entitled to deduct his or her unrecovered investment in the annuity contract, and the issuer’s basis in the transferred property is limited to the annuity payments actually made. The present value of annuity payments is determined under section 7520, which generally uses a higher discount rate than section 7872 and therefore requires larger payments compared to an installment note. Although private annuities are treated more leniently than installment notes in some respects, they became substantially less attractive with the issuance of Proposed Regulations which would, if issued in final form, require immediate gain recognition by a transferor who receives a private annuity in exchange for property. The Service has traditionally treated a purported self-cancelling installment note as a private annuity unless the maximum term of the note is less than the transferor’s actuarial life expectancy. This bright-line distinction is called into question by the original issue discount provisions, which generally apply to any “debt instrument” but carve out an exception for an annuity contract subject to section 72 which “depends (in whole or substantial part) on the life expectancy of 1 or more individuals.” Under the Regulations, an annuity contract with a maximum payout provision is unlikely to qualify for this exception. Thus, a sale of property for either a private annuity or a self-cancelling installment note raises substantial unsettled questions of classification and tax consequences.
B. Sale to a Grantor Trust
Most of the income tax consequences of a sale can be neutralized by selling property to a grantor trust that is treated as wholly owned by the transferor. As long as grantor trust status continues, typically until the grantor’s death, the trust will be disregarded as a separate taxable entity and transactions between the grantor and the trust will be ignored for income tax purposes. Moreover, the trust can be structured so that the powers that trigger grantor trust status (e.g., a retained nonfiduciary power to exchange the trust property for other property of equal value, or a power held by a nonadverse party to add beneficiaries) do not prevent the sale from being a completed transfer for gift tax purposes and do not cause the trust property to be includible in the grantor’s gross estate. Thus, assuming the transferor receives adequate money’s-worth consideration from the trust, the sale should be effective to accomplish an estate freeze without requiring the grantor to report any taxable gain or interest.
A sale to a grantor trust produces significant additional tax benefits. Under the grantor trust rules, any income realized by a wholly-owned grantor trust is taxed directly to the grantor. The grantor can pay the resulting tax liability from his or her own funds, depleting the grantor’s own estate while allowing the value of the trust property to grow free of tax. Moreover, the grantor’s income tax payments attributable to the trust’s income are not subject to gift tax because they satisfy the grantor’s own personal liability. Nor do those payments cause the trust property to be included in the grantor’s gross estate, unless the grantor retained a right to be reimbursed from the trust property. Thus, a sale of property to an “intentionally defective” grantor trust, if properly designed and implemented, is respected as a bona fide sale for adequate consideration for gift and estate tax purposes but is simultaneously ignored for income tax purposes. If the transferor-grantor receives full payment for the trust property during his or her lifetime, the amount included in the gross estate on account of the transaction will be limited to the sale proceeds less the income tax paid by the grantor on the trust’s income.
A further advantage of a sale to a grantor trust is that the transaction may be accelerated or reversed without adverse tax consequences. A grantor who retained a power of substitution can repurchase appreciated property from the trust for cash without recognizing gain, thereby ensuring that the appreciated property (now owned directly by the grantor) will receive a stepped-up basis at the grantor’s death. Indeed, if the grantor holds an installment note issued by the trust in the original sale and it becomes apparent that the grantor may die before receiving full payment, practitioners routinely recommend that the grantor exchange the outstanding note for trust property of equal value in order to avoid potential adverse tax consequences upon termination of grantor trust status.
IV. Termination of Grantor Trust Status
A trust that was created as a grantor trust will eventually cease to be a grantor trust, either during the grantor’s life on termination of the power giving rise to the grantor’s deemed ownership or at the grantor’s death. There is surprisingly little authority concerning the income tax consequences of termination, especially when the trust continues as a nongrantor trust after the grantor’s death.
A. During Grantor’s Life
If grantor trust status terminates during the grantor’s life, the income tax consequences are relatively straightforward. For income tax purposes, the termination of the grantor’s deemed ownership triggers a deemed transfer of the trust property to a newly-recognized nongrantor trust. If the grantor receives no consideration, the deemed transfer is generally treated as a nontaxable gift, and the trust property takes a carryover basis in the hands of the nongrantor trust. If the trust property is encumbered by liabilities in excess of the grantor’s basis, however, the deemed transfer is treated as part gift, part sale, and the grantor may realize gain. This result follows from the Supreme Court’s holding in Crane v. Commissioner that the amount realized by a transferor of encumbered property includes liabilities of which the transferor is relieved. The Crane doctrine reflects a notion of transactional accounting for a taxpayer’s investment. A borrower generally receives loan proceeds tax-free, on the assumption that the loan will eventually be repaid, and is entitled to include liabilities assumed (or taken subject to) in the cost basis of property at the time of acquisition. By including relief of liabilities in the amount realized on a subsequent disposition, the borrower accounts for the tax benefits previously received in the form of untaxed loan proceeds and an enhanced basis.
More generally, the section 1001 Regulations require the transferor to recognize gain on a disposition of property that relieves the transferor of liabilities (whether recourse or nonrecourse) in excess of the transferor’s basis in the property. Applied to a “net gift” of property, the same approach treats the donee’s assumption of the donor’s gift tax liability as consideration for the transfer, causing the transaction to be part gift, part sale. The amount of the gift tax is included in the donor’s amount realized, resulting in taxable gain to the extent the gift tax exceeds the donor’s entire basis in the property, and the donee takes the property with a basis equal to the greater of the donor’s basis or the amount of the gift tax.
The Service initially addressed the issue of taxable gain on termination of grantor trust status in a situation involving a deemed transfer of a partnership interest. In Revenue Ruling 77-402, a grantor, acting through his wholly-owned grantor trust, purchased an interest in a partnership which initially generated large operating losses. As deemed owner, the grantor deducted his distributive share of the partnership losses, reducing his basis in the partnership interest nearly to zero. Just as the partnership began to generate taxable income, the grantor relinquished the powers underpinning his deemed ownership of the trust, resulting in a termination of grantor trust status, a deemed transfer of the partnership interest to the nongrantor trust, and a deemed cash distribution under section 752 equal to the reduction in the grantor’s share of partnership liabilities. The Service concluded that the grantor realized gain to the extent that his share of partnership liabilities exceeded his basis in the partnership interest immediately before the termination of grantor trust status. An example based on substantially identical facts was added to the section 1001 Regulations in 1980, and in 1985 the Tax Court sustained the Regulations against a taxpayer challenge.
Presumably a similar analysis would apply whenever a grantor trust converts to nongrantor trust status during the grantor’s life. If the trust issued a note which has not been fully paid when the trust ceases to be a grantor trust, the transaction probably should be treated as a transfer of property by the grantor to the newly-recognized nongrantor trust in exchange for the trust’s note. In effect, the transaction would be ignored for income tax purposes as long as the trust was treated as a grantor trust, but the sale would be deemed to occur upon termination of grantor trust status. Accordingly, the grantor would realize gain to the extent the outstanding amount of the note exceeds the grantor’s basis in the transferred property, and the basis of the property in the nongrantor trust’s hands would be equal to the greater of the grantor’s basis or the amount of the note. Furthermore, if the transaction qualified as an installment sale, the grantor could report the gain ratably over the remaining term of the note.
B. At Grantor’s Death
If grantor trust status terminates at the grantor’s death, the income tax consequences are less clear. For at least 20 years, in the absence of administrative guidance or judicial decisions, commentators have debated whether death constitutes a taxable event for the grantor or the grantor’s estate and how to determine the basis of property that remains in a nongrantor trust or passes to the grantor’s other successors at the grantor’s death.
Property acquired from a decedent generally has a basis in the recipient’s hands equal to its fair market value at the decedent’s death. For this purpose, property is considered to be acquired from a decedent if it passes by “bequest, devise, or inheritance” (i.e., by will or intestacy) or is otherwise includible in the decedent’s gross estate. Although trust property automatically satisfies this threshold requirement if it is includible in the grantor’s gross estate (e.g., in the case of a trust subject to a grantor’s retained power of revocation or life income interest), until recently it was not entirely clear whether property held in a grantor trust that was not includible in the gross estate might also be eligible for a deathtime basis step-up. Indeed, some commentators argued that such property “should be viewed as passing [from the deceased grantor] as a bequest or devise when the trust ceases to be a grantor trust at the moment of death.” Under this view, because the grantor is treated as owning the property held in a grantor trust for income tax purposes, the deemed transfer upon termination of grantor trust status at the grantor’s death should be treated as a “testamentary” transfer substantially equivalent to a transfer by will or intestacy of property actually owned at death. In Rev. Rul. 2023-2, however, the Service emphatically rejected this argument and held that property in a grantor trust that is not included in the gross estate is not eligible for a deathtime basis step-up under section 1014. The Service’s conclusion is based on a straightforward reading of the statute. Because the trust property does not pass by bequest, devise, or inheritance and is not includible in the grantor’s gross estate, it falls outside the categories enumerated in section 1014(b) of property acquired from a decedent and is therefore ineligible for a fresh-start basis under section 1014(a).
Rev. Rul. 2023-2 confirmed the common understanding of most practitioners that property in a grantor trust would not receive a fresh-start basis under section 1014 if it successfully avoided inclusion in the grantor’s gross estate. Nevertheless, in Rev. Rul. 2023-2, the Service was careful to point out that estate tax inclusion is not an immutable prerequisite for a fresh-start basis under section 1014. Reaffirming an earlier revenue ruling, the Service noted that foreign real property inherited by a U.S. citizen from a nonresident, noncitizen decedent may be eligible for a stepped-up basis under section 1014 even though the property is not includible in the decedent’s gross estate. The most remarkable aspect of Rev. Rul. 2023-2 is its narrow scope. The Service expressly declined to address the tax consequences at the grantor’s death if the trust property were subject to liabilities in excess of basis or if there were outstanding obligations between the grantor and the trust. These are precisely the most pressing and controversial issues arising when a grantor dies after selling property to a grantor trust and before receiving full payment on a note issued by the trust.
Rev. Rul. 2023-2 acknowledges that the grantor is treated as the owner of the grantor trust for income tax purposes and concludes that the trust property is not eligible for a fresh-start basis under section 1014(a) because it does not pass from the grantor by any of the methods enumerated in section 1014(b). However, the ruling does not explain how the deemed transfer of the trust property at the grantor’s death should be treated. On the simple facts of Rev. Rul. 2023-2, presumably the transfer of unencumbered property for no consideration should be treated as a nontestamentary gift. Since the property is not acquired from the decedent under section 1014, the trust should take the property with a carryover basis under section 1015. If the grantor did not receive full payment for the property before death, however, the analysis would be complicated by the existence of the trust’s outstanding liability under the note given as consideration for the property. One possible approach would be to treat the deathtime transfer as part gift, part sale, in the same manner as a lifetime termination of grantor trust status. Under this approach, the grantor (or perhaps the grantor’s estate) should realize gain to the extent that the outstanding amount of the note exceeds the grantor’s basis in the trust property. As a corollary, the trust would receive the property with a basis equal to the greater of the grantor’s basis or the outstanding amount of the note.
The existing authorities concerning relief of liabilities arising from a gratuitous transfer involve lifetime transfers. Although the rationale of those authorities might support similar treatment for deathtime transfers, the Service has shown little interest in extending the part gift, part sale approach to liabilities relieved at death. The Service’s reticence may reflect the notion that a transfer of property at death to a decedent’s estate is not a taxable disposition, as well as a more general understanding that, in the absence of a specific exception, deathtime transfers enjoy broad income tax immunity even if the decedent is incidentally relieved of liabilities. It is also possible that, because the entire transaction was disregarded for income tax purposes during the grantor’s life, the grantor is not viewed as being relieved of any liability at death. In any event, if the grantor does not realize gain at death, the question remains whether the trust should nevertheless be treated as purchasing its property in exchange for the outstanding amount of the note. If so, the trust may end up with a basis in the transferred property equal to the greater of the grantor’s basis or the outstanding amount of the note while avoiding any corresponding gain recognition by the grantor on the deemed transfer. In contrast, if the deemed transfer of the trust property is viewed as separate from, and independent of, the actual transfer of the note by the deceased grantor, then the basis of the trust property should remain unchanged.
A closely related question involves the note issued by the trust and held by the grantor at death. Unlike the trust property, the note was actually owned by the grantor (although disregarded for income tax purposes during the grantor’s life) and transferred at death to the grantor’s estate (or other successor). Thus, the note is acquired from the deceased grantor under section 1014(b)(1) and should be eligible for a fresh-start basis under section 1014(a) unless it constitutes an item of IRD. If the grantor realizes gain on a deemed transfer occurring immediately before death and the transaction qualifies as an installment sale, the note would be an item of IRD and the grantor’s estate (or other successor) would report the gain on receipt of payments from the trust. In any other case—for example, if the grantor’s death is treated as a nontaxable event, or if the taxable transfer is treated as occurring immediately after death—many commentators conclude that the note should be eligible for a fresh-start basis in the hands of the grantor’s estate (or other successor). They argue that the note cannot be treated as IRD because the grantor would not include in gross income any payments received during the grantor’s lifetime while the trust continued as a grantor trust—or, stated differently, because the grantor would not have been taxable on any payments made by the trust after it ceased to be a grantor trust at the grantor’s death. The underlying premise appears to be that payments under the note could never have been included in the grantor’s gross income because the trust’s grantor trust status would necessarily have continued until the grantor’s death. But this may be an overstatement. In fact, the termination of grantor trust status coincided with the grantor’s death, but hypothetically it could have occurred during the grantor’s life (e.g., by release of powers giving rise to grantor trust status), and any subsequent payments by the newly-recognized nongrantor trust while the grantor was still alive would have been included in the grantor’s gross income. Accordingly, the possibility of treating the note as an item of IRD should not be summarily dismissed.
The notion of allowing even a partial basis adjustment for the transferred property (in the hands of the newly-recognized nongrantor trust) or the note (in the hands of the grantor’s estate) rests on both a deemed transfer and a constructive exchange occurring at the grantor’s death when the trust loses its grantor trust status. Given the lack of correlation between the outstanding amount of the note and the value of the trust property at that time, as well as the cascade of unresolved tax consequences, it is easier to understand why the Service limited the scope of Rev. Rul. 2023-2 to clarify that the trust property is not eligible for a full basis step-up under section 1014.
V. Conclusion
A sale of property to a grantor trust is a custom-designed tax anomaly. Its most distinctive feature is its intentionally ambivalent character. To achieve its primary purpose, the transaction must be treated, for gift and estate tax purposes, as a completed lifetime transfer of property for adequate money’s-worth consideration. At the same time, however, it must not be treated as a taxable disposition for income tax purposes during the grantor’s life. Moreover, although ownership of the transferred property is attributed to the grantor during the grantor’s lifetime for income tax purposes, it is not viewed as passing from the grantor at death. Whether the trust is treated, for income tax purposes, as acquiring the property by gift or in exchange for the outstanding amount (if any) of the note issued by the trust is only one of many unsettled questions. Nevertheless, the uncertainty and confusion surrounding the tax consequences of the sale transaction have not hindered its popularity among estate planners and their clients.
The sale of property by a grantor to a grantor trust is expressly designed to exploit discrepancies between the income tax and the gift and estate taxes, and in doing so it exposes serious shortcomings in the existing tax system. Given the uneven patchwork of statutes, proposed and final regulations, and sparse case law concerning sales to grantor trusts, the Service has limited options for responding to abusive transactions. One obvious line of attack would be to abandon the disregarded-entity approach of Rev. Rul. 85-13 and attribute the income realized by a grantor trust to the grantor in accordance with Judge Friendly’s opinion in Rothstein. The attraction of this strategy is that it could be implemented unilaterally by the Service, arguably without the need to amend existing statutes or regulations. The Service might be reluctant to pursue such a strategy, however, and with good reason. Simply revoking Rev. Rul. 85-13 would reopen troublesome questions of when and how to recognize a grantor trust as an entity separate from the grantor, not only in transactions between the grantor and the trust, but also in myriad situations involving third parties. It seems perfectly sensible to treat a conventional grantor trust (e.g., a revocable trust or a self-settled discretionary trust) as the grantor’s alter ego for most income tax purposes, and it would be impractical and undesirable to require differential tax treatment depending on particular combinations of powers and interests giving rise to grantor trust status under section 671. Although it might be possible to formulate a targeted anti-abuse rule treating specified transactions between a grantor and a grantor trust as taxable events, the Service is unlikely to undertake such action unilaterally.
A more promising response to the problems posed by grantor trusts would require legislative action. At least two broad-gauged reform proposals merit consideration. One proposal would be to prune back the provisions of sections 674 and 675 that make grantor trust status readily available for trusts over which the grantor retains no substantial dominion or control. This could be accomplished either by removing specific powers—e.g., a grantor’s power to substitute assets of equivalent value and a nonadverse party’s power to add beneficiaries—from the statutory list of prohibited powers, or more generally by allowing grantor trust status only if the grantor retains an interest or a power sufficient to prevent a completed transfer of the trust property for gift tax purposes. The opportunities for exploiting discrepancies between the income tax and the gift and estate taxes would be curtailed directly by aligning grantor trust status more closely with an incomplete transfer for gift tax purposes; there would be no need to revise the Service’s view of grantor trusts as disregarded entities or to impose special restrictions on “intentionally defective” grantor trusts. An even more far-reaching version of the same approach would achieve similar results by repealing most of the provisions triggering grantor trust status on the ground that they are no longer needed to deter income-shifting and have arguably become obsolete since the enactment of compressed rate brackets for nongrantor trusts.
The second reform proposal focuses on the income tax treatment of gratuitous transfers, especially those occurring at death. The tax-free basis step-up for appreciated property acquired from a decedent has long been recognized as a seriously defective provision which imposes substantial costs in terms of equity, efficiency, and lost revenue. In theory, the problem could be ameliorated either by imposing a deathtime tax on unrealized gain or by requiring a carryover basis for property transferred at death. As a practical matter, a deathtime gain tax appears distinctly preferable on grounds of fairness, administrability, and revenue-raising capacity. Moreover, a parallel provision treating lifetime gifts as taxable dispositions would provide consistent treatment of gratuitous transfers for income tax purposes and would allow a fair market value basis for the transferred property in the recipient’s hands. Such a provision would have no direct effect on a grantor’s sale of property to a grantor trust because both the trust and the transaction would be ignored for income tax purposes. On termination of grantor trust status during life or at death, however, the grantor would be treated as realizing an amount at least equal to the fair market value of the transferred property, regardless of whether the property was subject to outstanding liabilities at that time. A deemed realization rule would thus ensure that unrealized gain in property held in a grantor trust would be subject to income tax at the grantor’s death, if not earlier.
The two reform measures—scaling back the scope of the grantor trust rules and treating gratuitous transfers as realization events—are fully compatible with each other, although they are by no means interdependent. Each could be enacted independently of the other, with salutary results for the integrity of the income tax system and the public fisc. Taken together, they would go a long way toward repairing fundamental discrepancies between the income tax and the gift and estate taxes and dispelling confusion and uncertainty in the treatment of grantor trusts.