During the life of a trust, its tax status may change from grantor to non-grantor, or vice versa. This may be deliberate (a powerholder relinquishes a power that caused the trust to be a grantor trust), unintentional (a change in trustee) or even unnoticed (a beneficiary attains a certain age). Of course, a trust also will lose grantor status due to the death of the grantor, but that is not our focus here.
Whatever the cause of the change in grantor status, there may be unexpected income tax consequences because of that change.
On some issues, there is guidance on how to deal with the change. A number of sources describe the effect of a trust that is partially grantor; either by a percentage, by passage of time,1 or by rights to a specific portion of the trust.2 One point that is clear is that a trust files only one tax return, even if it has grantor and non-grantor portions, and even if those portions change within the taxable year.3 But these regulations do not provide specific guidance on how to allocate income and deductions between the grantor and non-grantor portions of the year.
Common sense would say that if the trust is on the cash method of accounting, income tied to a specific event (capital transaction) or date (dividends received) would be specifically allocated to the grantor or non-grantor period in which the income recognition event occurred. The same would apply for any deductions. Income (and expense) that accrues over time such as original issue discount income logically would be allocated between the grantor and non-grantor portions based on the number of days in each status.
What may not be so obvious is the treatment of income from entities.
Internal Revenue Code Section 706(a) requires that partnership income, loss or credits be included in the taxable income of the partner for “any taxable year of the partnership ending within or with the taxable year of the partner.” So, if the partnership year ends December 31, and the trust becomes non-grantor on December 1, it appears that the allocable partnership tax attributes are wholly included in the trust's taxable income, and none are allocated to the grantor. Conversely, if a trust becomes grantor in September, the entire year's results would be reported in the grantor portion, and none taxed to the trust.
For Subchapter S corporations, which generally follow a “per day, per share” method of allocating income,4 the results are quite different. With a permitted S corporation grantor trust, the deemed owner of the trust is treated as the S Corporation shareholder, as is the sole income beneficiary of a qualified subchapter S trust (QSST).5 So, a formerly grantor trust that makes a QSST election to retain its status as a qualified shareholder might have two grantor portions of its tax year: one for the original grantor, and one for the beneficiary who is deemed the grantor after the QSST election. If the trust was a grantor trust with respect to the beneficiary due to withdrawal rights under IRC Section 678, then the full year's income would be allocated to the same individual.
Unless the S corporation is eligible for (and makes) the book-closing election6 that would bifurcate the tax year, the income (or loss or credit) allocated to the grantor and non-grantor portions of the year would be allocated by days, even if the income were not earned evenly throughout the year.
If the formerly grantor trust cannot be a QSST, an electing small business trust (ESBT) election is the only alternative. ESBTs also can be partially grantor trusts,7 and the same “per share, per day” rules would apply to allocate the income between the grantor and non-grantor portions if the change were mid-year. If an ESBT becomes a wholly grantor trust, the trust continues to be an ESBT, and a qualified S shareholder. But the grantor is taxed on the income as with any other grantor trust.8
Although a grantor trust with a single U.S. citizen or resident grantor could qualify as a permitted S corporation trust without having to make an election, most non-grantor trusts must make either a QSST or an ESBT election to be a permitted S corporation trust to avoid terminating the S election.9 Trustees of trusts holding S corporation stock are well-advised to pay attention to the regulations and election deadlines.
What happens if the trust makes estimated payments during what turns out to be a grantor period? As long as the trust is non-grantor at the end of the year, based on IRC Section 643(g) and the instructions for Form 1041-T, the trustee may elect to treat those payments as a deemed distribution to the beneficiaries as of the last day of the year. The effect of that election (made by filing the Form 1041-T) is to allocate the estimates to the beneficiaries, but as of January 15 of the following year.10 Or, the trustee can file a Form 1041, and request a refund of any overpayment. Neither method is completely satisfactory. If the trust was grantor to the beneficiaries, allocating estimated payments via Form 1041-T may leave them subject to an underpayment penalty for the earlier, grantor, portion of the year; but having the trust file for a refund leaves the beneficiaries underpaid until they pay their taxes individually.
What if the trust is wholly grantor by the end of its year? Can the trustee still use Form 1041-T to allocate estimated payments to the beneficiaries? Apparently not: the Committee Reports for Section 643(g)11 and the Form 1041-T instructions contemplate that any amount subject to the election is deemed a distribution under the 65-day rule of Section 663(b). Because a grantor trust does not have a distribution deduction, this criterion seems to preclude the election by a trust that is wholly grantor by its year end.
If the trust was grantor to the settlor, the grantor cannot personally use the estimated payments made by the trust applied to its own taxpayer identification number, although any state payments would be deductible.12 The grantor might incur an underpayment penalty if the unexpected grantor status of the trust causes inclusion of significant additional income in his or her return.
Suspended Losses, Deductions
Assuming that a non-grantor trust has accumulated passive losses allocable to one or more activities at the time it becomes a grantor trust, what happens to those losses? There are at least three possibilities:
- the losses are suspended at the (now-grantor) trust level until the property is disposed of to an unrelated party;
- the losses are added to the basis of the property; or
- the losses are lost because there is no provision for them.
In most situations, the first option seems to fit best with the original intent of the law. Under IRC Section 469(g), a loss incurred by disposing of a passive activity to a related party is suspended until the purchaser sells the property to an unrelated party. Although the change to a grantor trust is not generally deemed such a disposition,13 such treatment would allow the economic loss to be deducted by the grantor when the property leaves the family unit. It is also possible that the Internal Revenue Service or the courts could find the rule for transfers by gift applies,14 even though there is no taxable or legal gift due to the change to a grantor trust. If that rule does apply, the suspended losses would become additional basis in the hands of the grantor, which might allow a deduction sooner than the first option if the activity generates additional losses.
The third option, besides being unfair, does not harmonize with the intent of the passive loss rules, which was to delay deductions until the activity was sold, not to deny the deduction of actual out-of-pocket losses. It's worth mentioning that between the enactment of the passive loss rules in 1986 and the effective date of the passive loss regulations applicable to personal bankruptcy estates under Section 1398,15 debtors could deduct their suspended passive losses on their 1040 when a passive activity was sold by their bankruptcy estate. So, triggering a deduction due to a sale by a different party is not without analogous support.
Different considerations apply when determining whether there's a good fit with the intent of the passive loss rules when a trust becomes grantor to a beneficiary due to the beneficiary's right to withdraw the property at a given age. In such cases, the transfer by gift provision16 or the distribution by a trust provision17 appear more appropriate, both of which add the suspended losses to the basis of the property. The difference is that a withdrawal right means the property can actually be removed from the trust, thus completing a transfer by gift that was contemplated at the trust's inception, and fitting better within the phrase “distribution from a trust.” The ability to remove the property should be extended the same treatment as an actual withdrawal even though the property is actually not removed from the trust.
What if the situation were reversed: a previously grantor trust becomes non-grantor? Following the pattern for a change to a grantor trust, any passive losses on the former grantor's return would be suspended on that return until the trust sold the activity to a third party. Should the rule for gifts apply instead, adding the suspended losses to the trust's basis in the activity? For a change from grantor to non-grantor, that rule would more closely follow the economics of the loss. When a trust changes from grantor to non-grantor, the gift rule appears to provide a better fit with the intent of the law, because the trust was out-of-pocket for the previously suspended losses. When the activity is eventually sold to a third party, the trust would have the benefit of deducting all suspended losses that it had incurred. But, given the lack of guidance on the subject, the position that the related party rule would apply enjoys the same level of support.
Often overlooked, or confused with limitations on losses due to insufficient basis, the at-risk limitation applies to certain investments18 by trusts as it does to individuals.19 If a trust has an activity with a suspended loss due to an at-risk limitation, the best available guidance is Proposed Regulations Section 1.465-67, which, when a transfer of the interest occurs, adds the suspended loss back to the basis of the activity in the hands of the transferee. This regulation applies to any transfers or dispositions when the basis of the activity carries over to the transferee. While not specifically addressing grantor trusts, these terms seem broad enough to encompass the deemed transfer from a grantor to a non-grantor trust or vice versa. Although these regulations were proposed more than a generation ago, the treatment is consistent with the treatment of suspended passive losses. These two statutes had similar intents: to limit deductions from activities that were deemed to be “tax shelters.”
Although Treasury Regulations Sections 1.1015-1 and 1.1015-2 allow the grantor's basis to carry over to trusts for most types of transfers, the at-risk amount is a narrower concept than basis, and there is no similar provision to allow the grantor's amount at risk to transfer into a trust upon a gift, sale or other transfer.
Basis of Property
One issue that seems clear enough regarding blinking trusts is that the basis of the property does not change when the grantor status changes. Treas. Regs. Section 1.1015-2(a)(1) is broad enough to cover any types of transfers between the grantor and a trust, a trust and a grantor, or a trust and a beneficiary. That section covers transfers other than by gift, bequest or devise, but even if the deemed transfer by change of grantor status is a gift, the same result is obtained under Section 1.1015-1(a)(1), which covers transfers by gift.
Of course, in tax as in the rest of life, any rule must have its exceptions, and the basis carryover rule has one. In addition to the basis increases that may occur by operation of the passive loss or at-risk rules, which may add suspended losses to basis, the grantor can sometimes recognize gain upon loss of grantor status. Any gain recognized by the grantor is added to the trust's basis in the property.20
The grantor will always recognize gain on grantor status termination in one situation. Assume a partnership had allocated losses to the grantor trust. The grantor deducted those losses supported by liabilities allocated to the trust, but deemed allocated to him, again because of the trust's grantor status. He will be deemed to have realized proceeds on sale equal to the amount of liabilities no longer deemed allocated to him when grantor status terminates, which would then be offset by his basis in order to determine any gain.21
Could a similar gain be triggered if the grantor trust had been holding S corporation stock instead of a partnership? Given the limitations on losses deductible by shareholders,22 such gain recognition is possible but less likely.
In addition to carryovers that attach to specific activities of trusts such as at-risk or passive losses, many trusts have carryover attributes that accumulate at the trust level. Among these carryovers are common ones such as capital or net operating losses, and less common ones such as depletion and investment interest. Trusts also can accumulate credit carryforwards, such as foreign tax credit and alternative minimum tax credit.
When a trust terminates, IRC Section 642(h) provides that excess net operating losses, capital losses and excess deductions on termination are allowed to the beneficiaries succeeding to the trust property. There are no provisions, not even “as provided in regulations,” for distribution of any other types of losses, nor of any credits.23 Therefore, any attempt to preserve other suspended losses or credits will have to look for a legislative, not a regulatory, solution.24
How might Section 642(h) apply when a trust changes grantor status, assuming it applies at all? In one situation, it seems reasonable that the listed deductions could be used when a trust changes from non-grantor to grantor status. If a beneficiary reaches an age where she could withdraw property from the trust, but chooses not to, the trust becomes grantor to her. For income tax purposes, this scenario is as if the beneficiary had withdrawn the property and recontributed it for her own benefit.25 Thus the existing non-grantor trust has effectively terminated for income tax purposes, even though it continues for legal purposes. It therefore seems possible that a beneficiary of a Section 2503(c) trust attaining age 21 could benefit from a capital loss, operating loss or excess deductions flowing out at the time of the trust's change in status.
Outside of that limited circumstance, it's difficult to justify deeming any attributes to be distributed to a grantor solely because a trust becomes grantor. The theory behind the distribution of those attributes is that they should flow to the party who suffered the economic loss that gave rise to them.26 In an irrevocable grantor trust, it's the beneficiaries who will eventually bear the economic losses that created the carryovers, not the grantor or deemed grantor. So, lacking either statutory or logical authority, it would be difficult to justify distributing capital, operating or excess losses solely upon a change to grantor status.
What if a trust is terminated by distribution to the beneficiaries while the trust is still a grantor trust? Should the beneficiaries then receive the benefit of capital or operating losses arising during the trust's prior non-grantor years, assuming any net operating losses have not expired? Although that's certainly in accord with the intent of the statute, the regulations do not contemplate that possibility. Disclosure might be advisable.27
If, instead, a grantor trust regains its non-grantor status in the future, there is no reason to think that all unexpired and undistributed attributes (deductions, losses or credits) would not again be available to the trust. After all, the trust is still the same taxpayer, notwithstanding the changes between grantor and non-grantor status.
Many of the consequences of a change from grantor to non-grantor status, or vice versa, can only be determined by analogy or analysis of the intent of a statute. If a particular position is at a “less than ‘more likely than not’” level of authority, the preparer probably will want to consider disclosure to avoid a preparer penalty.28 If the position taken affects the grantor's return as well as the trust's, the same considerations will apply to that return.
Any tax advice included in this written communication was not intended or written to be used, and it cannot be used by the taxpayer, for the purpose of avoiding any penalties that may be imposed by any governmental taxing authority or agency.
Private Letter Ruling 8035067, (June 6, 1980) describes the income tax effects of a trust that includes annual withdrawal rights and withdrawal rights at certain ages.
Treasury Regulations Section 1.671-3, 1.671-4(a).
Treas. Regs. Section 1.671-4(a).
Internal Revenue Code Sections 1366(a)(1) and 1377(a)(1).
IRC Section 1361(c)(2)(B)(i), 1361(d)(1)(B).
IRC Section 1377(a)(2) and Treas. Regs. Section 1.1377-1(a)(2)(iii).
Treas. Regs. Section 1.641(c)-1(a) and (b).
Treas. Regs. Section 1.641(c)-1(c).
IRC Sections 1361(c)(2) and 1361(d).
IRC Section 643(g)(1)(C)(ii).
Conference Committee Report on P.L. 99-514 Section 1404(b) (Tax Reform Act of 1986).
Treas. Regs. Section 1.671-2(c).
The exception involves debt in excess of basis: see Treas. Regs. Section 1.1001-2(c) Ex. 5.
IRC Section 469(j)(6).
Cases commencing after Nov. 8, 1992. Treas. Regs. Section 1.1398-1(f).
IRC Section 469(f)(6).
IRC Section 469(f)(12).
IRC Section 465(c)(1).
IRC Sections 465(a)(1) and 641(b), Revenue Rulings 78-175 and 80-75.
Treas. Regs. Section 1.1015-2(a)(1).
Treas. Regs. Section 1.1001-2(c) Ex. 5.
IRC Section 1366(d).
Contrast with IRC Section 1398(g)(8).
Rev. Rul. 58-191, 1958-1 CB 149.
IRC Section 678(a).
Treas. Regs. Section 1.642(h)-3, Nemser v. Comm'r., 66 TC 780.
IRC Section 6694(a) and Form 8275.
IRC Section 6694(a).
Laura H. Peebles is a director at Deloitte Tax, LLP, in Washington