How grantor trusts separate income and estate tax treatment

By Richard C. Wilson

For a proposed gift or sale to a trust, organize the review around separate questions: Who reports the income? Is the gift complete? What is the consideration worth? Which retained powers require an estate tax review?

Research notice: Based on primary sources linked below. Read each explanation with its stated conditions and exceptions. Ask an estate attorney or CPA to review the trust instrument, transaction documents, valuation, reimbursement provisions and reporting before acting. Use the instructions for the applicable filing year.

The grantor pays the income taxes

A grantor treated as owner under subpart E does not make a gift to trust beneficiaries by paying tax attributable to trust income included in that grantor’s taxable income. That conclusion concerns the income tax payment itself. Review a separate contribution to the trust separately.

Review the default income reporting method below with the return preparer. Keep the income tax reporting review separate from the gift and estate tax questions.

Tax reimbursement and estate inclusion

Mandatory reimbursement under the trust’s governing instrument or applicable local law causes the full value of the trust’s assets to be included in the grantor’s gross estate under §2036(a)(1). The reimbursement must concern income tax payable by the grantor attributable to the trust’s income.

If the governing instrument or applicable local law instead gives the trustee discretion to reimburse that tax, the discretion alone does not cause estate inclusion. That conclusion applies whether or not the trustee exercises the discretion.

Discretion combined with other facts may cause inclusion. Those facts include an understanding or arrangement about reimbursement, a retained power to remove the trustee and appoint the grantor as successor, or applicable local law exposing trust assets to the grantor’s creditors.

The IRS will not apply the mandatory reimbursement holding adversely to a grantor’s estate for a trust created before the ruling’s stated cutoff date. Review the reimbursement provision and the trust’s administration with your adviser.

Adding reimbursement authority to an existing trust

In the nonprecedential Chief Counsel advice linked below, beneficiaries made taxable gifts by consenting to modify an existing irrevocable grantor trust to add discretionary authority to reimburse the grantor. The advice reached the same result where a statute gives beneficiaries notice and objection rights but a beneficiary fails to object.

Its reasoning was that adding discretionary distributions to the grantor relinquished part of the beneficiaries’ interests. The advice rejects the contrary reasoning of the earlier private letter ruling identified in Sources. It cannot be used or cited as precedent and concerns later modification, rather than authority present when the trust was created.

Continue with the related grantor trust income tax and reimbursement guide. Bring the original instrument and every amendment so counsel can distinguish existing authority from a proposed modification.

Installment sales, gifts and valuation

An exchange of trust assets for the grantor’s promissory note is disregarded for federal income tax purposes when the grantor is treated as owning both the assets and the consideration before and after the exchange.

That treatment answers the federal income tax question only. Use the gift completeness, valuation and estate inclusion discussions below for the other questions.

Take note interest, the applicable rate, payment frequency, maturity, security and capitalization to a transaction specific review. Request separate note interest guidance addressing the applicable provisions and their exceptions before choosing terms or running a calculation.

Prepare the proposed note, the trust’s asset list, the property valuation and the intended funding sequence for the advisers’ review. Ask the advisers to identify which facts they still need before documenting the transaction.

When is a transfer a completed gift?

A gift is complete to the extent the donor relinquishes dominion and control without retaining a power to change the property’s disposition for the donor’s benefit or another person’s benefit. Examine each reserved power and its scope. A transfer may be wholly incomplete or partly complete and partly incomplete.

A retained power to revest beneficial title in the donor makes the gift incomplete. A retained power to name new beneficiaries or change their interests makes the gift incomplete to that extent, unless it is a fiduciary power limited by a fixed or ascertainable standard.

For the review, mark the provisions addressing the donor, beneficiaries and fiduciary powers. Ask counsel to explain the result for each affected interest rather than relying on the trust’s label.

Property value and note value need separate attention

For gift tax, property is valued at the gift date. A transfer for less than adequate and full consideration in money or money’s worth produces a gift equal to the excess property value over consideration value.

A sale, exchange or other transfer made in the ordinary course of business, meaning bona fide, at arm’s length and free from donative intent, is considered made for adequate and full consideration.

A secured or unsecured note is presumed worth unpaid principal plus accrued interest through the gift date unless the donor establishes a lower value.

Unless returned at face value plus accrued interest, the note requires satisfactory evidence supporting a lower value. The evidence must show that the note is worth less because of its interest rate, maturity or another cause, or is partly uncollectible because of insolvency or another cause. The evidence must also show that any pledged or mortgaged security is insufficient to satisfy the note.

Ask the valuation adviser to document both sides of the exchange. Keep the proposed transaction documents with the valuation materials so the review addresses the actual terms being considered.

Retained interests and powers that cause estate inclusion

Retained possession, enjoyment, income and designation rights

Section 2036 includes transferred property where the decedent retained possession, enjoyment, the right to income, or the right, alone or with another person, to designate who possesses or enjoys the property or income.

The retention must be for life, for a period not ascertainable without reference to death, or for a period that does not in fact end before death. A bona fide sale for adequate and full consideration in money or money’s worth is excepted.

Powers to alter, amend, revoke or terminate

Section 2038 includes transferred property whose enjoyment was subject at death to the decedent’s power to alter, amend, revoke or terminate. The power may be exercisable alone or with any other person, regardless of when or from whom it was acquired.

Relinquishment of such a power within the three years ending at death is also covered. A bona fide sale for adequate and full consideration in money or money’s worth is excepted.

Retained voting rights in a controlled corporation

Under §2036(b), retaining direct or indirect voting rights in transferred stock of a controlled corporation counts as retained enjoyment under §2036(a)(1). Apply the retention periods and sale exception described above.

Control requires ownership, applying §318 attribution, or the right to vote, alone or with another person, stock possessing at least 20 percent of the total combined voting power of all classes of stock.

The qualifying ownership or voting right must exist at some time after the transfer and within the three years ending at death. Relinquishment or cessation of voting rights is treated as a transfer of property for purposes of applying §2035.

The voting rights rule applies only to transfers made after the effective date stated in §2036(b)(3). Ask counsel to review the ownership records and voting agreements against those rules.

The estate tax safeguards for a substitution power

A retained power, exercisable in a nonfiduciary capacity, to reacquire trust property by substituting property of equivalent value does not by itself cause estate inclusion under §§2036 or 2038 if both safeguards apply.

The trustee must have a fiduciary obligation under local law to ensure that acquired and substituted properties actually have equivalent value. The power must not permit shifting benefits among beneficiaries. Review other retained powers independently.

Consideration and the inclusion amount

For a transaction described in §§2035 through 2038 or §2041 involving consideration in money or money’s worth, but lacking a bona fide sale for adequate and full consideration, §2043(a) limits the inclusion amount.

Only the excess of the otherwise includible property’s fair market value at death over the consideration received by the decedent is included on account of that transaction. Do not assume an exchange automatically includes both assets at full value.

Bring voting agreements, ownership records, attribution questions and any proposed exchange documents to the estate tax review. Request a separate conclusion for the transferred property, the consideration and each retained right.

A substitution power and income tax ownership

An equivalent value substitution power can cause owner treatment for the affected trust portion under §675(4)(C) when it is exercisable in a nonfiduciary capacity without the approval or consent of any person in a fiduciary capacity. If the power is not exercisable as trustee, capacity depends on all trust terms and the circumstances of creation and administration.

Compare the power’s wording and administration with the estate tax safeguards above. Ask the drafting attorney and trustee to review their respective responsibilities together.

Ending grantor ownership during life

In the Treasury regulation’s partnership example, the grantor renounces the powers causing grantor ownership during life, ending owner treatment for a trust holding a partnership interest.

The grantor is then treated as transferring that interest to the trust as a separate taxable entity, and the grantor’s share of partnership liabilities is treated as money received. The example does not establish that every outstanding sale note causes gain.

Before changing a power, assemble the trust instrument, partnership records, liability information and outstanding obligations for the tax adviser.

Investment transfers and trust reporting have distinct conditions

Qualifying Opportunity Fund contributions

Contributing a qualifying Qualified Opportunity Fund investment to a trust is not an inclusion event when the contributing taxpayer is the deemed owner and the portion holding the investment is wholly a grantor trust as to that taxpayer.

A gift of a qualifying investment to a nongrantor trust generally is an inclusion event, regardless of gift completeness or the recipient’s taxable or tax exempt status. Use separate opportunity zone guidance for changes in status, death, later dispositions and deferral deadlines. Limit this contribution distinction to qualifying QOF investments.

The default income reporting method

Under the default method, income, deductions and credits attributable to a trust portion treated as owned by the grantor or another person under subpart E appear on a separate statement attached to Form 1041.

Those items are not reported as the trust’s items on that form. The method is subject to paragraph (b)’s alternative methods and the referenced special reporting rules. Take questions about optional reporting methods to separate reporting guidance and the return preparer.

The trust instrument attachment for Form 709

The Form 709 instructions linked below require a certified or verified trust instrument with the return reporting the first transfer to that trust. For later reported transfers, the instructions permit a brief description of trust terms or a copy of the instrument.

Check the instructions for the applicable filing year. The attachment requirement does not determine whether every transfer requires a return.

Grantor ownership and basis at death

In the IRS basis ruling linked below, assets transferred by completed gift to an irrevocable trust received no §1014 basis adjustment at the grantor’s death under the ruling’s particular facts.

A retained power created income tax ownership without estate inclusion, liabilities did not exceed asset basis at death, and neither the trust nor the grantor held a note on which the other was the obligor.

The assets did not qualify as acquired or passed from a decedent under §1014(b), so their basis immediately after death equaled their basis immediately before death. The ruling does not exclude an adjustment for property otherwise qualifying under §1014(b), including property included in the gross estate or described in §1014(b)(2), (3) or (4).

For lifetime gift basis, including loss basis and gift tax adjustments, continue to the gift and inheritance tax basis guide. Bring acquisition records, prior basis information and any sale note to the adviser reviewing the proposed transfer.

Common questions

Resources to check out

• IRS revenue ruling: Income tax payments and reimbursement: Read the payment and reimbursement analysis with your adviser.
• IRS revenue ruling: Substitution powers: Review the equivalent value and beneficiary safeguards discussed above.
• IRS revenue ruling: Basis at the grantor’s death: Compare the ruling’s limited facts with the trust under review.
• Chief Counsel advice: Adding reimbursement authority: Read the nonprecedential advice concerning a later trust modification.
• Treasury regulation: Grantor trust reporting: Consult the default method and references to alternative reporting rules.
• IRS instructions: Form 709: Check the trust document attachment guidance for the applicable filing year.