At the beginning of every year, the IRS informs the public of those tax matters on which the IRS will not issue letter rulings. Typically, these are areas of the tax law that are under study at the IRS, and that the IRS hopes to address through the publication of a revenue ruling, a revenue procedure, regulations, or otherwise.
A couple of months ago, the IRS added the following item to the list:
Section 1014. Basis of Property Acquired from a Decedent. Whether the assets in a grantor trust receive a section 1014 basis adjustment at the death of the deemed owner of the trust for income tax purposes when those assets are not includible in the gross estate of that owner under chapter 11 of subtitle B of the Internal Revenue Code.
Although this addition to the no-ruling list may be disturbing to some, it is actually a welcome development insofar as it may lead to the resolution of a tax issue that accompanies a commonly-used estate planning technique for the transfer of interests in a closely held business: the sale to an “intentionally defective” grantor trust.
While many estate practitioners employ sales to grantor trusts to effect the transfer of interests in closely held business entities, many fail to explain to the client (and the client’s beneficiaries) the tax risks associated with this technique upon the premature death of a client.
To better appreciate the import of the IRS’s decision, the following outlines the basic tax consequences of the sale technique, and then discusses the addition to the “no-ruling” list.
The most common means for transferring a business interest to someone is through a sale of the interest. Thus, it not unusual for a parent to sell a business interest to a child. In fact, if the parent needs a flow of funds in respect of the business interest, a sale presents an attractive option.
A sale is also an effective tool where the parent wants to shift the future appreciation in the value of the business interest out of his or her estate, but the parent’s remaining gift tax exemption amount is insufficient to cover the transfer. If a parent sells a business interest to his or her child for consideration in an amount equal to the value of such interest at the time of the sale, no gift occurs. Moreover, the sale allows the parent to effectively “freeze” the value represented by the interest at its sale price – by exchanging the interest for non-appreciating cash or other property – and to shift any future appreciation in the interest (above the sale price) to the child.
The Cost of a Sale
Such a sale of a business interest to one’s children will usually come with a cost: income tax. Where the interest sold was a capital asset (as is typically the case), the sale of which generates long-term capital gain, the 20% federal capital gains rate would apply to the amount recognized, and the 3.8% federal surtax on net investment income may also apply.
A sale may be structured as an installment sale in order to defer this income tax liability; i.e., in exchange for the child’s promissory note.
In order to avoid gift characterization of any portion of the sale transfer, the child’s installment obligation should:
- Bear a statutorily prescribed minimum rate of interest;
- Be memorialized in writing (with a note and sale agreement);
- Be secured (at least by the transferred property);
- Have a term not exceeding the seller’s life expectancy;
- Require regular payments by the terms of the sale and note agreements; and
- State the value of the business interest as established by an appraisal.
Using this approach, the gain realized on the sale would be recognized, and taxed as capital gain, as principal payments are made; interest would be taxable as ordinary income.
Sale to Grantor Trust
While an installment sale may “freeze” the value of the parent-seller’s business interest for estate tax purposes, there are some disadvantages to consider:
- The interest and principal that must be paid are taxable to the seller;
- If the seller disposes of the note (or if the child disposes of the purchased property within two years after its purchase), the gain on the sale is accelerated;
- If the principal of the note exceeds $5 million, a special interest charge will apply that defeats the deferral benefit of installment reporting; and
- The sale of an LLC or partnership interest may result in immediate gain recognition (if the entity has any indebtedness).
However, there is another option that should be considered: a sale of the business interest to a grantor trust. In order to use this technique, an irrevocable trust must be created and funded. The trust is structured as a grantor trust so that the parent is treated as the owner of the trust’s income and assets for income tax purposes. In general, the funding requires a seed gift equal to at least 10% of the FMV of the business interest to be sold to the trust.
The parent then sells the business interest to the trust in exchange for a note with a face amount equal to the value of the interest, bearing a minimum rate of interest and secured by the property acquired. The interest may be payable annually, and the note is typically satisfied with a balloon payment at the end of the note term.
The sale to the grantor trust is not subject to capital gains tax (because the parent-taxpayer is treated as dealing with him- or herself), and the issuance of the note prevents any gift tax (because there is adequate consideration). The value of the business interest sold to the trust is frozen in the parent’s hands in the form of the note; the cash flow from the interest and/or the appreciation in the value of the interest should cover the loan; and the remaining, excess value of the interest passes to the beneficiaries of the trust.
Death of the Seller
If the parent dies before the note is satisfied, the value of the note as of the date of death will be included in his or her estate for estate tax purposes. Thus, the FMV of the note at that time, plus the accrued but unpaid interest thereon, may be subject to estate tax.
Moreover, because it represents an item of “income in respect of a decedent,” the note will not receive a basis step-up (unlike most items of property that are included in a decedent’s gross estate), thus preserving the tax gain inherent in the note.
Gain on the Sale?
This brings us back to the IRS’s “no-ruling” list.
So long as the grantor retains those rights or powers with respect to the trust property that caused the trust to be treated as a grantor trust for purposes of the income tax (for example, the right to substitute property of equal value), the grantor will be treated as owning the trust’s assets, and any transfer of property by the grantor to the trust, whether or not in exchange for any consideration, will be disregarded for purposes of the income tax.
It is well established that, if a grantor were to release these rights or powers, and the trust thereby ceased to be treated as a grantor trust, any “transfers” of property previously made by the grantor to the trust will become effective – will be “completed” – for purposes of the income tax. Where such a transfer was made in exchange for a promissory note that remained outstanding at the time of the release, a sale will occur at that time.
What if the “release” of the grantor trust powers occurs as a result of the death of the grantor? It is clear, from an income tax perspective, that the trust ceases to be a grantor trust and that the transfer to the trust is completed at the death of the grantor. The question of gain recognition, however, has not been resolved.
Basis Step-Up? Jonathan v. the IRS
The basis of property acquired from a decedent is the fair market value of the property on the date of the decedent’s death. Property that is acquired by bequest, devise or inheritance, or by the decedent’s estate from the decedent, is considered to have been acquired from the decedent.
Many commentators argue that, for income tax purposes, the grantor owned the “trust assets” until the date of the grantor’s death and, so, these assets did not pass to the trust until the grantor’s death. At that moment, these commentators go on, these assets should receive a step-up in basis to the then-FMV of the assets (which will be greater than the original face amount of the note if the asset has appreciated). Upon the immediately subsequent sale of the assets to the trust, this step-up would offset the consideration received (i.e., the note) and eliminate any gain.
The IRS, on the other hand, has stated that because the property was transferred to a trust prior to the death of the grantor, the basis step-up rule should not apply unless the property was included in the grantor’s gross estate for purposes of the estate tax.
This is consistent with legislative measures that have been proposed over the last few years to “remedy” the lack of coordination between the income and transfer tax rules applicable to a grantor trust that, according to the IRS, creates opportunities to structure transactions between the deemed owner and the trust that can result in the transfer of significant wealth by the deemed owner without transfer tax consequences.
Under these proposals, if the grantor of a grantor trust engages in a transaction with that trust that constitutes a sale, exchange, or comparable transaction that is disregarded for income tax purposes by reason of the person’s treatment as a deemed owner of the trust, then the portion of the trust attributable to the property received in that transaction (including the appreciation thereon, net of the amount of the consideration received by the grantor) would be subject to estate tax as part of the gross estate of the deemed owner, which tax would be payable from the trust.
Gross income does not include the value of property acquired by bequest, devise or inheritance. The transfer is a gratuitous transfer – there is no consideration. But what if the property so acquired was encumbered by a mortgage or other indebtedness?
In the case of an intervivos gift, the transferor would be deemed to have received consideration equal to the amount of the indebtedness to which the property was subject: a part-sale, part-gift.
However, the IRS has never tried to argue that the transfer of encumbered property that occurs upon the death of the property owner should be treated as a sale of the property, one that would result in gain to the extent the indebtedness exceeded the owner’s basis in the property.
Similarly, it may be said that, upon the death of the grantor, the property transferred to the trust is “encumbered” by the promissory note, which becomes an obligation of the trust. The trust’s “assumption” of that note (that was the grantor “obligation” until his death) should not be treated as consideration for the testamentary transfer – there is no sale. Moreover, the basis of the property “passing” at the death of the grantor should be adjusted pursuant to the usual step-up rules.
Hopefully, the IRS will resolve this issue sooner rather than later.
Until the issue is resolved, notwithstanding the IRS’s no-ruling position, estate practitioners should be able to proceed on the assumption that the property sold to the trust will receive a basis step-up on the premature death of the grantor and, so, no gain should be realized on the transfer that is deemed to occur upon such death while the note is still outstanding.
However, practitioners will have to educate their clients who are considering sales to grantor trusts. The clients have to be made aware of the IRS’s position and the uncertainty this creates as to the income tax consequences that may follow upon the death of the grantor. “An educated consumer is our best customer” – it is also the best protection for the practitioner.