Grantor Trust Liabilities: An Income Tax Analysis by Prof. Elliott Manning Prof. Kenneth Joyce Jerome Hesch and Scott Goldberger

Transcription

1 Grantor Trust Liabilities: An Income Tax Analysis by Prof. Elliott Manning Prof. Kenneth Joyce Jerome Hesch and Scott Goldberger

2 Grantor Trust Liabilities: An Income Tax Analysis 1 Introduction The use of installment sales to grantor trusts and installment sales to non-grantor trusts, in both situations using irrevocable family trusts that are not includible in the grantor s gross estate, are popular estate planning techniques, simultaneously involving three separate tax regimes: the income tax, the gift tax and the estate tax. The income tax issues relating to intra-family installment sales are complicated because the separate tax regimes have inevitable overlap, such as the step-up in basis at death under Section 1014, the treatment of income in respect of a decedent under Section 691, the treatment of gifts under Sections 102 and 1015 and the impact of liabilities under the income, gift and estate taxes. Today s program will address the income tax issues arising in the following situations: 1. Termination of grantor trust status by reason of the death of the grantor, where all or part of the grantor trust s note obligation to the grantor remains outstanding. 2. Termination of grantor trust status while the grantor is alive. a. What are the tax consequences where all or part of the grantor trust s note obligation to the grantor remains outstanding? b. Does the grantor incur cancellation of indebtedness income when the grantor s obligation to pay the income taxes on the trust s income is shifted to the trust? 3. Grantor trust disposes of the purchased asset subject to the installment note. 4. Grantor transfers the trust s installment note to another taxpayer while the grantor is alive. 5. Grantor purchases an asset from a grantor trust for an installment note and dies while the note obligation remains outstanding. 1 This is a draft of a paper that will be presented at the March 3-8, 2015 ACTEC meeting in Marco Island, Florida and will be published in a future issue of the Tax Management Estate, Gifts & Trust Journal. As a working draft, the authors welcome any comments you feel are needed to provide additional points that need to be addressed and clarify the existing materials. 2

3 6. Conversion of a non-grantor trust to a grantor trust where the non-grantor trust previously purchased an appreciated asset from the grantor for an installment note. 7. Grantor gifts an encumbered, appreciated asset to a grantor trust and grantor dies with the trust owning the asset. Before the meta-physical nature of the above issues can be adequately analyzed, and hopefully addressed, it is necessary to briefly review the fundamental income tax principles used to resolve the above issues. I. Installment sales to non-grantor trusts. Example 1. Senior owns a parcel of vacant land held as an investment with a basis of $200,000 and a value of $5,000,000. Senior sells the land to an irrevocable family trust (the purchasing trust) that is not characterized as a grantor trust for Federal income tax purposes. Senior takes back the irrevocable trust s promissory note (sellerprovided financing) in satisfaction of the entire purchase price. The $5,000,000 promissory note provides for the payment of annual interest at the long-term Applicable Federal Rate ( AFR ) with all $5,000,000 of note principal due at maturity in 20 years. Basis $ 200,000 Value $5,000,000 Realized Capital Gain $4,800,000 A. Income tax results at the time of the sale. Senior realizes a $4,800,000 long-term capital gain upon the sale, but does not have to report the gain in the year of the sale 2 because this installment sale is eligible for the installment method of accounting. 3 As a purchaser, the non-grantor trust s income 2 The seller must report the installment sale on the income tax return for the year of the sale (using Form 6652) even though none of the realized gain is taxable at that time. 3 Since the installment method is a method of accounting, it is used to determine when the gain is reported. 3

4 tax basis in the land is a $5,000,000 cost basis under The purchaser s basis includes all liabilities incurred by the purchaser as part of the acquisition of the asset, including the stated principal amount of the promissory note issued by the purchaser. B. Income tax treatment of interest payments. Upon the payment of the annual interest, Senior reports each payment received as interest income, and the trust treats each payment made as an investment interest expense. 5 C. Income tax treatment if Senior dies in year 12 with all $5,000,000 of note principal outstanding. Assume that, at Senior s death, the note passes to a qualified terminable interest property ( QTIP ) trust established under Senior s will for the benefit of Senior s surviving spouse. The note is included in Senior s gross estate at its fair market value, which may be equal to, greater than or less than its $5,000,000 principal amount. The QTIP trust cannot be a grantor trust as to Senior because Senior is deceased. Although the bequest of the installment note is a disposition of the installment note, this disposition in not an accelerating income tax event, and none of the capital gain is reported upon a transfer by death. 6 The successor-in-interest s income tax basis in the installment note is limited to Senior s $200,000 basis in the note because the note is income in respect of a decedent ( IRD ). 7 By taking the note with a carryover basis, the QTIP trust takes the note with all of the other income tax attributes inherent in the note (a step in the shoes approach) and can continue to use the installment method of accounting to report the gain. When the QTIP trust eventually collects the $5,000,000 principal payment on the note, the QTIP trust then reports the $4,800,000 capital gain. Since the note is IRD, how it is valued for estate tax purposes is irrelevant for the income tax. The purchasing trust s income tax basis in the land continues to be its $5,000,000 cost. And, the interest income and interest deduction continue to be reported as paid. 4 A purchaser s basis is determined by the amount paid, which includes not only cash and any existing liabilities on the encumbered asset, but any additional liabilities the purchase incurs as part of the acquisition, including the purchaser s installment note given in satisfaction of the purchase price. 5 The installment method only determines the timing for the reporting of the gain on the sale. The timing of the interest, both the interest income and the interest deduction, is governed by a separate set of timing rules. The general rule is that the reporting of interest is governed by a taxpayer s method of accounting B(c). 691(a)(4). 4

5 D. Senior gifts the note while alive. If Senior gives the note as a gift to his son, the gift is a disposition that triggers the acceleration of the reporting of the previously deferred gain as a gift an other disposition under 453B(a). 8 Senior will have to report the entire $4,800,000 capital gain if the value of the gifted note is equal to its principal amount. 9 The purchaser s basis in the property purchased is not affected by the gift. If Senior gifts the installment note to his spouse while alive, a special rule provides that a gift to a spouse is not an accelerating event. 10 If Senior gives the installment note to a grantor trust, there is no income tax accelerating event because the grantor of the trust is deemed to own all of the trust assets for income tax purposes. 11 E. Discharge of the note obligation at death. Assume that, under the terms of Senior s will, the family trust s note obligation is cancelled. The cancellation is treated as a bequest to the irrevocable family trust that purchased the land from Senior. 12 The note is included in Senior s gross estate for estate tax purposes. 13 Assume the note is valued in Senior s gross estate at $5,000,000. As a bequest to the obligor, the note obligation is satisfied. Upon this satisfaction of an installment note owed by a related party, the estate, not Senior on Senior s final income tax return, is treated as receiving a payment of no less than $5,000, Since the note is IRD, the estate must report a $4,800,000 long-term capital gain on its first fiduciary income tax return. The irrevocable family trust s basis in the land it purchased remains at $5,000, Rev. Rul , C.B B(a)(2) B(g), which is consistent with the non-recognition mandate under 1041(a) for all transfers between spouses Rev. Rul , C.B (a)(5)(A)(iii). Reg (b) (a)(5)(B). The $5,000,000 principal amount is used for income tax purposes even if the note is valued at a lower amount on the estate tax return. 5

6 With those fundamental principles in mind, we now move to the main event their application in the estate planning transactions listed at the start. II. Installment sales to irrevocable grantor trusts. Example 2. Same as Example 1 above Senior sells land with a basis of $200,000 and a value of $5,000,000 to an irrevocable family trust for a promissory note providing for annual interest at the long-term AFR with all $5,000,000 of principal due at maturity in 20 years except that the irrevocable family trust is treated as a grantor trust for Federal income tax purposes. Basis $ 200,000 Value $5,000,000 Potential Capital Gain $4,800,000 A. Income tax results at the time of the sale. None. There is no sale for income tax purposes. 15 Even though a grantor trust is treated as a separate taxpayer for estate tax and the gift tax, 16 the grantor trust is disregarded for income tax purposes because the grantor is deemed to own the trust s assets. 17 Thus, for income tax purposes only, there is no installment note. Since there is no installment sale for income tax purposes, there is no purchase and, by default, the trust s basis in the land is $200,000. B. Income tax treatment of interest and principal payments while grantor is living. None of the interest payments are reported as interest income by the grantor or as an interest deduction by the grantor trust. Instead, Senior, as the grantor of the trust, must report all of the income and losses generated by the land on Senior s individual income tax return. If the grantor trust sells the land for $5,100,000, the long-term capital gain is $4,900,000, and the grantor must report that entire gain on the grantor s income tax return. If the $5,000,000 of note principal is paid while Senior is alive, Senior does not 15 Rev. Rul , C.B A grantor trust is not a disregarded entity under Treas. Reg as the check the box regulation applies to the entire Internal Revenue Code. But, see REG Guidance Under 108(a) Concerning the Exclusion of 61(a)(12) Discharge of Indebtedness Income of a Grantor Trust or a Disregarded Entity, 76 Fed. Reg (4/13/2011)

7 report the receipt of the payment as the principal payment on an installment note because there is no note for income tax purposes. And, the irrevocable grantor trust s basis in the land remains at $200,000, regardless of the fact that the grantor trust expended $5,000,000 in cash for the land. C. Income tax treatment if Senior dies in year 12 with all $5,000,000 of note principal outstanding. The irrevocable trust s assets are not included in Senior s gross estate, but the installment note is included in Senior s gross estate. Is gain realized by Senior when Senior s death causes the grantor trust to become a non-grantor trust? [To be discussed later at Section IV and Example 6] Back to more fundamental income tax principles. III. Gift or bequest of encumbered asset. Example 3. Senior gifts a commercial rental property with a gross value of $7,500,000 and an adjusted income tax basis of $3,000,000 to an irrevocable non-grantor trust. 18 The property is subject to a non-recourse mortgage liability of $5,000,000 provided by a bank. Senior s equity in the property is only $2,500,000. Adjusted Basis $3,000,000 Gross Value $7,500,000 Gain potential $4,500,000 Mortgage $5,000,000 A. Gift of encumbered property to an irrevocable non-grantor trust: part-sale/part-gift treatment. A gift of an encumbered asset to an individual or a non-grantor trust is a part-sale/part-gift transaction. The donee is treated as having purchased that portion of the property with a value equal to the transferred liability. Accordingly, the donor is treated as having sold that portion of the property for the liability shifted to the donee. The remaining portion of the transfer is treated as a gift for income tax purposes. The 18 The adjusted basis reflects prior straight line depreciation deductions of $3,500,000. Thus, up to $3,500,000 of the gain is taxable at a Federal 25% capital gain rate as unrecaptured section 1250 gain. 1(h)(1)(D) and 1(h)(6). And, state income taxes can be as high as another 14.3% in California. 7

8 Regulations go on to provide the rules for how to allocate the donor s basis in the property between the sale portion and the gift portion. 19 The allocation of basis among the sale portion and the gift portion are different if the donee is a charity 20 rather than an individual or a non-grantor trust, except that there is no income tax transfer if the gift is to a grantor trust. Sale portion Gift portion Amount realized $5,000,000 Allocation of Basis - 3,000,000 none Realized gain $2,000,000 Donee s basis in property $5,000,000 none For gift tax purposes, Senior has made a $2,500,000 taxable gift. The transferee is treated as having acquired a portion of the property by purchase for $5,000,000 (the amount of the liability) and takes a carryover basis (which is zero here) for the gift portion. Under the Regulations, for purposes of determining gain only, the donor s entire basis in this example is allocated to the donor s sale portion. The above results are the same for a recourse liability and for a nonrecourse liability as long as the value of the property exceeds the amount of the liability. Since Treas. Reg provides that a transferee takes a single $5,000,000 unitary basis in the entire asset, the $5,000,000 basis is spread over the entire property. The above example was designed to illustrate how basis is allocated only for purposes of determining the gain realized. If, for example, the transferee proceeds to sell a 20% interest, the transferee can allocate $1,000,000 of basis (20% x $5,000,000) to the interest sold. B. Bequest of encumbered asset. Crane v. Commissioner 21 Although it is generally accepted that the transfer of an encumbered asset at death is not an income tax realization event, and that the estate or other successor to the encumbered property receives an income tax basis in the encumbered asset equal to its value, there is no authority directly on point stating that this is a fundamental principle. However, this position has been indirectly accepted in various cases and IRS pronouncements. The IRS indicated that it will follow this approach in C.C.A by stating: Reg See 1011(b). Crane v. Commissioner, 331 U.S. 1 (1947). 22 C.C.A (June 5, 2009). 8

9 We 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. If the liability is a recourse liability, then the gross value of the encumbered asset is reported on the estate tax return schedule for property owned at the time of death (for example, Schedule A, if the asset is real estate) and the amount of the recourse mortgage is reported on the estate tax return on a separate schedule (Schedule K) for claims against the estate. Thus, the value of the property included in the gross estate would be $7,500,000 on the schedule for assets owned at death, and the $5,000,000 mortgage is reported on the estate tax return under the schedule for claims against the estate. If the liability is a nonrecourse liability, there cannot be a claim against the estate. 23 Instead, the value of the property included in the gross estate is reported on the estate tax return under the schedule for assets owned at death at a net equity value of $2,500,000. For both recourse and nonrecocurse liabilities, the estate s income tax basis in the encumbered asset would be $7,500,000 (a tax-free step-up in basis at death under 1014(a)). C. Gift of asset encumbered by a nonrecourse liability. Commissioner v. Tufts 24 Example 4. Same as Example 3 above Senior gifts a commercial rental property with an adjusted basis of $3,000,000, which is subject to a $5,000,000 mortgage, to an irrevocable non-grantor trust except the property has declined in value to $4,000,000 and the liability is nonrecourse. Adjusted Basis $3,000,000 Gross Value $4,000,000 Mortgage $5,000, Treas. Reg , defining a recourse liability reinforces this treatment. If the liability is nonrecourse, it cannot be an estate liability and thus cannot be reported on the estate tax return liability schedule. That leaves the nonrecourse liability as an offset on the asset schedule of the estate tax return. 24 Commissioner v. Tufts, 461 U.S. 300 (1983). 9

10 The mortgage liability now exceeds the value of the property. Senior has to include the entire nonrecourse liability as an amount realized upon the surrender of the property. 25 Senior reports a $2,000,000 capital gain as follows: Amount realized $ 5,000,000 Less: Basis - 3,000,000 Realized gain $ 2,000,000 (capital gain) Suppose there was a foreclosure sale for $4,000,000 and the $5,000,000 mortgage liability is a recourse liability. Since the $4,000,000 of foreclosure sale proceeds is not sufficient to pay the entire liability, Senior is still liable for the $1,000,000 deficiency. If the lender cancels the $1,000,000 deficiency, then Senior has $1,000,000 of discharge of indebtedness income, which is ordinary income, in addition to the $1,000,000 capital gain on the foreclosure sale. 26 D. Nonrecourse liability in excess of value at the death of Senior. Example 5. Same as Example 4 above Senior owns commercial rental property with a value of $4,000,000 and an adjusted basis of $3,000,000, which is subject to a $5,000,000 nonrecourse mortgage liability except Senior owned the property at the time of his death. Since the liability is nonrecourse, the value of the property included in the gross estate has to be zero. Since death is not an income tax realization event, the amount by which the $5,000,000 liability exceeds the $3,000,000 basis is not reported as a gain. Although it is far from clear, the estate s income tax basis in the property may be the property s value of $4,000,000, which also becomes the income tax amount of the liability to the successor. 27 If the liability is recourse and continues as a recourse liability of the estate, there is still no income tax realization event (thus, no gain is reported). Since the estate will 25 Reg (a)(3). 26 Rev. Rul , C.B. 12 and Aizawa v. Commissioner, 99 T.C. 197 (1992), aff d. 29 F.3d 630 (9 th Cir. 1994). However, in Frazier v. Commissioner, 111 T.C. 243 (1998), the foreclosure purchaser bid an amount in excess of the actual value. Therefore, the court determined the debtor s amount realized by the actual market value and not the higher amount of the lender s bid. 27 The basis may be $4,000,000 under the rationale of Pleasant Summit Land Corp. v. Commissioner, 863 F.2d 263 (3 rd Cir. 1968), cert. den. sub nom. Commissioner v. Prussin, 493 U.S. 901 (1989), or it may be zero under the rationale of Est. of Franklin v. Commissioner, 544 F.2d 1045 (9 th Cir. 1976). 10

11 eventually have to satisfy the entire liability, it can then be argued that the estate s basis should be $5,000,000 even though the property is only worth $4,000,000. If the estate negotiates the liability down, the difference is discharge of indebtedness income. There actually would be an overall tax cost if the combined Federal and state income tax rates exceed the 40% estate tax rate. IV. Termination of grantor trust status upon the grantor s death. Example 6. Back to Example 2 above Senior sells land, with a basis of $200,000 and a value of $5,000,000, to an irrevocable grantor trust in exchange for a $5,000,000 interest-only promissory note, with all $5,000,000 of principal due at maturity in 20 years except assume that Senior dies in year 12, when all $5,000,000 of the note principal is still outstanding. Basis $ 200,000 Value $5,000,000 Potential Capital Gain $4,800,000 A. Conversion to a non-grantor trust occurs simultaneously with death. The only logical result is that the conversion to a non-grantor trust upon the death of the owner occurs with the death of the owner. Thus, it is impossible for the conversion to occur the moment before death or the moment after death under general income tax and estate tax principles. B. Death is not an income tax realization event. Crane v. Commissioner. Madorin v. Commissioner 28, Rev. Rul and Treas. Reg (c) Example 5 all involved situations where the encumbered asset, owed to a third party and not to the grantor, was owned by a grantor trust, and the trust s income tax status changed to a non-grantor trust while the grantor was alive. Those authorities cannot be applied to situations where death causes the switch to a non-grantor trust. Remember that if the grantor trust s liability is owed to the grantor, there cannot be a liability for income tax purposes. While in Madorin, the Ruling and the Regulation there was a liability for income tax purposes at all times Madorin v. Commissioner, 84 T.C. 667 (1985). Rev. Rul , C.B

12 Since death is not an income tax realization event, there cannot be any gain realized upon the conversion to a non-grantor trust by reason of death. C. Basis of the note included in the grantor s gross estate. IRD is defined as income realized by the decedent while alive that was not reported as income because of the decedent s method of accounting. Since no gain is realized upon an installment sale to a grantor trust, there has not been any income realized while the grantor was alive. Thus, the installment note cannot be treated as IRD. The grantor-decedent s estate takes a basis equal to the value of the installment note included in the gross estate. If the note is valued at its principal amount, a subsequent receipt of a payment of the note principal cannot be treated as gain. If the note is valued at less than its principal amount, the excess of the principal payment over the estate s basis is treated as ordinary income under the 1276 market discount rules. Example 7. The value of the installment note is discounted from its $5,000,000 principal amount and is valued in the gross estate at $4,600,000. The estate s income tax basis in the note is limited to that $4,600,000. Upon collection of all $5,000,000 note principal, the estate will have to report $400,000 of ordinary income because the note is treated as a market discount debt obligation. 30 Thus, by reporting the installment note at a discounted value, the estate has converted what would have been taxfree income into ordinary income, 31 offsetting any reduction in estate tax from the discounted value. D. The former grantor trust s basis in the property purchased from the grantor. Upon conversion of the trust at death to a non-grantor trust, the trust is now a separate taxpayer for Federal income tax purposes (as it has been all along for transfer tax purposes), and the purchase comes into income tax existence at that time. The family trust does not hold the assets as a gift with a transferred basis under 1015 because the original transaction was a purchase. As an acquisition of an asset by purchase, the trust should take a cost basis in the asset equal to the outstanding principal amount of the note 30 See If the combined Federal and state income tax rates on ordinary income exceed the estate tax rate, consideration should have been given to not taking a discount on the value of the note as an asset in the gross estate. 12

13 at the date of death. In that event, under the foregoing example, the trust s basis in the land would be $5,000,000 under Alternatively, some commentators believe that the estate s basis equals the value of the asset at the date of death, theorizing that 1014(b) can be used to determine the trust s income tax basis (b) applies to property acquired by bequest, devise or inheritance or to property acquired from the decedent. A very technical reading of 1014(b)(1) indicates that 1014(b)(1) does not require inclusion in the decedent s gross estate. 1014(b)(1) provides: (1) Property acquired by bequest, devise, or inheritance, or by the decedent s estate from the decedent. Therefore, it can be argued that assets held in such a trust should be viewed as passing as a bequest or devise when the trust ceases to be a grantor trust at the moment of death. However, a literal application is not consistent with what actually occurred. The property did not pass from the decedent; the trust has owned it all along for transfer tax purposes, although not for income tax purposes. Accordingly, we feel that 1014(b) is inapplicable. V. Termination of grantor trust status while the grantor is alive. A. Tax consequences where all or part of the grantor trust s note obligation remains outstanding. Example 8. Same as Example 6 above Senior sells land, with a basis of $200,000 and a value of $5,000,000 to an irrevocable grantor trust in exchange for a $5,000,000 interest-only promissory note, with all $5,000,000 of principal due at maturity in 20 years except that, in year 12, when all $5,000,000 of the note principal is still outstanding, the grantor trust is converted into a nongrantor trust by having the grantor renounce the powers that initially caused the trust to be treated as a grantor trust. 32 Alternatively, using the holding in Crane v. Commissioner that Mrs. Crane s basis was equal to the encumbered real estate s value at the date of death, the basis would still be $5,000, See Jonathan G. Blattmachr, Mitchell M. Gans and Hugh M. Jacobson, Income Tax Effects of Termination of Grantor Trust Status by Reason of the Grantor s Death, 97 Journal of Taxation 149 (2002). 13

14 Basis $ 200,000 Value $5,000,000 Potential Capital Gain $4,800,000 If Senior relinquishes the powers that intentionally made the family trust a grantor trust during his life, a realization event has occurred for income tax purposes. 34 The issue of the family trust s basis for the property is the same as that discussed in IV.D above (regarding termination of grantor trust status upon the grantor s death) whether it should be a basis determined under the part sale, part gift provisions of 1015, 35 or should be a cost basis. The considerations discussed there apply equally to transfers during the grantor s life. On the other hand, since the transfer is during life, Senior now realizes gain on the installment sale. Because the sale for income tax purposes occurs only upon termination of grantor trust status, it does not relate back to the time when the original sale was made for transfer tax purposes. The gain is measured using the then tax amount of the balance of the installment note, not the original sale price, and the then basis of the property. The tax balance of the note is, in turn, determined using the AFR at that time. 36 The then basis of the property is determined with appropriate adjustment for any depreciation since the transfer, any capital expenditures made by the trust and any other appropriate items. The conclusion that termination during life is a realization event is not inconsistent with the judgment that the automatic termination of grantor-trust status at death is not a realization event. Transmission of property at death is, as far as we know, the only disposition that is not a realization event and that generally eliminates unrealized gain or loss because of the basis adjustment under 1014(a). Most so-called nonrecognition transactions involve both basis carryover and recognition to the extent of boot. Donative family transactions involve recognition if consideration is received, including consideration in the form of a liability transfer. 37 Even transfers in connection with a divorce under 1041 can involve recognition under assignment of income principles. 38 At most, transmission at death can result in a transfer, not a realization, of 34 Rev. Rul ; Reg (c) Example 5; Madorin v. Commissioner, 84 T.C. 667 (1985); Rev. Rul , C.B. 222; G.C.M (Aug. 23, 1977). 35 See Reg (a)(1); Reg (b)(1); Mayerson v. Commissioner, 47 T.C. 340, 352, acq. Rev. Rul , C.B. 59; Bolger v. Commissioner, 59 T.C. 760 (1973), acq C.B See Est. of Levine v. Commissioner, 634 F.2d 12 (2 nd Cir. 1980); Ebban v. Commissioner, 783 F.2d 906 (8 th Cir. 1986); Diedrich v. Commissioner, 457 U.S. 191 (1982); Rev. Rul , C.B Temp. Reg T(a) Q&A-4; Kochansky v. Commissioner, 92 F.3d 957 (9 th Cir. 1996); Yonadi v. Commissioner, 21 F.3d 1292 (3 rd Cir. 1994); Balding v. Commissioner, 98 T.C. 368 (1992); Gibbs v. Commissioner, 73 T.C.M. (CCH) 2669 (1997). 14

15 IRD. 39 B. Cancellation of indebtedness income. Does the grantor incur cancellation of indebtedness income when the grantor s obligation to pay the income taxes on the trust s income is shifted to the trust? The narrow situation when an existing trust liability to an unrelated person is attributable to the grantor because of grantor trust status and that liability is deemed shifted to the trust when grantor trust status is terminated while the grantor is still alive is the only guidance we have as to the income tax consequences when grantor trust status is terminated. 40 These authorities treated the liability shift as an income tax realization event, specifically as an income tax sale under 1001(a). These authorities involve a liability owed to a third party and did not address a liability of the grantor trust to the grantor. Because these authorities take the position that the income tax shifting of the third-party liability from the grantor to the trust is an income tax realization event, that leads to the question whether the grantor would incur discharge of indebtedness income under 61(a)(12) when the grantor s obligation to pay the income taxes on the trust s income is shifted to the trust upon termination of grantor trust status. This issue has never been addressed by the IRS in its Regulations, in any of its official and unofficial administrative pronouncements or in the case law, and its resolution remains unclear at this time. The resolution of this issue needs to be addressed in light of the IRS position that the grantor does not make a gift when the grantor pays the income taxes on the grantor trust s income because that liability is the grantor s liability, and the IRS concludes that one cannot make a gift by paying one s own liability. 41 Because the IRS s position in Revenue Ruling recognizes the existence of this liability, although limited to the transfer tax consequences, it could lead one to the conclusion that when the grantor s liability to pay the income taxes on trust income is shifted to the trust, the grantor s liability is cancelled. Therefore, for income tax purposes, does the grantor have to recognize discharge of indebtedness income under 61(a)(12) of the Code? 42 The taxpayer friendly view is that discharge of indebtedness income should not result upon the cancellation of the grantor s obligation to pay the income taxes on the (c); but cf. Rev. Rul , C.B. 207 (accrued interest on Series E bond recognized by donor on transfer to ex-spouse in connection with divorce). 40 Treas. Reg (c) Example 5; Rev. Rul , C.B. 222 and Madorin v. Commissioner, 84 T.C. 667 (1985). 41 Rev. Rul , C.B The IRS s statement in C.C.A (June 5, 2009) that conversion of a non-grantor trust to a grantor trust is not a transfer for income tax purposes of the property held by the non-grantor trust to the owner of the grantor trust that requires the recognition of gain to the owner is questionable. 15

16 trust s taxable income. First, it is the individual grantor s liability paid out of the grantor s property for income tax purposes. 43 Second, the reason for attributing items of income, deduction, and credit to the grantor under 671 is that the grantor is deemed to be the owner of the trust property. The IRS s position of treating the grantor as the owner of the trust's assets is, therefore, consistent with and supported by the rationale in Rev. Rul In other words, tax liability attaches to the owner of the property. As the deemed owner of the property, the grantor s payment of income tax is in discharge of his own obligation. The income tax cannot be an obligation owed to the trust, because the trust does not exist for Federal income tax purposes. The language of Rev. Rul supports this by stating that any income tax [the grantor] pays that is attributable to Trust's income is paid in discharge of [the grantor s] own liability, imposed on [the grantor] by 671. It is only after grantor trust status terminates that the non-grantor trust springs into life as a separate entity for Federal income tax purposes. The grantor is deemed to relinquish ownership of the trust assets at that time. The trust, as owner of the assets must pay the resulting income tax liability. This transfer appears analogous to an individual who transfers income producing property by gift. While the individual owns the property, he reports the income from it, and thus pays the income tax on the income produced. Once the individual transfers the property to another person, he no longer reports its income, and thus has no corresponding obligation to pay the income taxes associated with the property. He does not, however, recognize any discharge of indebtedness income on the actual transfer of an income-producing asset by gift. Likewise, one should be treated similarly if there is a deemed transfer of an incomeproducing asset when grantor trust status is terminated. A fundamental income tax principle is that contingent liabilities are not treated as a liabilities until they become fixed. 46 Therefore, a grantor s income tax liability can only arise when a grantor trust has taxable income. When the trust realizes taxable income after termination of grantor trust status, it is the trust s liability, not the grantor s liability, because the grantor no longer owns the income. By analogy, suppose while the trust was a grantor trust, the trust distributed cash to the grantor to use to pay the grantor s income tax liability. This would not be treated as discharge of indebtedness income because the grantor is using his own asset (under the income tax fiction created by grantor trusts) to satisfy the grantor s own liability On the other hand, it arguably is withdrawn from the trust for transfer tax purposes C.B C.B Albany Car Wheel Co. v. Commissioner, 40 T.C. 831, aff d per curium, 333 F.2d 653 (2d Cir. 1964); David R. Webb Co. v. Commissioner, 77 T.C (1981), aff d, 708 F.2d 1254 (7 th Cir. 1983). 16

17 Because the transfer tax-free wealth shifting resulting from the grantor paying the income taxes on the grantor trust s taxable income can be significant and become financially burdensome on the grantor, the estate planning community typically recommends toggling off grantor trust status for the trust, especially after the installment note has been paid in full. An issue that has not been addressed is how the power to shift or not shift the income tax liability affects the transfer tax value and when. The following example illustrates that this is more in the nature of a valuation issue. Example 9. Senior is in the 40% marginal income tax bracket. If Senior purchases a $1,000,000 corporate bond paying 5% annual interest, Senior will receive $50,000 of taxable income and pay $20,000 of income taxes, thereby netting $30,000 after taxes. In a perfect financial world, a $1,000,000 tax-free municipal bond would pay 3% annual interest and the bondholder would also net $30,000 after taxes. Thus, the municipal bond is also valued at $1,000,000. If Senior gifts the above corporate bond or the above municipal bond to a nongrantor trust, the value of both gifts is $1,000,000, as the non-grantor trust will net $30,000 after taxes in both situations. Suppose, instead Senior gifts the corporate bond to a grantor trust which now has the right to receive the $1,000,000 of principal at maturity and the right to receive $50,000 annually in after tax dollars. Since the gift of the corporate bond to a non-grantor trust, representing the right to receive bond principal and $30,000 annually after taxes, is valued at $1,000,000, how should the gift of the same corporate bond be valued if the gift is to a grantor trust? Should the value of the gift be increased by the right to receive an additional $20,000 annually for the life of the bond or more appropriately for the life of the grantor? We hope you enjoy this mental exercise! The authors feel that no one would want to increase the value of the taxable bond by the value of the right to have the income tax paid by the grantor, since the Internal Revenue Code forces the grantor to pay the tax, and the payment of such tax is not a gift. 17 VI. Grantor trust disposes of the purchased asset subject to the installment note. Even though it does not involve a termination of grantor trust status, the family trust s disposition, while it is a grantor trust, of the purchased asset subject to the obligation on the promissory note must result in a similar taxable event for income tax purposes. The grantor now has a third-party obligor and is no longer taxable on the income from the purchased property transferred to the obligor. Under the principles of Rev. Rul , the grantor has made a taxable sale of the property for income tax purposes at that time. The taxable gain should be measured by the tax amount of the

18 promissory note, determined under the original issue discount ( OID ) rules based on the AFR at that time, plus any additional consideration received by the family trust. 47 VII. Grantor transfers the installment note to another taxpayer while the grantor is alive. Again, even though it does not involve a termination of grantor trust status, the grantor s disposition of the promissory note issued by the family trust while it is a grantor trust must result in a similar taxable event for income tax purposes. The note that was disregarded for income tax purposes as an obligation owed by the grantor to himself, when owed to a third party, can no longer be disregarded. 48 In the first instance, the grantor s transfer of the note should have the same consequences as would apply if the grantor issued the note to the transferee. If the note is given to a charity, it represents a charitable contribution, albeit one that probably cannot be deducted until paid. 49 The fact that the legal obligor on the note is the family trust probably does not change the general rules on payment since, under Rev. Rul , 50 the grantor is not merely taxed on the income of the trust, but owns the trust. 51 Similarly, if the family trust s note is transferred to a family member without consideration, it is a gift. 52 If the note is transferred in consideration of goods or services, it amounts to payment for those goods or services and has the appropriate tax character under general income tax principles as deductible, 47 See Tech. Adv. Mem , Nov. 23, 1999 (gain realized by grantor on termination of grantor trust when corpus of GRAT transferred to remainder trust subject to loan incurred to pay GRAT); Tech. Adv. Mems and , Nov. 23, 1999 (apparently identical rulings). 48 Cf. U.S. v. Wham Construction Corp., 600 F.2d 1052 (4 th Cir. 1979) (liability owed by one corporate division to another is not treated as a liability assumed by the transferee when the division is incorporated, but is treated as boot paid). 49 See, e.g., Don E. Williams Co. v. Commissioner, 429 U.S. 569 (1977) (corporation s note not deductible contribution to a qualified pension plan because not cash); Rev. Rul , C.B. 81 (taxpayer s note not deductible charitable contribution); Rev. Rul C.B. 22 (written option on corporation s stock granted to charity not deductible until exercised, no payment) C.B But see Rothstein v. United States, 735 F.2d 704 (2 nd Cir. 1984). In that case, the court determined that the grantor trust rules do not actually treat the grantor and the trust as one, but merely require that the grantor report all of the trust s items as his own and recognized a sale by the trust to the grantor as allowing the grantor-purchase to use the purchase price as the basis of the assets. A taxpayer who initially treated the transaction under Rev. Rul would almost certainly be bound by a duty of consistency in treating the transfer of the note. 52 Rev. Rul , C.B. 351 (gift of donor s note, assumed to be unenforceable under state law, is not gift until paid or transferred for value); Rev. Rul , C.B. 191 (gift of enforceable note is gift when delivered). 18

19 capitalizable or neither, when appropriate under the taxpayer s method of accounting. The more difficult question is whether the grantor s transfer of the note to a nongrantor trust should also be treated as a taxable sale for income tax purposes of the property previously transferred to the grantor trust. Although the matter can hardly be considered free from doubt, an argument can be made that since the grantor still owns the grantor trust corpus for income tax purposes and will still be taxed on the grantor trust s income used to pay the note, the note does not represent consideration for the property. 53 Under this construction, the grantor trust would not be entitled to a cost basis or even a part sale, part gift basis in the property. On the other hand, the initial transaction was an installment sale, disregarded for income tax purposes, that has become a transaction recognized for income tax purposes simultaneously with the transfer of the note. An installment sale is an income tax concept. There can be no installment sale to oneself. The transfer of the installment note does not affect the fact that, for income tax purposes, the grantor trust still owns the property. The fact that the grantor no longer owns the note means that the note comes into existence at that time. It should be a current installment sale, leaving the basis without a step-up. If the grantor is still alive when the payment becomes due, gain is realized. If not, the grantor trust realizes gain. Under this approach, Senior s transfer of the grantor trust s note is a taxable installment sale. The tax fiction of Rev. Rul should not be carried to the point of completely disregarding a transaction that has effect under both local law and the transfer tax. Disregarding the transaction for income tax purposes under the grantor trust rules does not change its nature as an installment sale that should be so characterized for income tax purposes when it is no longer disregarded. VIII. Grantor purchases an asset from a grantor trust for an installment note and dies while the note obligation remains outstanding. Example 10. Several years ago, Senior created and funded an irrevocable grantor trust. The trust will not be included in Senior s gross estate. At present, the trust owns appreciated stock in a closely-held company with a basis of $200,000 and a value of $5,000,000. Senior is in his late 80 s and is in poor health. Death is anticipated in the next year or two. Senior purchases the stock from the trust for a $5,000,000 interest-only promissory note, with all $5,000,000 of principal due at maturity in 9 years. Senior dies two years later, when the stock is valued at $5,500, Cf. U.S. v. Wham Construction Corp., supra note

20 Example 10 is essentially the opposite of the transaction described in Example 6 above, where Senior sold land with a basis of $200,000 and a value of $5,000,000 to a grantor trust for an installment note and all $5,000,000 of the note principal was still outstanding at Senior s death. Although the roles of Senior and the trust have been reversed, the transaction is still between the grantor and a grantor trust. Thus, the sale of the stock is disregarded for income tax purposes and there is no realization event. 54 The stock is includible in Senior s gross estate at its $5,500,000 value, and under 1014(a), Senior s estate takes a $5,500,000 basis in the stock. Upon Senior s death, when the trust becomes a separate taxpayer for Federal income tax purposes, the trust is deemed to have sold the stock to Senior for the $5,000,000 note, realizing a $4,800,000 gain. The $4,800,000 realized gain can be reported in the future under the installment method. On the other hand, if the trust had sold marketable securities to Senior, the installment method would be unavailable, and the trust would need to report the entire $4,800,000 realized gain at the moment of Senior s death. The foregoing result obviously differs from the result in Example 6 above, where the grantor sold property to the trust and then died while the note was outstanding. In that scenario, no gain was realized because the grantor s death is not an income tax realization event to the grantor. The same principle does not apply where the seller is a trust an entity that does not die with the grantor. Accordingly, there is no reason to disregard the trust s realized gain. All that has occurred is that the unrealized appreciation inherent in the grantor trust s assets has now been realized and will be reported. If the trust has no intention of selling the appreciated asset, it makes no financial sense to report a gain. IX. Non-grantor trust becomes a grantor trust while the grantor is living. C.C.A supposedly addressed the income tax treatment when a nongrantor trust that had purchased an appreciated asset from a related party paid for that asset by issuing a private annuity. Since the purchasing trust was not a grantor trust, the related party seller realized an income tax gain and was able to defer the reporting of the gain under the annuity method prescribed by a published revenue ruling. 55 While the 54 Rev. Rul , C.B Rev. Rul , C.B. 43. The transaction discussed in C.C.A occurred before 2006; therefore, it was not subject to Prop. Treas. Regs (e) and (j) (REG ), 71 Fed. Reg. 61,441 (Oct. 18, 2006)), under which gain on sales of private annuities would be immediately reportable. 20

21 seller-annuitant was alive and before the seller-annuitant had reported that portion of the remaining gain inherent in subsequent annuity payments, the trust converted to a grantor trust. In this CCA, the IRS announced that the authorities and income tax principles that applied when a grantor trust converts to a non-grantor trust were not applicable to a conversion of a non-grantor trust to a grantor trust. Instead of finding that the conversion of a non-grantor trust to a grantor trust was an income tax realization event, the IRS, apparently concerned that the conversion could be inadvertent, naively stated that: The Service should not take the position that the mere conversion of a non-grantor trust to a grantor trust results in taxable income to the grantor. But, at the end of the CCA, the IRS stated that: Because the case presents an apparent abuse 56, however, we would like to explore with you further case development that may lead to other arguments to [treat the conversion as an income tax realization event]. We believe that, under analogous principles, a taxable event has occurred upon the conversion of a non-grantor trust to a grantor trust. 57 The non-grantor trust should recognize gain, but only for any difference between the remaining amount of the liability on the private annuity at that time and its cost basis in the property. In the CCA, taxability to the non-grantor trust was apparently conceded, but because the initial private annuity sale had stepped up the basis of the assets, there was no gain. What is clear is that the liability no longer exists for income tax purposes because of the merger of the obligor and the obligee by application of the grantor trust rules. The CCA 56 Prior to the issuance of Prop. Treas. Regs (e) and (j), private annuity sales to non-grantor trusts were not subject to the restrictions on installment sales. For example, Senior, the owner of an appreciated marketable security with a basis of $200,000 and a value of $5,000,000, could sell the asset to a non-grantor trust for a private annuity and be able to defer the reporting of the realized gain under Rev. Rul , reporting the gain only as future annuity payments were received. The non-grantor trust took a $5,000,000 costs basis under Rev. Rul , CB 352. If the non-grantor trust, in turn, resold the asset for $5,100,000, its gain would be only $100,000, and Senior could continue to defer the gain realized on the private annuity sale. The abuse that C.C.A was concerned about was that if the non-grantor trust became a grantor trust, Senior would not have to report subsequent annuity payments as gain. 57 Cf. Rev. Rul. 99-5, C.B. 8 (dealing with converting an LLC taxed as a partnership into a single member LLC that is a disregarded entity); Reg (a)(1)(i) and (ii) and (a)(4) (dealing with the effect of an election to treat a qualified subchapter S subsidiary as, in effect, a division). 21