Proposed Revision of the Income Tax "grantor Trust Rules"and Corresponding Provisions of the Estate and Gift Tax Rules
| Jurisdiction | United States,Federal |
| Author | Written by Richard S. Kinyon, Esq. |
| Citation | Vol. 31 No. 2 |
| Publication year | 2022 |
IRC §§ 671-679, 2035-2038, AND 2511
Written by Richard S. Kinyon, Esq.1
The purpose of this paper is to examine the way in which the net income (including capital gains) of a domestic trust is taxed for federal income tax purposes during the lifetime of the U.S. resident settlor or grantor of the trust, and to recommend a revision of the so-called "grantor trust rules" in Subpart E of Subchapter J of the Federal Income Tax Law (IRC Sections 671 through 679) and the corresponding provisions of the estate and gift tax rules relating to irrevocable transfers in trust (IRC Sections 2035-2038 and 2511). Primarily as a result of the compression of the income tax rate brackets applicable to estates and trusts and the so-called "kiddie tax" in IRC Sections 1(e) and 1(g), respectively, enacted about 30 years ago, it is submitted that the bulk of those grantor trust rules are no longer needed to prevent the avoidance of income taxes, and ironically, they are now utilized by taxpayers to avoid gift and save estate taxes.
The income tax grantor trust rules are substantially different from the estate, gift, and generation-skipping transfer ("GST") tax rules in IRC Sections 2035 through 2038, 2511, and 2642(f), relating to gratuitous transfers of property in trust. Consequently, an irrevocable transfer of property in trust that is complete for gift tax purposes may be treated as being incomplete for income tax purposes, and a transfer that is complete for income tax purposes may be treated as incomplete for gift tax purposes; and a transfer in trust that is complete for gift tax purposes may not prevent the trust property from being included in the grantor's gross estate for estate purposes or allow the grantor's GST exemption to be allocated to the trust for GST tax purposes. The compression of the income tax rate brackets without eliminating most
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of the income tax grantor trust rules referred to above, and Revenue Ruling 85-13, 1985-7 I.R.B. 28,2 have led to the widespread establishment of so-called (1) Intentionally Defective Grantor Trusts ("IDGTs") that are irrevocable trusts resulting in a completed transfer for gift and estate tax purposes but an incomplete transfer for income tax purposes, enabling the grantor to (a) make a tax-free gift to the IDGT by paying the income tax attributable to the trust's taxable income and (b) avoid the recognition of gain or loss on a sale or exchange of property between the grantor and the trust, and (2) Incomplete Non-grantor Gift ("ING") trusts in states with no or low income tax rates applicable to undistributed trust income, enabling a grantor residing in relatively high income tax rate states to avoid paying state income taxes on the trust's income even though the grantor is treated as still owning the trust property for gift and estate tax purposes. Both the income tax grantor trust rules and the estate and gift tax rules relating to transfers in trust have been in the law for many decades without substantial revisions. This paper describes a proposal to revise those provisions by correlating the income tax grantor trust rules with revised estate and gift tax relating to transfers in trust.
The federal income tax law generally taxes net income with respect to property to the person to whom the property belongs. In the estate planning context, income with respect to property owned by an individual is taxed to the individual; and if that individual (a donor) makes a completed gift of property to another individual (a donee), outright and free of trust and any other restrictions, the net income with respect to that property thereafter is taxable to the donee. However, if a completed gift of property is made to an irrevocable trust, the person to whom the net income with respect to the trust property is taxable is either the grantor, the trust, one or more beneficiaries of the trust, and/or a person other than the grantor who is treated as the owner of the property because of powers exercisable or previously exercised by that other person.
In order to determine who should be taxable on the net income with respect to property given to an irrevocable trust, it seems logical and appropriate to (i) generally correlate the income tax grantor trust rules with the gratuitous transfer tax grantor trust rules, in furtherance of the principal referred to above, i.e., that the net income with respect to property is generally taxable to the person to whom the property belongs, and (ii) revise and simplify the way in which property ownership is determined for both income and gratuitous transfer tax purposes.
"For example, under current law, if the grantor of an IDGT transfers $1,000,000 to the trust and the money is invested in property that produces net income (including capital gains) totaling $2,000,000 during the period that the trust is a grantor trust, the grantor rather than the trust would be liable for the amount of the tax attributable to the trust's $2,000,000 of net income because of the grantor-trust provisions of the code. Because the grantor would have no right of reimbursement from the trust for paying the tax attributable to its net income, this would result in a reduction in the value of the grantor's gross estate for estate tax purposes equal to the amount of the tax paid. In effect, the grantor would be enhancing the value of the trust (effectively making a gift tax-free gift) as the trust is able to grow tax-free because the grantor, not the trust, is liable for the tax attributable to the trust's net income. However, the value of this enhancement would not be subject to gift tax because the grantor-trust provisions require the grantor to pay the tax attributable to the trust's net income. Because current law also treats the grantor as owning the trust property for income tax purposes, the grantor and the trust would be able to sell or exchange appreciated assets with each other without any recognition of gain. Under this proposal, (1) no such tax-free gift would be possible because by definition a grantor trust would be an incomplete gift for...
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