An installment sale to an irrevocable grantor trust is a popular estate-planning tool that allows the grantor to freeze the growth of an appreciating asset by selling it to a grantor trust in return for a promissory note. The sale is ignored for federal income tax purposes, because transactions between a grantor and a trust (all of which is deemed owned by the grantor under Subpart E of Subchapter J of the Internal Revenue Code) are not regarded as sales for federal income tax purposes.1 But the transfer is taken into account for estate and gift tax purposes. Therefore, all future appreciation inures to the benefit of the trust and is excluded from the grantor's taxable estate. However, if the trust converts to a non-grantor trust (either because the grantor dies or because the grantor powers terminate for another reason), a host of income tax questions arise if the note is still outstanding.

The first question is whether the grantor realizes gain when the trust converts from grantor to non-grantor while the note is still outstanding. If so, who should recognize the gain — the grantor or his estate — and how should that gain be calculated? Should there be a different treatment for conversions caused by the grantor's death than those caused by other reasons? And if gain is realized, does the note qualify for installment sale reporting under IRC Section 453 and thus constitute income in respect of a decedent (IRD) under IRC Section 691 to the extent of any unrecognized gain? And finally, what are the basis and holding period of the note and the property?

No single authority answers all of these questions. Some commentators have suggested that gain is realized upon termination of grantor trust status equal to the excess of the note balance over the grantor's basis in the property on the termination date.2 Consequently, they advise paying off the note before the grantor dies to avoid gain recognition. Others maintain that there should be no gain realized or recognized upon the conversion of a grantor trust to a non-grantor trust when the grantor dies — primarily because transfers at death are generally not income tax events.3 While they concede that the Internal Revenue Service and the courts have taxed terminations of grantor trust status caused by reasons other than death, they maintain that terminations on account of the grantor's death should be exempt from gain as testamentary transfers.4

In 2009, the IRS inched closer to definitive answers with two new Chief Counsel Advice opinions.

In my opinion, the available authorities now strongly suggest that the death of the grantor of an irrevocable grantor trust with an outstanding note balance is a “part sale-part gift” occurring on the last day of the grantor's taxable year. The grantor realizes gain equal to the excess of the note balance over his basis in the property. That gain constitutes IRD, which the grantor's estate or successors recognize when they collect the note payments. And the trust's basis in the property is the greater of the note balance or the grantor's basis in the property on the date of death.

Here's how I arrive at these conclusions.

Gain Is Realized

The IRS and the courts consistently maintain that a termination of grantor trust powers is a transfer of property from the grantor to the trust that is taxable to the grantor to the extent that the amount realized exceeds the grantor's basis in the property.5 The amount realized includes money plus the fair market value (FMV) of other property received.6

In Example 5 of Treasury Regulations Section 1.1001-2(c) and Revenue Ruling 77-402, the grantor renounced his retained powers over a trust that owned a partnership interest. These authorities hold that, as a result and “at that time,” the trust ceased to be a grantor trust and the grantor ceased to be considered the owner of the partnership interest. On the transfer, the grantor was relieved of his share of partnership liabilities. This debt relief was treated as money received in the transfer causing the grantor to recognize gain to the extent the money exceeded his basis in the partnership. Rev. Rul. 77-402 holds that “the result would be the same if the trust ceases to be a grantor trust by reason of the expiration or lapse of the powers.”

In other words, the ruling is not limited to terminations by renunciation, but also applies to any expiration or lapse of grantor powers, including those occurring because the grantor dies.

Similarly, a gift in trust conditioned upon the donee paying the donor's gift tax liability is a taxable transfer to the trust in return for consideration equal to the gift taxes paid by the donee. In Diedrich v. Commissioner, the U.S. Supreme Court held that a donor can realize income in a variety of ways, including relief from his obligation to pay gift taxes.7 To the extent that the gift taxes paid by the donee exceed the donor's basis in the property transferred to trust, the high court found that the donor received an “immediate economic benefit,” which was taxable to the extent it exceeded his basis in the gifted property. The amount of the gift was the excess of the property's FMV over the gift tax liability assumed by the donee. Such transactions are referred to as a “part sale-part gift” and are taxed in the same manner whether made in, or outside of a trust when the donor receives an economic benefit in connection with a gift.8

Although the economic benefit realized in these authorities involves reduction of the grantor's debt to third parties, these holdings are equally applicable to economic benefit realized in any form, including a note payable to a grantor.9 If we extend these holdings to the termination of grantor trust status at death with an outstanding installment note due the grantor, the grantor is treated as having transferred property to the trust in exchange for an economic benefit equal to the note balance on the date of death. The grantor realizes gain to the extent that the note balance exceeds the basis in the property.

Let's look at an example: Joe sold Blackacre on an installment basis to an irrevocable grantor trust, for $60,000. Joe died when the note balance was $30,000 and the basis of Blackacre was $20,000. On Joe's death, his grantor powers terminate and he is treated as having sold Blackacre to the trust for the note balance on his date of death. He realizes a $10,000 gain equal to the excess of the $30,000 note balance over the $20,000 basis in the property.10 (See “When a Grantor Trust Converts,” p. 21.)

The transfer for income tax purposes occurs the moment Joe's grantor powers terminate, which is the moment of his death, at which time he and the trust become separate taxable entities.11 Because the transfer occurs on Joe's date of death, it occurs during his lifetime because transactions occurring on the date of a taxpayer's death are included in his final tax year.12 It does not matter for federal income tax purposes whether the deemed transfer occurs the moment before or the moment after death as long as it occurs on the same day. In either case, it occurs during his lifetime.13 As such, the authorities addressing the grantor's tax consequences on renunciation of grantor trust status during the grantor's lifetime apply with equal force to terminations of grantor trust status caused by death.14 However, when the amount realized includes an installment note rather than immediate debt relief, the gain may be deferred under IRC Section 453.

Other Measures of the Gain

Until the IRS publishes guidance directly on point, it is tempting to think of other possible ways to measure and report the grantor's gain on termination of grantor trust status with an outstanding installment note. For example, we might measure the gain on a “catch up” basis by recognizing the cumulative gain that would have been recognized by the conversion date if the transaction had been regarded as a sale for income tax purposes when the sale occurred under state law. Thus, if half the proceeds had been collected by the conversion date, we might recognize half the original gain on the conversion date and the rest of the gain as the note payments are collected. Or, we simply might ignore the catch up and report only the remaining deferred gain prospectively.

Alternatively, we might calculate the gain under the “open transaction doctrine,” recovering the grantor's original property basis before any taxable gain is recognized. Thus, if the grantor's original basis was $20,000 and he had collected $30,000 by the time of the conversion, the grantor would recognize $10,000 of gain on the conversion date and all proceeds thereafter would be fully taxable. But the open transaction doctrine, first articulated by the Supreme Court in Burnet v. Logan, is used only in “rare and extraordinary cases,” when neither the property sold nor the consideration to be received can be valued on the date of sale.15 It has also been applied when it is impractical or impossible to value a component of a larger whole and when the part sold was inseparable or indivisible from the part retained when it was first acquired.16

The problem with the open transaction and installment sale “catch up” approaches is that they measure the gain by reference to the original sale proceeds and basis prior to the time that the transaction is regarded as a sale for income tax purposes. Rev. Rul. 85-13 makes it clear that a transfer between the grantor and a grantor trust “is not recognized as a sale for federal income tax purposes because A is both the maker and the owner of the promissory note.” “Recognized” here means regarded as a sale rather than recognized in the sense of reporting. Because the ruling does not regard transfers between a grantor and a grantor trust as a sale, it seems inappropriate to use any method to realize or recognize gain by reference to proceeds or basis before the transfer is regarded as a sale.

Finally, we might use an apportionment method, borrowed from bargain sales to charity. This method apportions the basis of the property between the sale and the gift in the same ratio that the consideration bears to the property's FMV at the time of the transfer.17 For example, if the note balance is equal to one-half of the property's market value on termination of grantor trust status, the grantor would be deemed to have sold one-half of the property for the note balance and made a gift of the other half. But the “bargain sale to charity” regulations prohibit the apportionment method if the bargain element is not allowed as a deduction under Section 170. Instead, they prescribe the part sale-part gift method in Treas. Regs. Section 1.1001-1(e); that is to say, the gain is equal to the consideration received less the adjusted basis of the entire property.18 This part sale-part gift method is the same method prescribed in Example 5 of Treas. Regs. Section 1.1001-2(c) and Rev. Rul. 77-402.

Therefore, it appears that the most appropriate method for measuring the grantor's gain on termination of his grantor trust powers, by death or otherwise, is the part sale-part gift approach prescribed in the regulations under Section 1001 and Rev. Rul. 77-402. This is also generally the most favorable to the grantor. (See “How To Calculate Grantor's Gain,” this page.)

“No Gain at Death”

It has been suggested that there is a general “no-gain-at-death” rule for termination of grantor trust status and that the authorities taxing lifetime terminations are merely carving out an exception to prevent abuses during lifetime that would not occur at death.19 For example, without a gain recognition rule, a grantor could borrow against an appreciated asset, transfer it to a grantor trust subject to the debt, renounce his grantor powers, and essentially convert the asset to cash without recognizing income or gift taxes.

But it is incorrect to say that this opportunity is not present for death-time planning. An individual wanting to convert an asset to cash before he died could accomplish the same result by going through the exercise just described yet maintain his grantor powers until death, if there were no gain at death. None of the authorities addressing the taxation of terminated grantor trusts suggests that they are limited to lifetime terminations.20 In fact, Rev. Rul. 77-402 expressly holds that “the result would be the same if the trust ceases to be a grantor trust by reason of the expiration or lapse of the powers.” Given that death is a reason that grantor powers expire, death is a taxable event under Rev. Rul. 77-402 to the extent the consideration exceeds the grantor's basis in the property.

It also has been argued that termination of grantor trust status with an outstanding note should be treated as a testamentary transfer of encumbered property to the trust, which would not be taxable under the holding of Crane v. Comm'r.21 The issue before the Crane court was the amount of income that the beneficiary should recognize when she inherited property subject to a nonrecourse mortgage and subsequently sold it, still subject to the mortgage. In determining her gain, the court found that the mortgage was properly included in both her basis on acquisition and in the amount she realized on sale. The court did not discuss whether the bequest was a taxable sale by the estate to the beneficiary for the amount of the debt or a nontaxable inheritance. Nor was it relevant to the holding.22 Thus, the issue was not whether a taxable transaction had taken place at death, but rather the amount of income the taxpayer realized as a result of a concededly taxable transaction involving nonrecourse liabilities.

Relying on Crane for a general no-gain-at-death rule seems misplaced.

More importantly, Crane involved a testamentary transfer rather than a deemed transfer for income tax purposes. While it may be tempting to think of a deemed transfer for income tax purposes on the death of the grantor as a testamentary transfer, no authority holds such. Indeed, the IRS recently confirmed that a deemed transfer on termination of a grantor trust at the grantor's death is not a testamentary transfer under IRC Section 1014.23

Nonetheless, in likening a deemed transfer for income tax purposes to a testamentary bequest, it has been suggested that the initial sale to the grantor trust can be considered an incomplete transfer that becomes testamentary when the decedent dies. This idea is derived from the Tax Court's analysis in DiMarco v. Comm'r, which found that an incomplete gift for gift tax purposes becomes a testamentary transfer on the donor's death rather than a completed gift.24 But applying DiMarco to argue that a completed transfer at the time of sale becomes a testamentary transfer because it was not regarded as a sale for income tax purposes before death seems to confuse the issues of completion and income taxation.

Whether a transfer is regarded as a sale for income tax purposes is not relevant in determining whether the transfer is complete for estate and gift tax purposes. The clear language of the statute and the regulations require that transferred property be recognized for estate and gift tax purposes at the time the transferor relinquishes dominion and control over the transferred property.25 Nothing in the statute or the regulations suggests that a completed transfer of property to an irrevocable trust during lifetime becomes testamentary simply because it is not regarded as a sale for income tax purposes until the grantor powers terminate at death.

While death does not generally trigger an immediate income tax result, it does not escape income taxation altogether when assets represent IRD under IRC Section 691. For example, when the owner of an installment sale obligation dies, the transfer of the note to his estate is not an immediately taxable disposition.26 Rather, the gain is deferred and reported by the estate or successors as the note payments are collected.27 But if the note has a self-cancelling feature, commonly known as a SCIN, and the obligor is related to the decedent, the estate is deemed to have collected the face value of the note and reports the full amount of the deferred gain at once.28

There are also other instances in which death causes immediate taxation, negating the idea of a general no-gain-at-death rule. For example, a Roth IRA owner, who elected to defer income from the Roth conversion but dies before the end of the deferral period, must include the remaining conversion income on his final income tax return.29 Death is also an immediate income tax event under IRC Section 684 for a U.S. grantor of a foreign irrevocable grantor trust. The regulations state that upon death, the grantor is deemed to have sold his assets to the trust “immediately before (but on the same date that) the trust is no longer treated as owned by that U.S. person.”30 The sale “immediately before death” acknowledges that the grantor does not legally own the assets in the trust on his date of death, which would be the same situation with a domestic irrevocable grantor trust. But the sale “on the same date” as death requires the grantor to report the gain on his final income tax return.31 Thus, the timing of income recognition under IRC Section 684 is identical to that under Treas. Regs. Section 1.1001-2(c), Example 5 and Rev. Rul. 77-402, which hold that the sale occurs “at the time” the grantor's powers terminate, and hence should be reported on the grantor's final income tax return. But the gain may be deferred if the amount realized is an installment note.

Non-Grantor to Grantor Trust

An equally interesting question is the tax treatment of the reverse situation when a non-grantor trust converts to a grantor trust.

This was the subject of CCA 200923024, in which the grantors contributed appreciated stock to a family partnership, then sold their partnership interests to several non-grantor trusts in exchange for unsecured private annuities payable by the trusts.32 The trusts' basis in the partnership interests was equal to their purchase price. The partnership made a Section 754 election to increase the inside basis of the stock to the outside basis of the partnership interest. Shortly afterward, the partnership sold the stock for an amount roughly equal to its basis and recognized little or no gain because of the Section 754 election. The grantors recognized gain on two years of annuity payments they received until the trusts became grantor trusts due to a change of trustees.33 But after the trusts became grantor trusts, the grantors were no longer required to recognize any gain because, as owners of the grantor trusts, they were both payors and payees of the annuities. Consequently, the grantors successfully escaped recognizing most of the gain on the sale of the stock.

Even though the IRS found the transaction potentially abusive, it determined that none of the existing authorities were sufficient to immediately tax either the grantor or the trust on the conversion.34

First, the CCA notes that the authorities only discuss the gain or loss to the grantor, who is deemed to have transferred assets to the trust. But the authorities are silent on the income tax consequences to the transferee of the assets, which in the CCA was the grantor.

Second, the Service noted 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.”

At first, it seems odd that the CCA mentions death because the taxpayer was not dead. But it may have anticipated the application of these authorities on the grantor's ultimate death. Yet even death would not have produced the immediate tax results the IRS was looking for in the CCA, because the annuity payments ceased at the grantor's death, providing no consideration in the transfer.

Finally, the IRS considered treating the grantor as having indirectly borrowed the trust corpus at the time he sold the partnership interest to the trust for the annuity under Rev. Rul. 85-13. This approach would have ignored the trust as a separate taxpayer and thus its purchase of partnership interests, vitiating the Section 754 election. The result is that the grantor would have been taxed as the partner when the partnership sold the stock without the benefit of the Section 754 election. But the facts of the CCA were substantially dissimilar to those in Rev. Rul. 85-13, in which the grantor was buying property for a note rather than selling property for an annuity. In addition, Rev. Rul. 69-74 provides that an exchange of appreciated property for a private annuity is a sale rather than a borrowing that would cause grantor trust status.35 Thus, the CCA ultimately concluded that it could not “take the position that the mere conversion of a nongrantor trust to a grantor trust results in taxable income to the grantor.”

The CCA should have mentioned the basis in the partnership interest upon conversion, but did not. This omission may have been because it would have produced no immediate income tax consequences to either the grantor or the trust. Moreover, the IRS previously has stated its position on the basis of trust property returned to the grantor. Rev. Rul. 72-406 provides that the basis is equal to the grantor's basis in the property at the time the grantor transferred it to the trust, adjusted for the period during which the non-grantor trust held the property.36 Although Rev. Rul. 72-406 did not address basis adjustments attributable to sales between the grantor and the trust, we still can apply its holding to the facts in the CCA. Doing so, we find that the basis in the partnership interest should be the original basis of the stock transferred to the partnership on formation, adjusted for partnership income and losses during the period the non-grantor trust owned it, and increased for the principal portion of the two annuity payments the trust made before conversion. But it should not be increased for any deferred installment gain that the grantor has not recognized. The deferred gain, like receivables and payables between the grantor and the trust, is an inter-entity account that represents the deferred portion of a transaction between the grantor and the trust that is disregarded once the entities become the same taxpayer.

Thus, even though the grantor in the CCA successfully avoided recognizing any current gain on the sale of his stock, he merely postponed its recognition because the basis in the partnership interest is substantially reduced after the conversion to a grantor trust. This reduced basis will have tax consequences to the grantor, who is now treated as the partner, if the partnership makes cash distributions in excess of its basis under Section 731(a) or dissolves and sells its assets, or if the trust disposes of its partnership interest. Moreover, the grantor cannot avoid these income tax consequences by waiting until he dies. Because he does not own the partnership interest for estate and gift tax purposes, he may not adjust its basis under Section 1014(b).

The CCA might have reached a different conclusion if the assets in the trust on the conversion date had been cash instead of partnership interests. For example, if the trusts had sold the partnership interests for cash prior to the conversion, there would be no property basis to reduce on conversion. In that case, the IRS may have taxed the grantor on the excess of the cash received in the deemed transfer over his basis in the annuity. Notice that CCA 200923024 did not rule out taxing the conversion of a non-grantor trust to a grantor trust in all circumstances. It simply declined to hold that “the mere conversion of a nongrantor trust to a grantor trust results in taxable income to the grantor,” which is generally correct.37 But the CCA did not close the door to finding a taxable event in the right circumstances.

Keep in mind that although CCAs are written opinions from the Office of Chief Counsel to IRS field personnel, they cannot be used or cited as precedent.38 Nonetheless, as Conference Report No. 105-599 observed, they are the “considered view of the Chief Counsel's national office on significant tax issues” and provide valuable insight into the IRS' thinking and litigation posture.39 Thus, we should be mindful that the IRS viewed the transaction in CCA 200923024 as abusive. Even though it could find no authority that immediately would tax the grantor or the trust on the transfer of assets in the conversion, the CCA concluded that doing so “would have an impact on non-abusive situations.” Therefore, it declined to apply the step transaction or the economic substance doctrine. But it promised to “explore with you further case development that may lead to other arguments to challenge the transaction.”

Installment Sales and IRD

Termination of grantor trust status caused by the death of the grantor raises the question of who should report the installment gain: the decedent on his final income tax return or the estate (or successors). The answer depends on whether the deemed transfer qualifies as an “installment sale” eligible for deferred gain reporting.

If it does not qualify as an installment sale, the decedent should recognize the gain on his final income tax return, because the deemed transfer occurs on the date of death and income received on the date of death is taxable on the decedent's final income tax return.40

On the other hand, if the deemed transfer qualifies as an installment sale, gain is not recognized on the transmission of the obligation at death.41 Instead, the estate or successor recognizes the deferred gain as IRD as payments are received.42

IRC Section 453(b)(1) defines an installment sale as a “disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs.” The deemed transfer to the trust on the grantor's date of death should meet the definition of an installment sale because his taxable year closes on his date of death. So all note payments are necessarily, as Treas. Regs. Section 1.451-1(b)(1) puts it “received after the close of the taxable year in which the disposition occurs.”43 Installment sale reporting is the default treatment for deferred payment sales unless the taxpayer elects out.44 Moreover, Section 1001(d) provides that “nothing in this section shall be construed to prevent (in the case of property sold under contract providing for payment in installments) the taxation of that portion of an installment payment representing gain or profit in the year in which such payment is received.” Accordingly, the IRS permits installment sale reporting in numerous partial non-recognition transactions, such as bargain sales to charity, tax-free exchanges with boot, and partially taxable transfers in exchange for stock under Section 351.45 Therefore, the note should qualify for installment sale reporting.

If the sale qualifies as an installment sale, then the excess of the face amount of the note over the basis is considered IRD.46

Arguments that the grantor's installment note does not produce IRD rely on Treas. Regs. Section 1.691(a)-2(b), Example 4, which involves an agreement between the decedent and a corporation that upon the decedent's death his executor would sell stock owned by him to the company at the book value on his date of death. Example 4 states: “A, prior to his death, acquired 10,000 shares of the capital stock of the X Corporation at a cost of $100 per share. During his lifetime, A had entered into an agreement with X Corporation whereby X Corporation agreed to purchase and the decedent agreed that his executor would sell the 10,000 shares of X Corporation stock owned by him at the book value of the stock at the date of A's death. Upon A's death, the shares are sold by A's executor for $500 a share pursuant to the agreement. Since the sale of stock is consummated after A's death, there is no income in respect of a decedent with respect to the appreciation in value of A's stock to the date of his death. If, in this example, A had in fact sold the stock during his lifetime but payment had not been received before his death, any gain on the sale would constitute income in respect of a decedent when the proceeds were received.”

The example involves a typical date of death buy-sell agreement between a decedent and his corporation, which by its terms, is effective only upon the decedent's death. It illustrates one of the requirements for determining whether the decedent possessed the requisite right to the sale proceeds if he had lived and thus constitute IRD.47 The decedent in Example 4 could not have received the sale proceeds if he had lived, because his death was a precondition of the sale, which was consummated after his death. Consequently, the proceeds in Example 4 do not constitute IRD.

Contrast an installment note owned by the decedent attributable to a sale consummated for income tax purposes on his date of death. Therefore, Example 4 does not compel the conclusion that the grantor's installment note is not IRD.

Basis in the Note and Property

The decedent's promissory note should be entitled to an adjusted basis under Section 1014(a), because it is owned by the decedent and included in the value of his gross estate.48 But, to the extent that part of the note constitutes IRD, the note is not entitled to a step up in basis.49 Any gain on the deemed transfer to the trust that is not required to be recognized on the decedent's final income tax return under his method of accounting would constitute IRD.50 Therefore, the note's basis depends on whether the deemed transfer of property to the trust on death in exchange for the note qualifies as an installment sale.

If the sale does not qualify as an installment sale, the decedent reports the full amount of the gain on his final income tax return and the gain increases the basis of the note to its fair market value. In that case there is no IRD because all the deferred gain has been reported. But as discussed above, the sale should qualify as an installment sale. Thus the basis of the note is not increased under Section 1014 to the extent of any deferred gain, which constitutes IRD, and the estate or successor reports the remaining deferred gain as payments are collected.51

Scholars also have debated how to determine the basis of property transferred to an irrevocable grantor trust upon the grantor's death. Some believe that a good argument can be made that the trust property receives an adjusted basis under Section 1014 at the grantor's death for a variety of reasons.52

I agree with those who conclude that Section 1014 does not apply — because the trust property is not acquired from the decedent under state law, the decedent did not reserve the right to alter, amend, terminate or revoke the trust, and the property is not included in the decedent's gross estate, which are the only enumerated circumstances in Section 1014(b) that could apply in this case to adjust the basis on death.53

Section 1014(b) describes 10 circumstances under which property is considered to have been acquired or passed from a decedent, thus afforded a basis equal to FMV on the decedent's death under Section 1014(a). These circumstances, as stated in Collins v. United States, “mark the limits of property acquired or passing from a decedent as those terms are used in subsection (a).”54 Property must meet the definition of at least one of these?categories before it can be considered as passing to or acquired from a decedent and thus be eligible for a stepped-up basis under subsection (a).55

The IRS recently analyzed these 10 circumstances in CCA 200937028 as they apply to property owned by an irrevocable grantor trust on the grantor's death and concluded that none of them apply.

First, the CCA determined that Section 1014(b)(1) does not apply because the assets are not passing from the decedent, but rather from an irrevocable trust to which the decedent transferred the assets during his lifetime.56 Second, it noted that only two provisions in Section 1014(b) apply to property owned by a trust, and they require the decedent grantor to have reserved the right to alter, amend, terminate or revoke the trust.57 An irrevocable grantor trust would fail this test as well. And finally, Section 1014(b)(9) does not apply because the property is not included in the decedent's gross estate. Estate tax inclusion is the quid pro quo for a basis adjustment under Section 1014. The statute affords relief from double taxation on the sale of appreciated assets that are also included in the gross estate, which is not available for assets that are not included in the gross estate, as explained by CCA 200937028. (See “No Stepped Up Basis, ” p. 25.)

Proponents who apply Section 1014 to property owned by an irrevocable grantor trust advance three primary arguments. First, they believe that because the assets are regarded as owned by the grantor for income tax purposes, they also should be regarded as passing from the decedent under Section 1014(b)(1). However, that argument invalidly expands the scope of Section 671 beyond its plain reading. Section 671 expressly provides that when the grantor is the deemed owner of the trust property under Subpart E of Subchapter J, the income, deductions and credits attributable to the trust property are taxed to the grantor in the same manner as if he owned them. Section 671 does not make the grantor the owner for estate and gift tax purposes, or any other purpose.

Moreover, Treas. Regs. Section 1.1014-2(a)(1) provides that to meet the requirements of Section 1014(b)(1), property must be “acquired by bequest, devise, or inheritance, or by the decedent's estate from the decedent, whether the property was acquired under the decedent's will or under the law governing the descent and distribution of the property of decedents.” This regulation appears to require a transfer under the grantor's will or state law, not merely a deemed transfer for federal income tax purposes.

A second argument advanced for allowing a Section 1014 basis adjustment for property owned by an irrevocable grantor trust is that Section 1014(b) has not been amended since Rev. Rul. 85-13 was issued and so Congress could not have considered how Section 1014(b)(1) would apply to the assets in such a trust on the grantor's death.

This argument is not persuasive. Rev. Rul. 85-13 merely clarified that Section 671 applies to all income tax transactions of the grantor trust, including sales between the grantor and the trust. Section 671 has not been amended since 1954 when it was codified along with Section 1014 in the IRC of 1954. Congress has had ample time to consider whether to allow a basis adjustment for property owned by an irrevocable grantor trust and chose to allow basis adjustments only when the grantor reserved the right to alter, amend, revoke or terminate the trust under Sections 1014(b)(2) and (3).

The third argument for allowing a Section 1014 adjustment for grantor trust property owned on the grantor's death is a policy one. That is, because a grantor can easily achieve a stepped up basis in the trust property by repurchasing it from the trust shortly before his death, it would be unfair to allow him this advantage over grantors who were unaware of this opportunity. Under this strategy, the grantor purchases the trust property back from the trust shortly before death. The purchase is ignored for federal income tax purposes under Rev. Rul. 85-13 because the grantor is the owner of the trust. When the grantor dies, the property is included in his taxable estate because he owns it for state law purposes and thus it acquires an adjusted basis under Section 1014(b)(1).

While this strategy may accomplish the desired basis step up for the grantor, it produces an immediate taxable gain for the trust. Here's why. On the grantor's death and termination of trust powers, the grantor and the trust become separate taxable entities for income tax purposes.58 At that time, the grantor is deemed to transfer cash to the trust in return for property and the trust is deemed to transfer property to the grantor in return for cash. The grantor has no income tax consequences because he has simply purchased property.

But the trust has exchanged its property for cash from the grantor, now a separate legal entity. This exchange results in immediate gain recognition to the trust equal to the difference between the cash received and the basis of the property transferred.59 The basis in the property is the grantor's basis before death because the grantor and the trust were one and the same before that time. Assuming the property has a basis less than the cash received, the sale will result in a gain to the trust. If the result were otherwise, a taxpayer could sell his entire estate to an irrevocable grantor trust, shift all future appreciation to it, borrow money to purchase it back again shortly before death, obtain a full step up in basis in the property, and accomplish all of these maneuvers with no income, estate or gift tax to either the grantor or the trust. Allowing such tactics would seem to undermine the entire income, estate and gift tax regime.

It might be tempting to view the deemed transfer of cash to the trust on the date of death as if it occurred for income tax purposes immediately before the grantor's death. After all, this view tracks the state law ownership of the assets on the date of death. Also, it would disregard the sale for income tax purposes under Rev. Rul. 85-13.

But this position is contrary to the authorities, which consistently hold that the grantor and the trust are treated as separate taxpayers at the time the grantor trust powers terminate.60 As such, a taxable exchange occurs on the termination date whereby the trust has sold property to the grantor for cash and realizes gain under Section 1001 as a separate taxpayer.

Finding nothing in Section 1014(b) that would allow a basis adjustment for property owned by an irrevocable grantor trust on the grantor's death, we turn to Section 1015(b), which governs the basis of property transferred to a trust other than by a gift, bequest or devise. Section 1015(b) provides that the basis to the trust is the “same as it would be in the hands of the grantor, increased in the amount of gain or decreased in the amount of loss recognized to the grantor on such transfer.” The regulations paraphrase the statute a little differently and provide that the transferee's basis is the greater of the amount paid or the transferor's adjusted basis in the property at the time of the transfer.61 These two methods of calculating basis in the IRC and regulations — (1) grantor's basis increased or decreased by the grantor's gain or loss; and (2) greater of the amount paid or the grantor's basis — produce identical results as far as the amount of the transferee trust's basis is concerned. But they affect the holding period differently.

Holding Period

The holding period of property generally includes the holding period of the transferor under a “tacking rule” if the transferee's basis is determined “in whole or in part” by reference to the transferor's basis.62 Section 1015(b) would allow the trust to tack the grantor's holding period in a part sale-part gift because it provides that the trust's basis is the same as it would be in the hands of the grantor plus or minus the grantor's gain or loss recognized on the transfer. However, the regulations under Section 1015(b) would not allow tacking when the trust's basis is determined by the amount paid — because it is greater than the grantor's basis. The U.S. Court of Appeals for the Fifth Circuit in Citizen's National Bank of Waco v. U.S., addressing this discrepancy between the IRC and the regulations, held that tacking should be allowed under the statute in a part sale-part gift because the basis of property acquired by the trust was at least in part determined by reference to the grantor's basis.63 The court found that insofar as the regulations would prevent tacking, they were invalid as “an inconsistent and unreasonable interpretation of the code.”64

The Service disagrees with the holding in Citizen's National Bank and continues to maintain that Treas. Regs. Section 1.1015-4 is valid and that a trust may not tack the grantor's holding period in a part sale-part gift where its basis is determined by the amount paid rather than the grantor's basis.65

This issue is still unresolved.

Putting it All Together

So, here's how I see the income tax consequences to the grantor and the trust on death of the grantor of an irrevocable grantor trust with an outstanding installment note playing out in our example:

Let's say that Joe sold Blackacre on the installment basis to the Brown Family Trust, an irrevocable grantor trust, for $60,000. The sale is ignored for federal income tax purposes. Joe died when the note balance was $30,000 and the basis of Blackacre was $20,000. Therefore, there is a $10,000 gain on the transfer equal to the excess of the consideration ($30,000) over the basis of the property ($20,000).66 The gain is IRD, which Joe's estate or successor reports as income over the remaining term of the note. The trust's basis in Blackacre is $30,000, the greater of the $30,000 paid or Joe's $20,000 basis. The Service will assert that the holding period for Blackacre begins on Joe's death because its basis was not determined by reference to Joe's basis. The estate's basis in the note is $20,000, its market value of $30,000 less IRD of $10,000.

This outcome is both logical and supported by authority. Any gain required to be recognized by the grantor's estate or successors increases the trust's basis in the property. To the extent the note is fully paid, no gain is realized by the grantor and no basis step up is obtained by the trust. But in no event do the authorities support a full basis step up in the property and no gain is realized or recognized by the grantor. (See “The Tax Effects,” p. 26.)

Perhaps the IRS will someday clarify in a single authoritative pronouncement the income tax treatment of an installment sale to an irrevocable grantor trust when the grantor dies before the note is paid. It seems that the Service could do so simply by patching together the existing authorities. Until then, we're left to do that for ourselves. And together they paint a fairly clear picture.

Endnotes

  1. Internal Revenue Code Section 671; Treasury Regulations Section 1.671-2(a); Revenue Ruling 85-13, 1985-1 CB 184.

  2. Deborah V. Dunn and David A. Handler, “Tax Consequences of Outstanding Trust Liabilities When Grantor Status Terminates,” J. Tax'n (July 2001), at p. 49.

  3. 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,” J. Tax'n (September 2002).

  4. Ibid.

  5. Treas. Regs. Section 1.1001-2(c), Example 5 (grantor recognized gain upon termination of grantor trust status equal to the excess of his relief from partnership debt over the basis in his partnership interest.); Madorin v. Commissioner, 84 T.C. 667 (1985) (upholds Example 5 in Treas. Regs. Section 1.1001-2(c) on similar facts when the grantor realized gain from debt relief on disposition of trust assets at moment when grantor trust status ceased and trusts became separate taxable entities); Rev. Rul. 77-402, 1977-2 C.B. 222 (grantor recognized gain on cessation of grantor trust status as a taxable disposition of partnership interest measured by the difference between the basis in the partnership and his share of the partnership liabilities); Technical Advice Memoranda 200011005 (debt incurred by grantor trust which was secured by property of trust is included in founder's amount realized when trust terminates and assets and liabilities of trust are transferred to remainder trusts); General Counsel Memoranda 37228 (grantor must recognize gain when the trust ceases to be a grantor trust and becomes the owner of grantor's assets subject to liabilities).

  6. IRC Section 1001(b).

  7. Diedrich v. Comm'r, 457 U.S. 191 (1982) (grantor was taxable to the extent the donee paid the donor's gift tax liability in a net gift arrangement.); see also Private Letter Ruling 7752001 (gift conditioned on the payment of the donor's gift taxes by the donee is a part sale-part gift in which the donor's basis is determined under Treas. Regs. Section 1.1015-4).

  8. Ibid; see also Treas. Regs. Section 1.1001-1(e), Ex. 1 (income recognized by the transferor on sale for less than adequate consideration with the intent to make a gift is a part sale-part gift).

  9. Diedrich, supra note 7 at p. 195 (“Gross income” means income derived from whatever source and may be realized by a variety of indirect means, including income from discharge of indebtedness, payment of a donor's gift taxes, payment of an employee's income taxes, etc. The substance rather than the form of the economic benefit controls. The form of the economic benefit is immaterial as long as the taxpayer realizes an economic benefit.)

  10. Treas. Regs. Sections 1.1001-1(e), Ex. 1, 1.1001-2(c), Ex. 5.

  11. Treas. Regs. Section 1.1001-2(c), Ex. 5 (when the grantor (C) renounced his powers, the grantor and the trust (T) became separate taxable entities. “Consequently, at that time, C is considered to have transferred ownership of the interest in P to T, now a separate taxable entity, independent of its grantor.”); see also Rev. Rul. 77-402, supra note 5.

  12. Treas. Regs. Section 1.451-1(b)(1) (a taxpayer's taxable year ends on the date of his death); Treas. Regs. Section 1.443-1(a)(2) (the return of a decedent is a return for the short period beginning with the first day of his last taxable year and ending with the date of his death).

  13. Ibid.

  14. Supra note 5; Rev. Rul. 77-402 (“result would be the same if the trust ceases to be a grantor trust by reason of the expiration or lapse of the powers”).

  15. Burnet v. Logan, 283 U.S. 404 (1931) (stock sold for consideration based on the quantity of ore to be mined could not be valued and payments were therefore taxed as received); see also Rev. Rul. 58-402, 1958-2 C.B. 15 (Service will require valuation of contracts and claims to receive indefinite amounts of income and will apply the open transaction doctrine only in rare and extraordinary cases); Treas. Regs. Section 1.1001-1(a) (only in rare and extraordinary cases will property be considered to have no fair market value (FMV)); Treas. Regs. Section 15A.453-1(d)(2)(iii) (only in rare and extraordinary cases involving sales for a contingent payment obligation when the value of the obligation cannot reasonably be ascertained will the taxpayer be entitled to assert that the transaction is “open.” Transactions will be carefully scrutinized to determine whether a sale in fact has taken place.)

  16. Fisher v. U.S., 82 Fed. Cl. 780 (2008), aff'd per curiam (Fed. Cir. 2009) (demutualization proceeds were applied first to reduce the taxpayer's basis in the insurance contract where it was impossible to determine what portion of the basis represented the right to receive those proceeds).

  17. IRC Section 1011(b); Treas. Regs. Section 1.1011-2(b), (c), Ex. 1.

  18. Treas. Regs. Section 1.1011-2(c), Ex. 3 (donor denied a charitable contribution for the bargain element of a part sale-part gift to a private foundation because he had exceeded his 50 percent contribution base that year. The sale was treated as a part sale-part gift with the donor's gain equal to the excess of the consideration over his adjusted basis in the property as provided in Treas. Regs. Section 1.1001-1(e)); Treas. Regs. Section 1.1011-2(a) and (c) erroneously refer to part sale-part gifts in Treas. Regs. Section 1.1011-1(e) instead of Treas. Regs. Section 1.1001-1(e). The error is obvious because there is no Treas. Regs. Section 1.1011-1(e) and also because of the cross reference in Treas. Regs. Section 1.1001-1(e) back to Treas. Regs. Section 1.1011-2.

  19. Supra note 3.

  20. Supra note 5.

  21. Crane v. Comm'r, 331 U.S. 1 (1947).

  22. The nonrecourse debt was exactly equal to the property's FMV on the date she acquired the property. Therefore, the beneficiary's basis would have been the same whether she acquired the property by inheritance with a basis equal to FMV or by purchase for the amount of the debt.

  23. Chief Counsel Advice 200937028 (Sept. 11, 2009) (property owned by a grantor trust upon conversion to a nongrantor trust on account of the grantor's death does not receive an adjusted basis under Section 1014 because it was not acquired by bequest, devise, or inheritance, or by the decedent's estate from the decedent).

  24. Estate of DiMarco v. Comm'r, 87 T.C. 653, 659, (T.C. 1986), acq. 1990-2 C.B. 1.

  25. Ibid, at pp. 658-661.

  26. IRC Section 453B(c).

  27. IRC Section 691(a)(4).

  28. IRC Sections 691(a)(5), 453B(f); Frane v. Comm'r, 998 F.2d 567 (8th Cir 1993).

  29. IRC Section 408A(d)(3)(E)(ii)(I).

  30. IRC Section 684(b); Treas. Regs. Section 1.684-2(e)(2), Ex. 2.

  31. Treas. Regs. Section 1.451-1(b)(1) (taxpayer's taxable year ends on the date of his death); Treas. Regs. Section 1.443-1(a)(2) (the return of a decedent is a return for the short period beginning with the first day of his last taxable year and ending with the date of his death).

  32. CCA 200923024 (June 5, 2009); see also Rev. Rul. 85-13, 1985-1 C.B. 184 (A non-grantor trust ceased to be a separate taxable entity at the time the grantor became the owner of the trust. As a result, the transfer of trust assets to the grantor was not a sale for federal income tax purposes and the grantor did not acquire a new cost basis in those assets).

  33. The transaction occurred before 2006 and was not affected by Proposed Treasury Regulations Section 1.1001-1(j) and 1.72-6(e), which would change the taxation of private annuities after Oct. 18, 2006 (or after April 18, 2007 for certain annuities issued by individuals).

  34. The CCA cited Treas. Regs. Section 1.1001-2(c), Ex. 5; Madorin v. Comm'r, 84 T.C. 667 (1985); Rev. Rul. 77-402, 1977-2 C.B. 222; and Rev. Rul. 85-13, supra note 32.

  35. Rev. Rul. 69-74, 1969-1 C.B. 43.

  36. Rev. Rul. 72-406, 1972-2 C.B. 462, cited by Rev. Rul. 85-13, 1985 C.B. 184.

  37. Rev. Rul. 85-13, supra note 32.

  38. IRC Section 6110(k)(3) (CCA may not be cited as precedent); IRC Section 6110(i)(1) (Chief Counsel Advice are written instructions or advice, whether taxpayer-specific or not, issued in final form after July 22, 1998 by the National Office of Chief Counsel (OCC) to IRS field components and conveys (1) any legal interpretation of a revenue provision; (2) any IRS or OCC position or policy concerning a revenue provision, or (3) any legal interpretation of state, foreign, or other federal law relating to the assessment or collection of any liability under a revenue provision.)

  39. Conf. Rep. No. 105-599 (P.L. 105-206), pp. 300-301 (CCA opinions are the “considered view of the Chief Counsel's national office on significant tax issues.”)

  40. Treas. Regs. Section 1.451-1(b)(1) (taxpayer's taxable year ends on the date of his death); Treas. Regs. Section 1.443-1(a)(2) (the return of a decedent is a return for the short period beginning with the first day of his last taxable year and ending with the date of his death).

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

  42. IRC Section 691(a)(4) (the excess of the face amount over the basis of an installment obligation on the decedent's date of death shall be considered income in respect of a decedent (IRD)); IRC Section 453B(c) (death is not a disposition of an installment obligation that causes gain or loss to be recognized); Treas. Regs. Section 1.451-1(b)(2) (if the decedent owned an installment obligation the income from which was taxable to him under Section 453, no income is required to be reported in the return of the decedent by reason of the transmission at death of such obligation.)

  43. Treas. Regs. Section 1.451-1(b)(1) supra note 40.

  44. IRC Section 453(d); ibid.

  45. Rev. Rul. 79-326, 1979-2 CB 206 (installment sale reporting permitted on bargain sale to charity); Treas. Regs. Section 1.453-1(f) (installment sale reporting permitted for partial recognition exchanges such as tax-free exchanges under Section 1031, 351, etc); PLR 7933009 (bargain sale to charity with an installment note qualified for installment sale reporting).

  46. IRC Section 691(a)(4); Treas. Regs. Section 1.691(a)-5(a).

  47. Peterson v. Comm'r, 74 T.C. 630, 641 (July 7, 1980) (sets forth four requirements for determining whether the decedent possessed the requisite right to sale proceeds on his date of death and therefore constitute IRD: (1) There was a contract on the date of death; (b) the decedent had performed the preconditions of sale before death; (c) no economically material contingencies might have disrupted the sale; and (d) the decedent himself would have collected the proceeds if he had lived.)

  48. IRC Section 1014(b)(1), (9).

  49. IRC Section 1014(c).

  50. IRC Section 691(a)(4).

  51. IRC Section 453B(b); IRC Section 1014(c).

  52. Supra note 3.

  53. Supra note 2.

  54. Collins v. United States, 318 F. Supp. 382, 385-386 (C.D. Cal. 1970), aff'd 448 F.2d 787 (9th Cir. 1971).

  55. Ibid.

  56. CCA 200937028 (Sept. 11, 2009); IRC Section 1014(b)(1), (9).

  57. IRC Section 1014(b)(2) and (3).

  58. Supra note 5.

  59. The tax consequences to the trust on the grantor's death are identical to those of the transferor in the authorities listed in supra note 5, in which the transferor is deemed to transfer property in exchange for an economic benefit that is taxable to the extent it exceeds the transferor's basis in the property.

  60. Supra note 5.

  61. Treas. Regs. Section 1.1015-4(a)(1).

  62. IRC Section 1223(2) (property takes the transferor's holding period if it has the same basis, in whole or in part, as it had in the hands of the transferor).

  63. Citizens National Bank of Waco Trust v. U.S., 417 F.2d 675 (5th Cir. 1969), aff'g 22 AFTR 2d 5226 (W.D. Tex. 1968) (trusts permitted to tack the settlor's holding period in a part sale-part gift transfer to trust where the trust's basis was determined by the amount paid rather than the grantor's basis because it was at least in part determined by reference to the grantor's basis).

  64. Ibid, at p. 679.

  65. PLR 7752001 (transferee acquires a new holding period where his basis in the property is the amount paid because it is greater than the donor's basis under Treas. Regs. Section 1.1015-4); See also James J. Freeland, Guy B. Maxfield, and Edward E. Sawyer, “Part Gift-Part Sale: An Income Tax Analysis With Policy Considerations,” 47 Tax L. Rev. 407 (Winter 1992).

  66. Supra note 10.

Carol A. Cantrell is a shareholder in the Bellaire, Texas-based CPA firm of Briggs & Veselka Co. and co-author of the Fiduciary Accounting Answer Book (CCH)

When a Grantor Trust Converts

The grantor realizes gain when his grantor trust becomes a non-grantor trust because the grantor died

Assumptions:

Original sale price = $60,000

Constant property basis = $20,000

Outstanding note balance on date grantor trust status terminates = $30,000

Grantor Transfer on Death Estate Non-grantor Trust
Property $20,000 $10,000 $30,000
Note receivable 30,000 $30,000
Note payable (30,000) (30,000)
Deferred gain (10,000) (10,000)
Total $20,000 -0- $20,000 -0-

Carol A. Cantrell

How To Calculate Grantor's Gain

Of the possible measuring methods, the “part sale-part gift” approach not only is supported by the authorities, but it's also the most favorable to the taxpayer

Assumptions:

Original sale price = $60,000

Constant property basis = $20,000

Outstanding note balance on date grantor trust status terminates = $30,000

Grantor's Basis Amount Realized Gain Realized
Installment sale with catch up $20,000 $60,000 $40,000
Installment sale with no catch up 20,000 60,000 20,000
Open transaction 20,000 60,000 40,000
Apportionment 20,000 30,000 20,000
Part sale-part gift $20,000 $30,000 $10,000

Carol A. Cantrell

No Stepped Up Basis

A recent CCA found that IRC Section 1014 does not apply to adjust the basis of property owned by an irrevocable grantor trust on the grantor's death

Chief Counsel Advice 200937028 stated: “We strongly disagree with [the] taxpayer's contention [that property owned by an irrevocable grantor trust would be subject to a Section 1014 basis adjustment on the grantor's death]. In this case, the taxpayer transferred assets into a trust and reserved the power to substitute assets.

“Section 1014(b)(1)-(10) describes the circumstances under which property is treated as having been acquired from the decedent for purposes of the Section 1014 step-up basis rule. Since the decedent transferred the property into trust, section 1014(b)(1) does not apply. Sections 1014(b)(2) and (b)(3) apply to transfers in trust, but do not apply here, because the decedent did not reserve the right to revoke or amend the trust. None of the other provisions appear to apply at all in this case.

“Quoting from section 1.1014-1(a) of the Regulations: ‘The purpose of section 1014 is, in general, to provide a basis for property acquired from a decedent which is equal to the value placed upon such property for purposes of the Federal estate tax. Accordingly, the general rule is that the basis of property acquired from a decedent is the fair market value of such property at the date of the decedent's death …. Property acquired from the decedent includes, principally, … property required to be included in determining the value of the decedent's gross estate under any provision of the [Internal Revenue Code.]’

“Based on my reading of the statute and the regulations, it would seem that the general rule is that property transferred prior to death, even to a grantor trust, would not be subject to section 1014, unless the property is included in the gross estate for federal estate tax purposes as per section 1014(b)(9).”
Carol A. Cantrell

The Tax Effects

What happens when a grantor dies before a note is paid? When it's half-paid? Or when it's paid in full?

Assumptions:

Original sale price = $60,000

Constant property basis = $20,000

Outstanding note balance on date grantor trust status terminates = $30,000

Note Status (a) Note Balance at Death (b) Grantor's Basis in the Property (a) minus (b) Gain Realized at Death Whichever is greater, (a) or (b) Trust's Basis in Property After Death
None paid $60,000 $20,000 $40,000 $60,000
Half paid 30,000 20,000 10,000 30,000
Fully paid -0- $20,000 -0- $20,000

Carol A. Cantrell