The booby prize when property held in trust is included in a decedent's taxable estate is that the property receives a fresh income tax basis. So, there's estate tax on the property because it's in the estate. But at least the fresh basis wipes out all the income taxes on the property's appreciation during the decedent's lifetime.

Unfortunately, there's no fresh basis for the taxable income that the decedent had coming during his lifetime — but didn't receive before dying (called income in respect of a decedent or IRD, in the Internal Revenue Code.)1

But trusts aren't decedents. So that raises the question: When, if ever, might trusts that are includible in the estate of a decedent avoid IRD and receive fresh basis?

It's a provocative question. A few phone calls and emails to practitioners and commentators drew a predictable response: of course IRD is still IRD when held in trust. At least two treatises that cover both fresh basis and IRD are silent on the subject (hard to believe).

But scratch the surface and there's no “of course” about it. IRD may not be IRD when held in a trust.

My “exhibit A” is a qualified terminable interest property trust under a QTIP election.2 Such a trust is included in the surviving spouse's estate3 — yet the trust property generally receives fresh basis.4

Say, for example, the trustee of a trust that is includible in a decedent's estate sold real estate held by the trust during the decedent's lifetime for a gain in exchange for a promissory note. The promissory note was payable over a term of years. The sale was being treated as an installment sale for income tax purposes, meaning the gain is taxed over the note's term of years, as note principal is collected.5 The decedent died when the note principal had not yet been paid off and there were yet-to-be reported taxable capital gains relating to unpaid principal.

When such a note passes from a decedent, those capital gains are IRD. But are those capital gains IRD if the note was always in the hands of the trustee? Or does the installment obligation get a fresh basis that blocks further income taxation of the unreported gain?

The answer to those questions lies in the rules on fresh basis and IRD.

Fresh Basis

The income tax basis of property acquired from a decedent generally is the fair market value (FMV) of that property as determined for estate tax purposes.6 When it comes to trust property, there are two noteworthy provisions of the IRC that treat trust property as though it was acquired from a decedent, so that trust property receives fresh basis.

One of these provisions — IRC Section 1014(b)(9) — doesn't specifically mention trusts, but can apply to them. It says property is treated the same as property acquired from a decedent and receives a fresh basis:

  1. if the property is acquired from the decedent by reason of death, form of ownership or other conditions (including property acquired through the exercise or non-exercise of a power of appointment), but only if
  2. the property so acquired is required to be included in determining the value of the decedent's gross estate.

But there may be an adjustment to the fresh basis for special circumstances. Fresh basis is reduced by depreciation, amortization or depletion if the property was transferred during the decedent's lifetime. Also, annuities don't get fresh basis, and that includes, by extension, qualified retirement plans as well as IRAs.7

That provision can apply to a trust granting a general power of appointment, because the presence of a general power of appointment over a trust causes that trust's property to be included in the power holder's estate.8 For example, some trusts grant this power to children of the trust settlor to avoid imposition of the generation-skipping transfer (GST) tax by intentionally causing trust property to be included in the estate of the child, who is a non-skip person by statute. Other trusts combine a general power of appointment and a life estate in a surviving spouse to qualify the trust for an estate tax marital deduction.9

Likewise, a general power of appointment over a portion of a trust, such as a power granted to an individual to appoint the greater of 5 percent of the value of the trust or $5,000 to himself, will cause only that portion of the trust to be included in the power holder's estate. Such a power is sometimes granted to a surviving spouse.

Another type of trust that can potentially receive fresh basis is one that is includible in the decedent's estate because the decedent retained the right to enjoy income from the transferred property for life,10 but has made a completed gift of the remainder interest in the trust property.

The other of these two provisions — IRC Section 1014(b)(10) — says property held in a QTIP trust is also treated the same as property acquired from a decedent when the surviving spouse dies.11 Here, too, fresh basis is reduced by depreciation, amortization or depletion — if the property was transferred during the surviving spouse's lifetime. Again, annuities and retirement benefits don't get fresh basis.

So there are two IRC provisions that clearly provide fresh basis rules for certain trusts.

Alas, the fresh basis party is spoiled when IRD is present.12 First, of course, you must determine whether IRD is present. If it is, there's no fresh basis for the IRD. This point was made back in 1974 when, in Hedrick v. Commissioner,13 a taxpayer argued a decedent's promissory notes received during lifetime in an installment sale received fresh basis (no trust was involved). The Tax Court found that the unreported capital gains on the installment sale were IRD,14 satisfying the condition necessary to apply IRC Section 1014(c)'s denial of fresh basis to IRD. The court held for the Internal Revenue Service and against the taxpayers.

For trusts, therefore, this crucial question arises: When, if ever, does a trust formed and funded during a decedent's life avoid the IRD rules? Because, if there's no such thing as trust IRD, then trust property arguably receives fresh basis if that property is included in the estate of the decedent.

IRD and Trusts

IRD received after death is taxed as it would have been before death.15 There isn't a definition of IRD in the code. The regulations provide a general definition, saying that IRD “refers to those amounts to which a decedent was entitled as gross income but which were not properly includible in computing his taxable income for the taxable year ending with the date of his death or for a previous taxable year under the method of accounting employed by the decedent.”

At first blush, it looks like trusts can't have IRD because trusts are never decedents. There's no reference to trusts of any kind in the IRD statute or the regulations. But what if a decedent was treated as entitled to gross income in the context of grantor trust rules? After all, when those rules apply, the grantor is treated as being entitled to income for income tax purposes.16 Could application of the grantor trust rules mean trust income is treated as amounts to which a decedent was entitled as gross income?

Apparently so. In Sun First Nat'l Bank v. United States,17 capital gains from an installment obligation were held to constitute IRD because it was found that the trust's income portion constituted a grantor trust with respect to the decedent and that installment sale capital gains had been properly allocable to the trust's income. Evidently, the court would not have so held if the capital gains had been allocated to principal instead. In an odd twist, it was the IRS that argued the capital gains weren't IRD because the underlying installment obligation was payable to a trust. The IRS was seeking to defeat the income tax deduction for estate taxes relating to IRD.18 That's why, ironically, the taxpayer wanted IRD status and the IRS argued against it.

The decedent in Sun First Nat'l Bank had made a lifetime transfer of corporate stock to a trust, retaining income for life, leaving the remainder interest to a daughter. The trust sold the stock in an installment sale at a gain while the decedent was alive. The estate tax return didn't include any trust property in her gross estate, but the trust had paid income taxes on gains embedded in the installment sale payments received after death. The IRS sought to include the trust in the decedent's taxable estate under IRC Section 2036 and was upheld by the Tax Court. The estate then filed a claim for an income tax refund based on the income tax deduction for estate tax. The IRS disallowed that claim; litigation ensued.

Here, the trust was a grantor trust only with respect to the income portion and not the principal portion. The court framed the question: “[D]id the trust properly treat the entire gain on sale of the stock as allocable to income rather than to corpus, so that under the grantor trust provisions [the grantor-decedent], the income beneficiary, was viewed as the owner of that portion of the trust, the ‘income’ of which was distributed to her?”

The question's form strongly suggests that if the gain had been allocable to principal instead of to income (so that the grantor trust provisions hadn't applied to the portion of the trust that was entitled to the capital gains), there would have been no IRD. In any event, the holding clearly is based on application of the grantor trust rules.

So, it seems that the only time IRD rules apply to a trust is when the grantor trust rules do. IRD is truly a concept that applies only to individuals. Conversely, the IRD rules don't seem to apply to a trust or any portion of a trust when the grantor trust rules don't apply.

Fresh Basis Achieved?

So, unless the grantor trust rules apply, trusts can't have IRD. And, in the absence of IRD, the IRD prohibition against fresh basis can't apply to trusts or portions of trusts when the grantor trust rules don't apply but the trust is includible in the estate of the decedent. In other words, there's a fresh basis for what would be IRD if inherited from a decedent but can't be IRD if the latent income first arose in the hands of a trustee.

In my opening example, there was an installment sale by a trust before the decedent died. Installment sale gains not yet reported by the decedent's date of death generally are IRD, and that prevents basis step up.19 But if no part of the trust is a grantor trust, there's no IRD and the trust's installment note will receive a basis step up. Alternatively, if the gains are allocable only to principal but the principal portion of the trust isn't a grantor trust, there's still no IRD, and the trust's installment note in the example will receive a basis step up.

What about a QTIP trust? The decedent, who in this case was a surviving spouse, was entitled to income for life, as required under the IRC's QTIP provisions.20 The installment sale and its related untaxed gain is, in most cases, likely to form a part of trust principal, and not trust income. Assuming the trust is not a grantor trust, that installment obligation should receive fresh basis.

What if that result is correct but the property receiving the fresh basis was not an installment note, but instead was commercial real estate subject to depreciation while that property was held in the QTIP trust? Then, the fresh basis must be reduced by that depreciation.

What about interest income from the installment obligation paid to a QTIP trust but not yet paid over to the surviving spouse? After all, IRD status turns on whether the surviving spouse is entitled to the income. The answer then depends on the trust terms. Most QTIP trusts pay income at an interval, such as at the end of each calendar quarter. The spouse almost certainly will die during a quarter, creating “stub” income. Some trusts pay “stub” income to the estate of the surviving spouse, while others don't. The ones that don't pay “stub” income to the estate of the surviving spouse require survival in order to vest the right to receive income. So perhaps a QTIP trust's “stub” income receives fresh basis if the spouse or the spouse's estate isn't entitled to it.

What about accrued but unpaid interest on the installment obligation as of the date of the surviving spouse's death? This accrued interest is included in the surviving spouse's estate. But that doesn't make it income to which the surviving spouse was entitled. Most trusts are on the cash basis of trust accounting, meaning trust receipts are allocated to income or principal only at the time received. That's how the default trust accounting laws of most states work. Accrued but unpaid interest isn't received by the trust during the lifetime of the surviving spouse, so it's not income to the trust during the lifetime of the surviving spouse. And a life estate in the surviving spouse means the surviving spouse is only entitled to income during her lifetime. Therefore, accrued but unpaid interest isn't something to which the spouse is entitled and so can't be IRD. Perhaps a QTIP trust's accrued but unpaid interest gets fresh basis.

The Work Ahead

Tax professionals need to rethink how fresh basis rules apply to trusts, when trusts are included in the taxable estate of a decedent. Hopefully, conversations among professionals and academics alike will be shared in public forums and a consensus will emerge. Ideally, that consensus will be memorialized in our respected tax treatises and practice guides.
— For her assistance with this article, the author thanks Natalie B. Choate, an attorney with Nutter McClennen & Fish LLP in Boston and a contributing editor to Trusts & Estates.

Endnotes

  1. Internal Revenue Code Section 691(a).
  2. IRC Section 2056(b)(7).
  3. IRC Section 2044.
  4. IRC Sections 1014(a) and (b)(10).
  5. IRC Section 453.
  6. IRC Section 1014(a).
  7. IRC Section 1014(b)(9) provides: “In the case of decedents dying after December 31, 1953, property acquired from the decedent by reason of death, form of ownership, or other conditions (including property acquired through the exercise or non-exercise of a power of appointment), if by reason thereof the property is required to be included in determining the value of the decedent's gross estate under chapter 11 of subtitle B or under the Internal Revenue Code of 1939. In such case, if the property is acquired before the death of the decedent, the basis shall be the amount determined under subsection (a) reduced by the amount allowed to the taxpayer as deductions in computing taxable income under this subtitle or prior income tax laws for exhaustion, wear and tear, obsolescence, amortization, and depletion on such property before the death of the decedent. Such basis shall be applicable to the property commencing on the death of the decedent. This paragraph shall not apply to… (A) annuities described in section 72; (B) property to which paragraph (5) would apply if the property had been acquired by bequest; and (C) property described in any other paragraph of this subsection.”
  8. IRC Section 2041.
  9. IRC Section 2056(b)(5).
  10. IRC Section 2036.
  11. IRC Section 1014(b)(10). Paragraph 10 incorporates by reference all but the first sentence of paragraph 9.
  12. IRC Section 1014(c).
  13. Ray Bert Hedrick v. Commissioner, 63 T.C. 395 (1974).
  14. IRC Section 691(a)(4).
  15. IRC Section 691(a).
  16. IRC Sections 671 through 679, inclusive.
  17. Sun First Nat'l Bank v. United States, 607 F.2d 1347 (Cl. Ct. 1979).
  18. IRC Section 691(c).
  19. IRC Sections 691(a)(4) and 1014(c)
  20. Supra note 2.

Michael J. Jones is a partner in Monterey, Calif.'s Thompson Jones LLP and chairs the Trusts & Estates Retirement Benefits Committee