Every Friday, we feature Tax Law & Policy Perspectives from Monte A. Jackel, UBalt Law’s graduate tax program scholar-in-residence. The posts reflect the views of the author and do not reflect the views of the University of Baltimore. Although we strive to be accurate in our posts, they do not constitute legal advice. Independent advice should therefore be sought if it is deemed advisable.
Grantor trusts have been a statutory feature of our income tax system since the early days of the income tax. Section 671 of the Internal Revenue Code provides in part that:
“Where it is specified….that the grantor or another person shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deduction and credits against tax of the trust….which are attributable to that portion of the trust….”
The pertinent regulations (Treas. Reg.§1.671-2(a), (c)) then state:
“Under section 671 a grantor or another person includes in computing his taxable income and credits those items of income, deduction, and credit against tax which are attributable to or included in any portion of a trust of which he is treated as the owner…. An item of income, deduction, or credit included in computing the taxable income and credits of a grantor ….under section 671 is treated as if it had been received or paid directly by the grantor….”
There has been a lingering question over the past several decades about whether ownership of a grantor trust means the same thing as actual ownership of the property held by the trust or, alternatively, whether such ownership means only the attribution of the trust’s items of income, gain, loss, deduction, or credit. (Jackel, “More on Grantor Trusts: Tax Attribution or Asset Ownership,” Tax Notes Federal, Jan. 24, 2022, p. 517; and Jackel, “Grantor Trust Ownership: What Does It Mean?” Tax Notes Federal, Apr. 13, 2020, p. 269.) This question relates to what the proper treatment of a transaction between the grantor and the grantor trust is: disregarded or recognized in the tax system?
In Revenue Ruling 85-13 (1985-1 C.B. 184), a grantor trust sold trust property held by it and previously contributed by the grantor back to the grantor for a promissory note. The IRS stated:
“Because A is treated as the owner of the entire trust, A is considered to be the owner of the trust assets for federal income tax purposes…. In this case, A is considered to be the owner of the promissory note held by the trust. Therefore, the transfer of the [trust property] by T [trust] to A [the grantor] is not recognized as a sale for federal income tax purposes because A is both the maker and the owner of the promissory note. A transaction cannot be recognized as a sale for federal income tax purposes if the same person is treated as owning the purported consideration both before and after the transaction…..”
In so holding, the IRS rejected the contrary holding of the Second Circuit Court of Appeals on the same facts. (Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984)). That court viewed section 671 and its accompanying regulations as only attributing tax items to the grantor. The trust was still viewed as a separate tax entity for all transactions by the grantor with the trust.
Many estate planning techniques revolve around the fact that the IRS’s position over the years has been that a transaction between a grantor and his grantor trust is disregarded for federal income tax purposes. However, that same transaction is taken into account for federal estate and gift tax purposes. A recent IRS revenue ruling involves the related issue of whether there is a basis step-up under section 1014 for an irrevocable grantor trust (Rev. Rul. 2023-2, 2023-16 IRB 658) not included in the gross estate for estate tax purposes. This revenue ruling denies the basis step-up but expressly does not address as facts either when liabilities are in excess of basis at death or a transaction between the grantor and grantor trust involving a sale in exchange for a promissory note of the grantor, meaning a transaction between the grantor and his trust. That ruling, therefore, has limited usefulness.
A good argument can be made that the Congress should address these issues by statute before the IRS addresses them administratively. This is primarily because of the need to avoid endless litigation on these issues if done by the IRS because the current grantor trust statutes and underlying regulations are unclear on these issues, as well as necessary coordination with other provisions of the IRC and regulations thereunder if grantor trust ownership is addressed by a future statute. Time will tell.
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