The grantor trust rules: An exploited mismatch.

• Author: Hubers, Jesse

EXECUTIVE SUMMARY

* A mismatch in determining whether a transfer is complete under the income tax regime on the one hand and the transfer tax regime on the other creates what could be considered an estate planning loophole.

* A taxpayer can exploit this mismatch by creating an intentionally defective grantor trust (IDGT) in which the taxpayer retains the power to reacquire trust property by substituting other property of equivalent value. Retention of this power will cause the taxpayer to be treated as the owner of any property subject to it for income tax purposes, but, for estate tax purposes, the property will not be included in the taxpayer's estate.

* By swapping high-basis property into the IDGT in exchange for low-basis property, a taxpayer can favorably manipulate the amount of estate tax paid at his or her death and the amount of income tax his or her heirs pay upon disposition of property they inherit.

* The grantor trust rules were enacted to combat income-shifting schemes designed to evade a steeply progressive tax rate structure. However, the Tax Reform Act of 1986's compression of the tax rate structure for trusts and estates obviated the need for the rules, which are now frequently exploited to avoid estate and income tax.

* Legislative remedies to eliminate such gaps in the grantor trust rules have been proposed, including their harmonization with the transfer tax system and repeal of Sec. 675(4)(C), which applies to the "swap" power.

One of the most critical tax planning decisions for the affluent taxpayer is whether to transfer wealth during life or at death. Conventional wisdom frames this decision as a choice between two mutually exclusive tax outcomes: If a taxpayer transfers wealth at death, the legatee benefits from a stepped-up basis, thereby avoiding income taxation on any unrealized appreciation in the wealth. On the other hand, if the taxpayer transfers wealth during his or her life, the donee forfeits a stepped-up basis in favor of transfer tax avoidance on any post-gift appreciation of the wealth.

Conventional wisdom, however, is rarely any match for crafty estate planning. The income tax and the estate and gift tax (the latter here referred to as "transfer tax") are governed under two separate subtitles of the Internal Revenue Code. Although these taxing regimes generally jibe with one another to prevent so-called loopholes, arguably, a huge loophole is created by a mismatch in the standards for determining whether a gratuitous transfer is "complete" under each regime. This mismatch opens a tax planning opportunity to obtain a stepped-up basis for income tax purposes while also "freezing" the value of the wealth for transfer tax purposes. While reasonable minds could quibble about whether this mismatch is a "loophole," (1) it certainly creates a significant tax planning opportunity that Congress probably did not intend, and it has no ascertainable public policy benefits. Nevertheless, while it stands, the taxpayer can not only have his or her cake; he or she can eat it, too.

Substitution property

In anticipation of significant appreciation of an asset, taxpayers traditionally have two alternatives: (1) transfer the property today and save estate taxes on the appreciation, or (2) transfer the property at death and save income taxes on the appreciation.

If the taxpayer transfers the property today, the value will be "frozen" for transfer tax purposes--the gift will be valued under Sec. 2512 as of the date of the gift. Thus, the property will escape transfer taxes on any appreciation between the date of the gift and the date of the donor's death. On the flip side, the donee will take a carryover basis in the property under Sec. 1015--so, when the donee disposes of the property, the donee will end up paying income tax on the appreciation that "escaped" transfer taxation.

If the donor transfers the property at death, the value will be determined as of the date of death under Sec. 2031 (2)--the transfer tax regime will capture all appreciation in the value of the property. On the flip side, the donee will take a stepped-up basis under Sec. 1014--so, when the donee disposes of the property, he or she will not be subject to income tax on any appreciation that accrued prior to the donor's death.

The concept of "basis" applies only to income taxation, which taxes "accessions to wealth," (3) and requires the use of basis to determine the extent to which the taxpayer has been enriched. However, the transfer tax is an excise tax on the privilege of transferring property and therefore is unconcerned with a taxpayer's basis. (4) Thus, taxpayers prefer to maximize the amount of basis allocated to property that will be taxed under the income tax regime but are indifferent as to the amount of basis allocated to property taxed under the transfer tax regime.

Clearly, Sec. 1015 operates to protect Treasury from being whipsawed by taxpayers who would transfer property to their heirs in anticipation of future appreciation and thereby dodge transfer taxation. (5) However, taxpayers have managed to circumvent Sec. 1015 by intentionally violating the income tax regime's "grantor trust rules" and exploiting the consequences. The grantor trust rules deem a gratuitous transfer in trust to be incomplete (or "defective") if the grantor retains any proscribed control with respect to the property. (6) Thus, for income tax purposes, the grantor is treated as owning any portion of the trust over which the grantor retains such control. Neither Sec. 1014 nor Sec. 1015 comes into play until the transfer is complete. Because the transferor is still treated as owning the property for income tax purposes, the property retains its basis determined under Sec. 1012 until there has been a complete transfer by gift or at death. Thus, by swapping property in and out of the trust, the transferor can effectively elect whether that property's basis will be determined under Sec. 1014 or 1015 in the hands of the transferee.

In large part, the transfer tax regime is harmonious with the income tax regime; if a grantor retains control over transferred property that violates the grantor trust rules, that property is generally also treated as owned at death for estate tax purposes. For example, if a grantor retains a power to revoke a trust, Sec. 676 will treat the grantor as owning the property for income tax purposes, while Sec. 2038 will treat the grantor as owning the property at death for estate tax purposes. Similarly, if a grantor retains an income interest in a trust, Sec. 677 will treat the grantor as owning the property for income tax purposes, while Sec. 2036 will treat the grantor as owning the property at death for estate tax purposes.

However, there are a few narrow gaps between the two tax regimes; some powers that violate the grantor trust rules do not rise to the requisite amount of control that would trigger estate tax inclusion.7 The most significant and widely exploited mismatch between the two regimes is the "power to reacquire the trust corpus by substituting other property of an equivalent value" (hereafter, "swap power"). (8) For income tax purposes, Sec. 675 provides that such a power will cause the grantor to be treated as owning any property subject to it; however, no corresponding transfer tax provision will cause the property to be included in the grantor's estate.

Suppose a grantor transfers property to a trust that is subject to a swap power, and the transferred property subsequently appreciates. The grantor has successfully "frozen" the value of the transfer for transfer tax purposes--the property will be valued under Sec. 2512 as of the date of the gift because the swap power does not trigger estate tax inclusion under Sec. 2036 or 2038. (9) Because the grantor is treated as owning any portion of a trust subject to a swap power under Sec. 675, transactions between the grantor and the trust are disregarded for income tax purposes. So, when the grantor exercises the swap power and reacquires property from the trust in exchange for property of equivalent value, the transaction has no income tax consequences because the grantor is considered to have in effect taken property from one pocket and put it into the other. (10)

Ordinarily, the carryover basis rule of Sec. 1015 would ensure that the appreciation was taxed under the income tax regime; however, by exercising the swap power, the grantor can swap high-basis property into the trust in exchange for the appreciated (low-basis) property, which will pass through the grantor's estate and receive a stepped-up basis under Sec. 1014.

When utilized for tax planning purposes, a trust that violates the grantor trust rules in this way is referred to as an intentionally defective grantor trust (IDGT).

The plan in action

The best way to demonstrate the concepts of this planning strategy is by way of a (somewhat extreme) example. Consider the following scenario:

Example 1: A is the sole shareholder and CEO of a closely held business, W. A has no basis in the stock, which was recently appraised for $1.7 million (A has no...