Estate Planning With Grantor Trusts

Grantor trusts have been at the heart of most leveraged estate-planning techniques since the publication of Revenue Ruling 85-13.¹ In this ruling, the Internal Revenue Service established the now widely accepted premise that a transfer to and from a grantor trust is a disregarded (ignored) transaction for income tax purposes as long as the trust retains its grantor trust status. These transactions are ignored even though they’re given full effect for purposes of estate, gift and generation-skipping transfer taxes. This lack of coordination between the income tax system and the transfer tax system has enabled transfers of assets, such as businesses and real estate, with a value that greatly exceeds the available transfer tax exemptions. This leveraging of exemptions enables the transfers of income and appreciation on much greater asset values. Leveraging exemptions with grantor trusts is at the forefront of transfer tax minimization planning for the ultra-high-net-worth client. One prevalent technique to take advantage of this leveraging effect is the installment sale to an intentionally defective grantor trust (IDGT). 

In recent years, the Obama administration budget proposals have suggested the need to curtail this type of planning as a significant revenue raiser.  (See discussion below.) However, there’s been little support in Congress for those proposals. Nevertheless, an act of Congress may not be required to curtail or even eliminate certain of the currently perceived benefits of estate planning involving grantor trusts—especially the installment sales. The IRS’ recent issuance of Revenue Procedure 2015-37 may be an indication that the golden age of planning with grantor trusts is coming to an end. There may indeed be storm clouds on the horizon.

In anticipation of action by the IRS, it’s important to understand the current treatment of grantor trusts, as well as likely changes or so-called “interpretations” of the law in this area. This area of the law is fraught with ambiguity and isn’t as clear as many in the estate-planning community tend to assume. In particular, the tax consequences of termination of grantor trust status haven’t been well understood by the government or advisors. There’s developed much “lore” but little definitive “law” on this important topic. 

In light of the uncertainty and possible changes that will clarify the law in a manner that’s not favorable to the taxpayer (explained below), estate plans should be revisited with the view towards mitigating these risks.  The use of freeze partnerships can accomplish much of the leveraging needed in these plans and do so without the risks associated with installment sales to IDGTs.   

Potential Action by the IRS

On the death of the grantor, do grantor trust assets receive an Internal Revenue Code Section 1014 basis adjustment, even though the assets aren’t includible in the grantor’s gross estate? A definitive answer to this question has eluded practitioners for years. The IRS now appears poised to provide an answer.  

On June 15, 2015, the IRS released Rev. Proc. 2015-37, which advised that, until the IRS resolves the issue, it will no longer issue individual private letter rulings on whether the basis of assets in a grantor trust must be adjusted to reflect their fair market value (FMV) on the grantor’s death if those assets aren’t includible in the grantor’s estate. Soon thereafter, on July 31, 2015, the IRS and Treasury released the 2015-16 edition of their Priority Guidance Plan (PGP), which identifies the “basis of grantor trust assets at death under section 1014” as a project that will be a priority for resource allocation. Although the PGP expressly refers to Section 1014, the forthcoming guidance is likely to address the flip side of this issue—namely whether gain is recognized on the grantor’s death. 

The addition of this issue to the no-ruling list and the PGP strongly indicates that the IRS is preparing more authoritative guidance on this question, thereby putting an end to the uncertainty. This guidance, especially if it’s issued during the remainder of the Obama administration, will likely reflect some of the policies already expressed in the Obama budget proposals to the extent they can do so as interpretations of existing law. These proposals could significantly curtail leveraged planning with grantor trusts and would treat death as a realization event. While it’s unlikely that administrative action could accomplish all of the objectives set forth in the budget proposals, it could severely impact planning with grantor trusts—especially installment sales. 

Installment Sale to IDGT

For estates that include large assets, such as commercial real estate or large interests in business entities, use of the federal applicable exclusion amount (currently $5.45 million) is insufficient to transfer these assets during lifetime, so that their growth and appreciation will occur outside of the estate, which would reduce transfer taxes. Estate tax planning for these large assets requires “leveraging” the exclusion. For example, lifetime gifts may be leveraged: (1) by using minority interest and marketability discounts; (2) through the statutorily sanctioned technique of grantor retained annuity trusts; and (3) by the seemingly ubiquitous technique of an installment sale to an IDGT. All of these techniques allow the growth and appreciation to be transferred on assets that may have value greatly in excess of available exemptions.  

A brief review of this strategy will provide the context necessary to explain the risks. An installment sale to an IDGT is designed to transfer future appreciation to trusts for individuals, typically family members, in a tax-efficient manner. The trust is structured to cause the grantor to be taxed on the trust’s income under the grantor trust rules,² while excluding the trust property from the grantor’s gross estate for estate tax purposes.  The grantor then sells assets to the trust, typically in exchange for an interest-bearing promissory note. As transactions between a grantor and grantor trust are ignored for income tax purposes, the sale to the trust is ignored for income tax purposes, and no gain or loss is recognized by the grantor (Rev. Rul. 85-13), even if the assets have significant built-in gains.      

If the assets sold to the trust appreciate in value at a rate in excess of the note’s interest rate, the appreciation in excess of the interest rate passes free of transfer tax. This creates significant opportunity for transfer tax leveraging. For example, the terms of the promissory note may include interest based on the historically low applicable federal rate, with interest-only payments and a balloon principal payment. And, if the asset sold is an interest in a closely held business, potential valuation discounts provide additional leveraging opportunities. The difficult question is whether the gain recognition avoided at the inception of this transaction is merely a deferral or is permanent. This issue must be linked to the question of whether there’s a basis step-up under Section 1014 on the death of the grantor.   

What Happens if the Grantor Dies?   

In answering the question of whether there’s a Section 1014 basis adjustment on the death of the grantor, the IRS may address related issues. For example, if the amount of liabilities assumed by the trust exceeds the adjusted basis of the property transferred, is there gain? If the grantor dies while the note is outstanding, does that death trigger taxable gain under IRC Section 1001(a)? Is the installment method available for reporting the gain under IRC Section 453? Is this gain treated as income in respect of a decedent (IRD) under IRC Section 691? No case, regulation or published ruling directly addresses these questions.  

Given the importance of these issues to this ubiquitous estate-planning technique, it naturally follows that there’s no shortage of commentators willing to opine—ourselves included.³ We believe that there’s a risk that the death of the grantor will trigger gains on some or all of these items and that a closer examination of these risks may also shed light on the IRS’ impending action. 

Termination During Grantor’s Life

While there’s disagreement regarding the effect of the termination of grantor trust status on the grantor’s death, the income tax effects of terminating grantor trust status during the grantor’s life are well settled. If the grantor trust status ends, the grantor is deemed to have transferred the assets and liabilities in the trust to the trust. The trust becomes a separate taxable entity for income tax purposes, and the grantor is taxed on consideration received by the grantor in excess of the basis in the property transferred.⁴

Termination on Grantor’s Death 

Despite the relative certainty regarding a lifetime termination of grantor trust status, there’s sharp disagreement regarding the income tax consequences when the grantor trust status ends as a result of the grantor’s death. Here are three prevailing views.

View 1: No gain on death of grantor. Proponents of this view state that there’s no existing rule that expressly treats a transfer at death as a realization event for income tax purposes. And, as death isn’t an income tax realization event, there can’t be any gain realized at death, regardless of the deemed transfer resulting from the termination of grantor trust status. 

Under IRC Section 1001(b), the term “amount realized” is defined as “including cash and the fair market value of other property received upon a sale or disposition of an asset.” In the case of a lifetime gift, which ordinarily doesn’t involve the receipt of any consideration, gain isn’t recognized. And by analogy, bequests should be treated the same.  

The U.S. Supreme Court case of Crane v. Commissioner⁵ is often cited for the proposition that a testamentary gift shouldn’t trigger gain. In Crane, a beneficiary inherited property encumbered by a nonrecourse liability equal to the FMV of the property. The property was sold several years later. In determining the amount of gain realized on the sale by the beneficiary, the court held that the beneficiary’s basis in the property was equal to the appraised value at the time of inheritance. That is, the property received a basis step-up on the previous death of the decedent. Noteworthy is that Crane established the proposition that’s now well settled that the basis step-up includes not just the equity value of the property transferred (there was none in Crane under the stipulated facts of the case) but also the nonrecourse liabilities to which the property was subject at death.         

The proponents suggest that Crane implies that there wasn’t a sale of the asset at death, and therefore, there was no gain realized at death. Within the context of a sale to a grantor trust, the proponents of this view argue that the death of the grantor should similarly not be treated as a sale, but rather as a bequest. But, they ignore the fundamental nature of the sale to grantor trust technique: It’s a “sale” and can’t be analogized to a bequest without an extraordinary leap of logic. They also ignore the well-established principle that if property is gifted but subject to liabilities in excess of basis, even a nominally gratuitous transfer will be treated as a part sale to the extent of that excess.         

Furthermore, whether the death of a grantor is characterized as a sale or a bequest isn’t fully dispositive of the question of whether gain is realized at death. In fact, Crane itself suggests otherwise by finding that “amount realized” includes debt relief. Keep in mind that the debt in Crane didn’t exceed the property’s basis. 

In addition to the overstatement of the holding in Crane, proponents ignore the importance of Treasury Regulations Section 1.684-2(e). This regulation states that when a foreign trust ceases to be treated as a grantor trust as a result of the death of the grantor, the grantor will be deemed to have transferred the trust assets in a fully taxable transaction immediately before, but on the same date that, the trust is no longer treated as a grantor trust. It’s a glaring exception to the no-gain-at-death rule. The mere existence of such an exception strongly suggests that the Supreme Court decision in Crane didn’t establish a blanket no-gain-at-death rule.   

The IRS’ position regarding the income tax consequences of a grantor’s death are purportedly found in Chief Counsel Advice 200923024. In this CCA, the IRS advised that a conversion of a non-grantor trust to a grantor trust isn’t a transfer for income tax purposes (of the property held by the non-grantor trust to the grantor) that requires recognition of gain to the grantor. In response to the authorities that conclude there’s a taxable event when grantor trust status is terminated during the grantor’s life, the IRS stated that, “[w]e would also note that the rule set forth in these authorities is narrow, insofar as it only affects inter vivos lapses of grantor trust status, not that caused by the death of the owner which is generally not treated as an income tax event.”  

While CCAs may provide some insight into how the Office of Chief Counsel analyzes the issue, there’s no assurance that the IRS will apply a particular CCA in other situations. Furthermore, the part of the CCA previously quoted is essentially dictum, as it’s not essential to the advice given. In any event, CCAs are issued to field or service center employees and, pursuant to IRC Section 6110(j)(3), can’t be used or cited as precedent. Nor is a CCA subject to the levels of review and vetting of a published revenue ruling or Treasury regulation—which are authoritative. Taxpayers and their advisors simply can’t rely on CCAs as precedent.

View 2: Gain on outstanding promissory note.  Proponents of this view follow the same rules for termination of grantor trust status at death that apply during lifetime. If the grantor dies before the note is paid off, the death causes a realization of the portion of the grantor’s gain attributable to the unpaid portion of the note.⁶ This view suggests that the resulting realization of gain would be the same that would occur had the grantor trust status terminated during the grantor’s lifetime.  

View 3: Gain on third-party liabilities in excess of basis. Proponents of this view also argue that death causes a realization of gain to the extent that third-party liabilities secured by the trust assets exceed the basis in the assets. Again, proponents suggest that the resulting gain would be the same that would have occurred had the grantor trust status terminated during the grantor’s lifetime. They find no reason to differentiate the outcome when grantor trust status is terminated as a result of the grantor’s death. If the liability is recourse, then the gross value of the asset is reported on the estate tax return, for example, if real estate, then on Schedule A. The amount of the recourse mortgage is reported separately on the estate tax return on Schedule K. If the liability is nonrecourse, the net equity value of the property (net of the debt) is included in the gross estate and is only reported on the estate tax return. The view that death causes realization of gain, whether it be attributable to the unpaid portion of the note or third-party liabilities in excess of basis, assumes that the trust property wouldn’t be entitled to a basis step-up under Section 1014(b)(1) because property in a grantor trust isn’t “acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent.” This point of view doesn’t extend the fiction of Rev. Rul. 85-13. It doesn’t “deem” the trust assets to have been included in the grantor’s estate for income tax purposes. And, it doesn’t agree that gain realization is avoided by reason of the basis step-up under Section 1014.   

IRD 

An issue related to whether there’s gain on the outstanding promissory note is whether the gain should be recognized as IRD under IRC Section 691 when the note is paid.      

Again, it’s unclear how far the grantor trust fiction of Rev. Rul. 85-13 would be extended. The analogy to Treas. Regs. Section 1.684-2(e) is compelling. As previously discussed, that regulation treats the termination of grantor trust status as a transfer by the decedent on the date of death, leaving the gain to be taxed in the decedent’s final return. However, the “deemed sale” on the expatriation of assets isn’t an actual sale and thus should be contrasted with the sale to the IDGT. For example, the sale to the IDGT may be entitled to deferral under the installment method. Therefore, we should look to the authorities governing actual sales for further guidance.   

If an actual sale takes place, but its tax consequences are deferred until death under Rev. Rul. 85-13, should Section 691 IRD rules be applicable?  

One may argue that Section 691 shouldn’t be applicable because the gain wasn’t realized during lifetime. Section 691(a)(4) treats an installment obligation as IRD when the gain was reported by the decedent but deferred under the installment method until after death. The argument would be that the installment gain that arises from the termination of grantor trust status isn’t IRD because it wasn’t “reported by the decedent.” However, this argument ignores the compelling similarity to Treas. Regs. Section 1.684-2(e), which treats the gain as having been realized during lifetime. It also ignores Rev.

Rul. 78-32, which found IRD treatment even when the gain on a sale of property wasn’t realized during the decedent’s lifetime.  

In Rev. Rul. 78-32, there was a sale of property that was “fully baked” prior to death but which didn’t close until after death. In Rev. Rul. 78-32, prior to death, a decedent entered into a binding executory contract for sale of real property and had substantially fulfilled the prerequisites to consummation of the sale. However, the decedent’s executor completed the sale subsequent to death. In finding that the decedent was unconditionally entitled to the sales proceeds at the time of death, the IRS ruled that the gain realized from the sale was IRD.  Actual consummation of the sale prior to death wasn’t determinative.

In light of the similarity to Treas. Regs. Section 1.684-2(e), it’s illogical to treat the sale to the IDGT as not having occurred during lifetime under Rev. Rul. 85-13. The sale to the IDGT occurs and is fully closed during lifetime. Asserting that the sale doesn’t occur for tax purposes until after death makes little sense, especially in light of Rev. Rul. 78-32. At a minimum, a strong argument could be made that the fiction of Rev. Rul. 85-13, that the sale is disregarded as long as grantor trust status continues, shouldn’t be extended to avoid IRD treatment. To conclude otherwise relies on an overly expansive reading of Rev. Rul. 85-13—beyond what was likely intended. Rev. Rul. 85-13 doesn’t actually speak to what happens when grantor trust status ends. Rev. Rul. 85-13 was a results-oriented ruling designed to overrule the too-good-to-be-true ruling in the U.S. Court of Appeals for the Second Circuit decision in Rothstein v. United States.⁷ In Rothstein, the court concluded that the taxpayer, on the purchase of property from a grantor trust, obtained a cost basis even though the purchase from the trust didn’t result in recognition of gain. Rev. Rul. 85-13 was the IRS’ attempt to disallow this result, which would have no doubt spawned a generation of abusive basis-creating transactions with grantor trusts. It’s ironic that Rev. Rul. 85-13 is now being relied on to support another generation of basis-creating transactions—namely, the use of grantor trusts to avoid gain recognition permanently while arguably ensuring a full basis step-up on the death of the grantor—without gain recognition, IRD and estate tax inclusion. What’s wrong with this picture? Our position is that Rev. Rul. 85-13 is being ascribed an expansive meaning that was never intended and that’s not actually articulated in the ruling. It’s also our view that imposing a gain-on-death rule would be harsh and contrary to taxpayer expectations and sound tax policy. Any attempt to impose such a rule would be highly ridiculed and subject to challenge. A more practical solution would be to treat the unrecognized gain as IRD, provided there’s a method in the IRC to preserve that treatment, such as the installment method under IRC Section 453. Unfortunately, the installment method has limited application and couldn’t provide a blanket shield against gain recognition on death.  

The application of the installment method under Section 453 has considerable appeal. The Treasury regulations provide that if an individual makes a sale before the individual’s death, which is recognized under the installment sale rules of Section 453, then it should be treated as IRD.⁸ One might argue that the sale that in fact occurred at the consummation of the estate-planning transaction should be ignored under Rev. Proc. 85-13 and that this precludes the application of Treas. Regs. Section 1.691(a)-5(a) because no gain was recognized during the grantor’s lifetime. As discussed, this is probably an overly broad interpretation of Rev. Proc. 85-13, which didn’t actually speak to what happens when grantor trust status ends whether or not that occurs on the grantor’s death. It’s difficult to ignore Rev. Rul. 78-32, which also involved a sale that didn’t close until after death but was nevertheless treated as giving rise to IRD. Even if the transaction can be treated as an installment sale giving rise to IRD, the more difficult question is whether gain is recognized on death when the installment method isn’t applicable. There are significant exceptions to the installment sale method of reporting gain. For example, gain from the transfer of assets with liabilities in excess of basis doesn’t qualify for the installment method (to the extent of the liabilities in excess of basis). And, sales of depreciable property to a related person similarly don’t qualify. If a sale to an IDGT falls under these exceptions, the gain (to the extent of liabilities in excess of basis or all gain if considered a sale to a related party) wouldn’t be able to be deferred at death. Perhaps the IRS could simply deny the basis step-up, leaving the gain to be deferred until the assets are sold. Certainly, that would be a preferred outcome to gain recognition at death, which would be quite repugnant. The IRS would risk taxpayer revolt if it were to impose both an income tax and an estate tax on the same assets at death. However, that’s the result provided for in the Obama budget proposals. Potentially, if the IRS could find a way to justify that treatment, it would do so during the remainder of the Obama administration.   

Basis Step-Up in the Trust Assets?

Related to the question of whether gain is triggered as a result of the grantor’s death is whether the death of the grantor would give rise to a basis step-up under Section 1014. Do the trust assets receive a basis step-up under Section 1014(b)(1) because the trust is deemed to “acquire property from a decedent”? Or, is the basis step-up denied under Section 1014(b)(9) because the assets are excluded from the grantor’s gross estate? Here again, there’s no definitive legal authority and therefore disagreement among the commentators. Here’s a comparison of the prevailing views.

View 1: Yes, there’s a basis step-up under Section 1014. The trustee is viewed as having acquired the assets by bequest or devise, and as a result, the basis will equal the estate tax value under Section 1014. Section 1014(b)(1) doesn’t depend on actual estate tax inclusion. Instead, the trust assets receive a date-of-death value basis adjustment under Section 1014(b)(1)

as property “in the hands of a person [the trust] acquiring the property from a decedent or to whom the property passed from a decedent.”⁹ A variation of this view is that the deemed change of ownership for income tax purposes at the grantor’s death (from the grantor to the trust) constitutes the receipt of property from a decedent for purposes of Section 1014 and that there should be a basis step-up even though the assets aren’t included in the gross estate.¹⁰ It’s argued that the note, as well as the trust assets, receives a basis step-up under Section 1014, as the note is included in the decedent’s gross estate. This position relies on the premise that the gain isn’t recognized during the decedent’s lifetime because the grantor trust ends at death, not before. As discussed, this ignores Rev. Rul. 78-32 and the regulations under Section 684.

In PLR 201245006 (July 19, 2012), a U.S. non-resident alien proposed to transfer U.S. situs assets (stock publicly traded in the United States) to an irrevocable grantor trust. Under the terms of the trust, all of the income is required to be paid to the taxpayer, making it a grantor trust under IRC Section 677(a). The IRS ruled that the basis of property held in the grantor trust will be stepped up under Section 1014(a) on the taxpayer’s death, despite the fact that the assets in the trust aren’t subject to estate tax. At a panel conducted at a meeting of the Tax Section of the American Bar Association, an attorney from the Chief Counsel’s office commented that the government was troubled by its own lack of coordination that resulted in the issuance of PLR 201245006 and CCA 200937028, which appear to directly contradict each other. In a matter of months after that meeting, the IRS issued Rev. Proc. 2015-37 to prevent any further contradictions. As stated, the inclusion of this item on the PGP during 2015 indicates that this issue will be resolved at some point definitively. Reliance on PLR 201245006 may be perilous at this point.   

View 2: No, there’s not a basis step-up under Section 1014. Under this view, the trust assets weren’t “acquired from a decedent” and don’t “pass from a decedent.” The trust assets didn’t pass pursuant to decedent’s will or by intestacy. And, the grantor doesn’t have rights over the trust that would result in inclusion of the trust assets in the grantor’s estate for estate tax purposes. The termination of grantor trust status by reason of the grantor’s death shouldn’t be viewed as a testamentary transfer. And, because the trust assets aren’t included in the gross estate, there’s no step-up under Section 1014.¹¹ In regard to the outstanding promissory note, although it’s included in the grantor’s estate for estate tax purposes, to the extent it’s IRD, it isn’t entitled to a step-up in basis under Section 1014(a).

The grantor trust status is terminated on the grantor’s death. As the trust then becomes a separate taxpayer for federal income tax purposes, the purchase comes into income tax existence at that time. The deemed transfer should be viewed as a sale by the grantor to the trust, and the trust’s basis will equal the purchase price under Section 1012. Under Section 1012, the trust should take a basis in the asset that includes the outstanding principal amount of the note at the date of death.   

Note that there are two distinct sides to this transaction—the transferor and the transferee. On the transferor side, there’s a sale in exchange for a note. The note is the asset that in actuality is included in the transferor’s estate. If the note doesn’t get a basis step-up, the gain is preserved but the asset will be subject to both estate tax and income tax—a result that’s generally abhorrent under our tax system except in the case of IRD—which can only apply if the installment method under Section 453 also is available. As stated, the installment method isn’t available for liabilities in excess of basis and for sales of depreciable property to related parties. As to property subject to liabilities in excess of basis, it’s difficult to imagine how these liabilities can be carried over to the estate absent a basis step-up because it’s clear that this amount will be subject to income taxation for inter vivos transactions. The difficulties of obtaining this carryover treatment would likely require an act of legislature. Thus, at least as to liabilities in excess of basis or in the case of interests in a partnership, negative capital, it’s hard to imagine how to avoid gain recognition on death even if the trigger is termination of grantor trust status. This suggests a similar treatment to that of lifetime terminations of grantor trust status—namely, gain is recognized to the extent liabilities exceed basis.   

The other side of the transaction is the basis obtained by the former grantor trust, which is the purchaser. If one concludes that gain must be recognized by the estate to the extent of liabilities in excess of basis, it would be incongruous not to allow the trust to obtain a cost basis under Section 1012 to the extent of the liabilities assumed or to which the property is subject—but not on any equity value in excess of that amount. Note that Crane, which established that the basis of inherited property includes liabilities to which the property was subject, was decided under a predecessor to Section 1014—not Section 1012 (cost basis). Thus, Crane doesn’t support the conclusion that on termination of the grantor trust status at death, the trust should obtain a cost basis for the liabilities. Nevertheless, that appears to be the correct result.   

In sum, the correct result seems to be that the estate, which is the deemed transferor of the assets, may be required to recognize gain—but such gain should be limited to the liabilities in excess of basis. But the trust, as the deemed transferee, should only attain a basis step-up to the extent of liabilities assumed or to which the property is subject in excess of basis.   

IRS guidance may soon repudiate the conclusion that there’s no gain recognition and that the trust obtains a full basis step-up. Pending further guidance on this issue, it’s imprudent to assume there’s no gain recognized in planning for sales to IDGTs (including gifts of property with liabilities in excess of basis). Moreover, existing plans should be revisited to the extent that they were structured in reliance on this treatment.  

President Obama’s Budget Proposals 

Several of the Obama administration’s prior budget proposals would end the sale to an IDGT as a viable estate-planning technique. The 2013 fiscal year budget proposal would have included all of the grantor trust assets in the grantor’s gross estate for estate tax purposes. The 2014 and 2015 fiscal year budget proposals somewhat temper the approach by including in the gross estate only the portion in a grantor trust that’s attributable to a “sale, exchange or comparable transaction” from the grantor. 

The Obama administration’s goals are evident in these proposals. It wants to eliminate the use of grantor trusts as a method of estate tax minimization. No one expects the current Congress to take action. As a result, in the final year of the presidency, the Obama administration is likely to take action on its own. It will likely do administratively what it can’t do legislatively. For example, the IRS can issue revenue rulings and notices in an attempt to achieve as much of their goals as they can, including those related to gain on death, IRD and basis step-up.

Planning to Avoid the Risks 

One option is for the grantor to pay off or unwind the installment note before he dies. This action avoids the entire question of whether there’s gain on the death of the grantor relating to the installment note. Another option is for the grantor to reacquire the trust assets using cash.  This may be the only option for assets subject to liabilities in excess of basis. If the assets are highly leveraged, it may be less expensive for the grantor to reacquire them for cash than to pay down underlying mortgage indebtedness. If the grantor reacquires the assets, the uncertainty regarding a basis step-up for grantor trust assets is entirely avoided because assets owned directly by the grantor will receive a basis adjustment. If the assets were previously transferred to the grantor trust and have since appreciated, a repurchase will leave the appreciation in the trust, which will accomplish the desired planning objective. An alternative may be to exchange the low basis appreciated assets for assets with a high basis more recently acquired by the grantor.   

As to the assets reacquired or for new planning, the grantor should explore alternative planning techniques, such as the freeze partnership (FP), which avoid these risks altogether. The FP is a leveraging technique that if properly structured, can leave the built-in gains, including liabilities in excess of basis, in the estate to obtain a basis step-up while transferring appreciation to a trust.    

FPs Under Section 2701

A partnership (or limited liability company (LLC)¹²) freeze under Section 2701, if properly structured, can avoid the tax consequences associated with transfers to grantor trusts, whether those consequences are incurred at inception or at the termination of the trust’s grantor trust status. The FP technique typically doesn’t depend on a transfer to a grantor trust to avoid the income tax consequences of its creation. For example, if the entity freeze involves a partnership, or LLC taxed as a partnership, the initial transfer would typically be treated as a contribution to a partnership rather than a transfer to a grantor trust. The rules governing contributions of appreciated property to partnerships are very different from the grantor trust rules. Contributions to partnerships in exchange for partnership interests are typically entitled to no recognition under IRC Section 721. Even if the property is subject to liabilities in excess of basis, in general, gain won’t be recognized at inception under the interplay between Section 704(c) and Section 752.

The FP is the preferred method of planning when the client owns low basis leveraged real estate. Failure to appropriately plan for the inherent income tax consequences of property with liabilities in excess of basis can have devastating tax consequences as discussed above.

The FP technique can avoid this uncertainty and attendant risk. This technique should be carefully considered among the alternative planning techniques for low basis leveraged real estate. A retained frozen interest in an FP will be entitled to a basis step-up on death. Moreover, if properly structured, the liabilities in excess of basis can be allocated to the frozen interest so that the basis step-up can eliminate the inherent gains attributable to liabilities in excess of basis or negative capital.¹³

The FP can thus transfer appreciation and, perhaps, values out of the estate without foregoing the basis step-up that’s necessary to eliminate the phantom income attributable to liabilities in excess of basis (in the case of outright real estate ownership) or negative capital accounts (for real estate owned by a partnership or LLC).  

Guidance Forthcoming

It’s likely that there will be guidance forthcoming from the IRS that will refute the notion that the termination of grantor trust status on the death of the grantor will result in a basis step-up without gain recognition for both the estate and the trust. At this point, reliance on that notion is perilous. Planning to attain the maximum basis step-up is more important than ever given the current transfer tax system and the greatly reduced disparity between income tax and estate tax rates. There’s a premium in the current environment on any planning that results in the maximum basis step-up.   

Given the uncertainties and risks associated with the installment sale to the IDGT, especially when the assets transferred are low basis real estate with liabilities in excess of basis, practitioners should explore alternative techniques, such as the leveraged FP. They should also restructure existing plans that rely on the installment sale technique to mitigate these risks. One method to restructure these transactions is to have the grantor reacquire the assets by exchanging them for high basis assets or cash. It’s not advisable to reacquire those assets for installment notes until there’s definitive guidance from the IRS as to whether assets in the trust obtain a basis step-up. Absent a basis step-up, the notes in the trust may also result in an income tax liability to the trust.  

As stated, the FP technique may be the preferred method of planning to avoid these income tax pitfalls. The FP is a less efficient transfer tax planning technique than the installment sale because the payments back to the grantor can’t be measured based on the artificially low applicable federal rate. Nevertheless, there are techniques involving leveraging the partnership to mitigate that distinction. These techniques will be explored in greater detail in a subsequent article.   

Endnotes

1. In Revenue Ruling 85-13, the Internal Revenue Service held that a sale between a grantor and a grantor trust wasn’t a taxable event. In doing so, the IRS rejected the then-recent holding in Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984), which had concluded that a taxpayer could enter into a sales transaction for income tax purposes with a grantor trust because the trust was a separate taxpayer. The ruling’s rejection of Rothstein set the stage for modern estate-planning techniques.

 2. The commonly referred to “grantor trust” rules are found in Internal Revenue Code Sections 671-679, which is in Subpart E of Part I of Subchapter J of Chapter 1 of Subtitle A of the IRC, entitled “Grantors and Others Treated as Substantial Owners.”

3. Deborah V. Dunn and David A. Handler, “Tax Consequences of Outstanding Trust Liabilities When Grantor Trust Status Terminates,” 95 J. Tax’n 49 (2001); Jonathan G. Blattmachr, Mitchell M. Gans and Hugh H. Jacobson, “Income Tax Effects of Termination of Grantor Trust Status by Reason of the Grantor’s Death,” 96 J. Tax’n 149 (September 2002). Carol A. Cantrell, “Gain is Realized at Death,” Trusts & Estates (February 2010), at p. 20; Jonathan G. Blattmachr and Mitchell M. Gans, “No Gain at Death,” Trusts & Estates (February 2010), at p. 34.

4. Madorin v. Commissioner, 84 T.C. 667 (1985); Treasury Regulations Section 1.1001-2(c), Ex. (5); Rev. Rul. 77-402. Each of these authorities involves debt relief as consideration paid.

5. Crane v. Comm’r, 331 U.S. 1 (1947).

6. See Frane Estate v. Comm’r., 998 F.2d 567 (8th Cir. 1993), in which the cancellation of an installment note occurred at the death of the borrower, and the court held that it constituted a disposition of the note that triggered gain that had to be recognized by the decedent’s estate under IRC Section 691(a)(2).

7. Rothstein, supra note 1. 

8. Treas. Regs. Section 1.691(a)-5(a).

9. See Private Letter Ruling 201245006 (July 19, 2012), in which there was a basis step-up on the grantor trust’s assets that passed to the grantor’s issue at the grantor’s death.

10. See Blattmachr, Gans and Jacobson, supra note 3.

11. See Chief Counsel Advice 200937028, which states that there’s no basis step-up under IRC Section 1014 unless the asset is included in the decedent’s estate.

12. Limited liability companies are generally treated as partnerships for tax purposes.  

13. For a more detailed discussion of this technique, see Stephen M. Breitstone, “Estate Planning for Negative Capital,” Trusts & Estates (May 2012), at p. 26; Stephen M. Breitstone, “Estate and Income Tax Planning for the Long Term Real Estate Investor,” 44th Annual Estate Planning Institute, Practicing Law Institute; and Stephen M. Breitstone and David C. Jacobson, “Moving the Real Estate Empire to the Next Generation, Balancing Income Taxes and Transfer Taxes,” NYU 74th Institute on Federal Taxation.