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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. 20312 — 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 other assets or liabilities worth mentioning). A's son, B, is in upper management of W and has high hopes for the future of the company. In early 2020, A unexpectedly inherits from her uncle a $10 million portfolio of Treasury bonds that yields about $200,000 in interest income annually. A has been wanting to retire for years so that she can travel the world, and this inheritance is the key to her dream.That same day, B calls A excited about a deal he struck with bank G. G was impressed with B's vision for the business and wants to offer shares of W to the public through an initial public offering (IPO). G has high expectations for the IPO and expects the value of W to skyrocket after it hits the market.
Excited that B's vision for the company is being realized and eager to begin traveling, A decides that she wants to give all her stock in W to B. She calls her lawyer, D, to get his advice. D recommends that A transfer the shares to G as trustee for the benefit of B. Furthermore, he recommends that she retain the power to reacquire the stock by substituting other property of an equivalent value.
In late 2020, A steps down as CEO and transfers all her shares to G as trustee for the benefit of B. G votes the shares in favor of the IPO and names B CEO of W. A correctly reports this as a gift of $1.7 million to B, but she pays no gift taxes because she still had her entire unified credit prior to the gift.
As expected, the shares of W skyrocket almost immediately after the IPO hits the market. By early 2021, the shares in the trust are valued at $10 million.
To highlight the scheme's benefits to come, consider the tax outcome if A suddenly dies: Having given the stock to B, A successfully froze the value of the stock at $1.7 million.11 Thus, her taxable estate would be $11.7 million, composed of the $10 million bond portfolio and $1.7 million in adjusted taxable gifts. Conveniently equal to the basic exclusion amount for 2021,12 her estate will not owe any tax.13 B takes the stock with a carryover basis of zero under Sec. 1015 and would owe income tax of $2 million upon disposition of the stock (assuming a 20% long-term capital gains rate and ignoring any possible exclusion that may be available under Sec. 1202).
Alternatively, if A had not made the gift and instead bequeathed the stock to B in her will, the entire appreciated amount of $10 million would have been included in her estate, and her estate would owe taxes of $3.32 million (her gross taxable estate would be $20 million, composed of the $10 million bond portfolio and $10 million of W stock).14 B would take the stock with a stepped-up basis of $10 million under Sec. 1014 and would not owe any income tax upon disposition of the stock.
Either way, somebody is paying millions of dollars in taxes. However, watch closely as the tax liability evaporates after A acts on the sage advice of her lawyer:
Example 2: Overcome with pride in her son's success, A calls D to brag on B. After congratulating A on B's accomplishment, D surprisingly recommends that A exercise her power to reacquire the stock from the trust. Unable to travel due to the COVID-19 pandemic, A agrees to swap her $10 million bond portfolio into the trust in exchange for the W shares. After signing all the transfer documents, A walks out of D's office, has a heart attack, and dies.
As outlined above, this trust is an IDGT. For income tax purposes, Sec. 675 treats A as owning all the property in the trust subject to the swap power. Consequently, all transactions between A and the trust are disregarded, and the swap of property between A and the trust is a "tax nothing."
Although A's exercise of the swap power did not change the value of her taxable estate, it changed the composition of her taxable estate in a significant way. A's taxable estate is still $11.7 million, but it is now composed of the $10 million W stock and $1.7 million in adjusted taxable gifts. The same as without the swap, her estate will not owe any estate tax because it is equal to the basic exclusion amount.
The income tax consequence is where the beauty of this transaction is revealed: B takes the stock with a stepped-up basis of $10 million under Sec. 1014 and does not owe any income tax upon disposition of the stock. Thus, A has passed $20 million of value to B free of transfer tax and without a built-in gain and impending income tax liability.
If the facts are right, the grantor trust rules can truly allow a taxpayer to have his or her cake and eat it, too.
How did we get here?
When the grantor trust rules were originally codified by Congress in 1954,15 the income tax structure was significantly more progressive than it is today: Its 24 marginal tax rate brackets began at 20%, climbing as high as 91%.16 During this era, the grantor trust rules served an important purpose: preservation of this structure in an environment where taxpayers were incentivized to divert income to lower-bracket taxpayers to skirt the progressive rates.17
Crucial to the integrity of the steeply progressive rates was the notion that income ought to be taxed to the taxpayer who earns it.18 Without limits on taxpayers' ability to splinter their income, the integrity of the progressive nature of the tax system would be at risk.19 One of the earliest tax planning techniques was to split income among family members,20 shifting it to other, lower-bracket taxpayers, to avoid the impact of the progressive nature of the tax.21
Early on, the Supreme Court intervened in Lucas v. Earl, creating the "assignment-of-income doctrine."22 The doctrine generally disregards taxpayer attempts to split income among multiple taxpayers to reduce the effective tax rate on that income without the concomitant transfer of the income-producing property.23 The Court expressed the doctrine with this metaphor: "[T]he fruits [cannot be] attributed to a different tree from that on which they grew."24 The gist is that if a taxpayer is not willing to transfer title to the assignee, he or she cannot obtain the tax benefits associated with the assignee's effective rate.
Similar attempts were made to divert income by transferring legal title to the income-producing property to "revocable trusts" while retaining equitable title for all intents and purposes.25 The income earned by the trust property is distinguishable from the income assigned in Earl because it never "vested" in the grantor (the grantor had given away the "tree," at least in form).26 This technique was shot down six years prior to Earl when Congress passed Sec. 219(g) as part of a narrow group of anti-abuse rules in an "endeavor to keep pace with the fertility of invention whereby taxpayers had contrived to keep the larger benefits of ownership and be relieved of the attendant burdens."27
Sec. 219(g) provided: "Where the grantor of a trust has, at any time during the taxable year, . . . the power to revest in himself title to any part of the corpus of the trust, then the income of such part of the trust for such taxable year shall be included in computing the net income of the grantor" (akin to the current Sec. 676).28 The same year Earl was decided, the Supreme Court validated Sec. 219(g) as constitutional, holding that "taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed — the actual benefit for which the tax is paid."29 Thus, a mere title change could not provide a means for tax avoidance.
Still, taxpayers dreamed up clever ways to sidestep the rules and create trusts that would shift income without crossing the line to trigger inclusion under the old rules. For example, after adoption of Sec. 219(g), "taxpayers resorted to the creation of revocable trusts with a provision that more than a year's notice of revocation should be necessary to termination. Such a trust was held not to be within the terms of §219(g) . . . because not revocable within the taxable year."30 More work needed to be done to curb taxpayers' efforts to spin a web of income assignments to reduce their marginal rate.
Nearly a decade after Earl, the Supreme Court finally brought down the hammer. In Helvering v. Clifford, the Court smelled abuse in a transaction that did not trigger the assignment-of-income doctrine or any anti-abuse statute. Having no direct statutory authority, the Court nonetheless found that the trust was taxable to the grantor under the broad scope of the gross income statute.31 The Court found that the crucial test was whether the grantor had retained "dominion and control" over the property, noting, "The bundle of rights which he retained was so substantial that [the grantor] cannot be heard to complain that he is the 'victim of despotic power when for the purpose of taxation he is treated as owner altogether.' "32
The problem was that the Court just stopped there; it proclaimed broader power for Treasury without defining its bounds.33 The Clifford decision did not explicitly state which trust provisions would constitute "dominion and control" of trust property; it merely stated that the provisions of that particular trust definitely gave the grantor control over the property.34 After Clifford, unless a trust fell within the original narrow grantor trust rules, "its status for income tax purposes was suddenly up for grabs."35 The result "was a scramble to figure out what the decision meant. Allowing the courts to sort it out was leading to pure chaos, with the rule being continually refined and confused through litigation."36
"The flood of Clifford trust litigation, coupled with the taxpayers' cries of frustration, stirred the Treasury Department. It promulgated a set of regulations that are the basis for the present-day grantor trust rules."37 Treasury basically took the offending trust provision from Clifford and "broke it down into pieces."38 The problem with the Clifford regulations is that they were less a creation of Treasury and more something that just happened to Treasury.39 They grew out of a vague holding from the Supreme Court about a trust provision that offended the broadest section of the Code. Although the Clifford regulations did not always produce the right result, "[t]hey were the repair that cemented over the hole in the dam that was hemorrhaging revenue that the treasury wanted and needed."40
Still, the regulations were generally well received at the time and have been described as striking "the right balance between protecting legitimate trust arrangements and inhibiting tax subterfuge."41 Their rigidity gave taxpayers the certainty they longed for while also protecting the progressive rate structure from being eroded through division of incomes. The regulations quickly became well established, and Congress adopted them as the model for the current grantor trust rules when it overhauled the Code in 1954.42 Had Congress taken up the baton earlier to protect the progressive rates through the normal legislative process, perhaps there would be a less piecemeal set of grantor trust rules that better aligned with the transfer tax regime.
A shift in outcomes
The legislative history of the grantor trust rules ties them to the Clifford decision and the necessity to protect the progressive income tax structure of the time.43 The trouble is that the progressive rate structure in place at the time is now merely a memory. While there still are progressive income tax rates, the Tax Reform Act of 1986 (the 1986 Act) reinvented the rate structure and, with it, the way grantor trusts are used.44
Prior to the 1986 Act, taxpayers and their advisers were careful to avoid the grantor trust "trap," but in a major reversal, the opposite is now true.45 The goal is no longer to work around the grantor trust rules but to carefully wade into them. Classification as a grantor trust once carried with it a significant burden: the running up of the progressive income tax rates. Today, the vast majority of tax outcomes are improved by classification of a trust as a grantor trust.
The shift in tax outcomes is primarily due to the compression of the rate structure for nongrantor trusts.46 When the grantor trust rules were codified in 1954, trusts and individuals generally faced a similar rate schedule and identical maximum rates,47 so there was an advantage to utilizing the trust rate schedule to divide income among as many trusts as required to reduce a taxpayer's effective tax rate (if the division could pass muster).
The 1986 Act eliminated that advantage by compressing the rate schedule on trusts so that the maximum tax rate applied at very low income thresholds. As a result, trusts are essentially subject to a flat tax imposed at the highest marginal rate,48 while income earned by a grantor trust is subject to the grantor's more graduated rate structure, with the highest marginal rate not kicking in until a threshold up to 48 times higher than the trust threshold.49 The difference between the two rate structures consistently puts taxpayers and their families in a better financial position if their trusts are taxed to the grantor.50
The rate compression for trusts, by itself, has defeated the purpose of the grantor trust rules and rendered them obsolete. There are no longer any significant income tax incentives to diverting income to trusts; any tax advantage attained by running up an additional trust bracket is paltry compared with the expense of administering the trust.51 The rules almost always offer taxpayers refuge, making their invocation by the Service futile.52 In fact, the Service has not invoked the rules in 30 years: "[T]here is not a single case involving a post-1991 fact pattern in which the Service has invoked the grantor trust rules."53
Not only are the grantor trust rules obsolete, but they are also counterproductive. Unfit for their original purpose to frustrate tax avoidance, the rules invite opportunists to exploit them and secure the tax advantages discussed in this article (not to mention other techniques outside the scope of this article). The rules have effectively been reduced to an elective system whereby a taxpayer can elect grantor trust status by incorporating a trivial power of substitution into the governing instrument. Trusts can even be designed to have grantor trust status "toggled" on and off. Such a trust allows the grantor to "turn off" grantor status by releasing a proscribed power and allows a trust protector to "turn back on" grantor status by reconferring the proscribed power to the grantor. In today's day and age, a trust will generally find its way into the grantor trust rules only if it was specifically designed that way.
In the words of one commenter, this type of planning "furthers the already widely held impression that the IRC is a venal collection of provisions designed to allow those whose advisors are 'in the know' immense latitude in minimizing their tax liabilities."54 This impression compounds the loss of revenue to Treasury because the perceived unfairness in the tax system is positively correlated with tax-evasive behavior.55 The United States' tax system is based on the concept of voluntary compliance, which makes perceived unfairness particularly problematic. Taxpayers who consider themselves "outside the know" will find it much easier to rationalize underreporting income in ways that are virtually undetectable to the Service.
Where do we go from here?
Supposedly, the Code is designed in accordance with the concept of neutrality. The concept of neutrality in tax policy means that "the tax system should strive to be neutral so that decisions are made on their economic merits and not for tax reasons."56 When the grantor trust rules were codified, they sought to do exactly that. The grantor trust rules made a taxpayer neutral as to whether to create a Clifford-style trust or not, because the tax consequences were the same either way.
The neutrality supplied by the grantor trust rules has been rendered superfluous by the compression of the trust rate schedule under the 1986 Act. If anything, the grantor trust rules now cut against neutrality because taxpayers are incentivized to design their trusts to accomplish the type of planning that is the subject of this article. In the examples above, A had no economic reason to reacquire the W stock other than the tax benefit that would inure to B. Of course, congressional policy goals trump neutrality all the time; however, that does not appear to be what is going on here. So what solutions are available to remedy the situation?
Repeal
One solution to the current state of the grantor trust rules would be to repeal them en masse. Trusts that violate the grantor trusts rules would no longer be taxed to the grantor but would be subject to the compressed rate applicable to trusts — again, essentially, a flat tax at the highest marginal rate.
A large-scale repeal of the grantor trust rules would surely cause an uproar within the estate planning community.57 Taxpayers who relied on the grantor trust rules in establishing IDGTs would be materially harmed by a repeal of the rules and the resulting tax hike on their trusts. By definition, IDGTs are irrevocable, so the damage to their estate plans will be irreversible and irremediable.
Scholars have warned of the grantor trust rules' impending demise for years, so estate planners might be hard-pressed to argue that Congress is unfairly changing the rules.58 Nevertheless, Congress could always exempt preexisting IDGTs to the extent it finds a fairness argument meritorious.59
Assuming Congress decides to repeal the grantor trust rules, some remnant would need to be left to deal with revocable trusts. Any serious proposal for repeal of the grantor trust rules should consider retaining Sec. 676 (and by necessity Sec. 671, the rules' operative provision) pertaining to revocable trusts. Treating the grantor of a revocable trust as owning the trust assets is sensible because the grantor can reacquire them at any time. This is so similar to an assignment of income that it would be unreasonable to treat the trust as separate from the grantor.
Many revocable trusts are created as will substitutes, serving important purposes in the administration of estates but functionally as nothing more than an alter ego of the grantor during life. The grantor is generally the trustee and the life beneficiary, having created the trust under the understanding that it was tax-neutral. Revocable trusts have been described as "nothing more than a specially-labeled custody account and should be a tax nothing."60 Subjecting these types of trusts to taxation as trusts would impose massive administrative costs on both taxpayers and the government. Imposing the compressed rate schedule on these trusts would be nonsensical.
Retention of Secs. 676 and 671 would also quell concerns that repeal of the grantor trust rules might revive the uncertainties and resulting litigation loosed by Clifford. Sec. 671 states "clearly and unequivocally that [the grantor trust rules are] the exclusive determinant of whether a [grantor] has retained dominion and control over an inter vivos trust."61 Thus, Clifford is entirely moot, and a trust's form would be respected in all cases not falling squarely within Sec. 676.
Harmonization
Even if the grantor trust rules are retained in some form, they need not be preserved intact, with their gaps and holes that let tax revenue flow through like a sieve. Harmonization of the grantor trust rules with the transfer tax regime would restore the trade-off between transferring property at life or at death discussed earlier in this article.
A completely harmonized system would unify the definition of a completed transfer for income tax and transfer tax purposes.62 Such a unification is a natural fit because both tax regimes attempt to capture those transfers in which a grantor has retained dominion and control over the transferred property.63 Harmonization could be implemented by adopting the definition from either tax system or by replacing both with an entirely new one.64
Should this option be pursued, the chosen definition is no trivial matter. Adoption of the transfer tax definition would merely subject the trust income to a higher tax rate. On the other hand, adoption of the income tax definition would subject many grantor trusts to an estate tax on the entire value of the trust that would have otherwise been dodged altogether.
Alternatively, it has been suggested that Congress could amend Sec. 2036 to include in the value of the gross estate the value of any property with respect to which a decedent retained a power that would cause a decedent to be deemed the owner of any portion of a trust under the grantor trust rules. For applying this proposed rule, the decedent would be deemed to have retained any power held by a third party that would cause the decedent to be deemed the owner of any portion of a trust under the rules.65 This too would deal a huge blow to truly completed transfers that have retained some trivial power for estate planning purposes. Considering the punitive consequences on the table, it is hard to imagine that this would get any traction in Congress absent a provision exempting preexisting trusts.
In a recent turn of events, the House Ways and Means Committee has advanced new legislation as part of the budget reconciliation bill that would have a similar effect to the proposed amendment to Sec. 2036. As of this writing, the legislation proposes the addition of Sec. 2901, which would make three important changes to the Code. First, it would include in the grantor's gross estate any portion of a trust that he or she was deemed to own under the grantor trust rules (the grantor being the "deemed owner"). Second, it would treat any distribution from such a trust to one or more beneficiaries (other than the deemed owner or his or her spouse) during the life of the deemed owner as a taxable gift. Third, if the grantor ceases to be the deemed owner of any portion of the trust, the grantor will be considered to have made a taxable gift of all assets attributable to such portion. Should this legislation get sufficient support in Congress to become law, it could potentially bring an end to the grantor trust problem. Fortunately, the legislation would only apply prospectively, as written, which improves its likelihood of success.
Targeted repeal
If Congress remains unable or unwilling to undertake the more comprehensive solutions discussed above, it could selectively repeal any grantor trust rule that does not also trigger estate tax inclusion. In fact, Congress could cripple most grantor trust abuse by simply striking one provision from the rules: Sec. 675(4)(C). Although there is more than one way to create a grantor trust without triggering estate tax inclusion, the estate planning industry has whittled its options down to the "old reliable" power to reacquire the trust corpus by substituting other property of an equivalent value.66 Its removal would bring an immediate end to the basis-swapping outlined earlier in this article and would deal a crippling blow to most other IDGT strategies. Such an ad hoc solution would be the most straightforward approach, as it would not require any coordination or harmonization of the income and transfer tax systems.67
Closing the loophole?
The mismatch in determining whether a transfer is complete under the income tax and the transfer tax regimes creates what could be considered an estate planning loophole. While there are strong tax policy and revenue-raising arguments for closing that loophole, Congress has had little appetite to do so until quite recently. In this time of proposed tax reform, it remains to be seen whether Congress will take up any of the legislative proposals discussed above.
Footnotes
1 The term "loophole" generally connotes a frustration of the intent of the law, which is the subject of the section headed "How Did We Get Here?"
2 This discussion disregards the alternate valuation date provided for under Sec. 2032.
3 See Glenshaw Glass Co., 348 U.S. 426 (1955).
4 See New York Trust Co. v. Eisner, 256 U.S. 345 (1921), and its progeny.
5 In addition to its more obvious purpose: preserving gain for income tax purposes.
6 See Secs. 671-679.
7 See Ricks, "I Dig It, But Congress Shouldn't Let Me: Closing the IDGT Loophole," 36 ACTEC L.J. 641, 644 (2010) "The key to the IDGT tax-planning strategy is the misalignment between the grantor trust rules' and the estate tax's treatment of transfers to trusts. Not all retained powers listed in the grantor trust rules will cause trust assets to be included in the grantor's estate at death under §§2036–2038."
8 Sec. 675(4).
9 Rev. Rul. 2008-22, modified by Announcement 2008-46.
10 See Ascher, "The Grantor Trust Rules Should Be Repealed," 96 Iowa Law Review 885, 917 (March 2011), citing Rev. Rul. 85-13, which adopted this position. Although the Second Circuit held contrary to this ruling in Rothstein, 735 F.2d 704 (2d. Cir. 1984), there was very little agreement within the court, and the IRS openly opposed the outcome of that case in Rev. Rul. 85-13, deciding not to follow Rothstein as precedent.
11 The transfer of the stock to the IDGT is a completed gift for transfer tax purposes; the substitution power does not bring the stock back into the estate under Sec. 2036 or 2038.
12 See Rev. Proc. 2020-45, §3.41.
13 An estate tax of $4,625,800 would be imposed under Sec. 2001 on the taxable estate, which would be completely eliminated by the unified credit of $4,625,800 under Sec. 2010.
14 An estate tax of $7,945,800 would be imposed under Sec. 2001 on the taxable estate, which would be reduced by the unified credit of $4,625,800 under Sec. 2010, for a net tax payable of $3,320,000.
15 As Subpart E of Part 1 of Subchapter J of Chapter 1 of Subtitle A (then Secs. 671-678), by the Internal Revenue Code of 1954, P.L. 83-591.
16 For all taxpayers other than heads of households, who had 26 brackets covering the same range of tax rates. Secs. 1(a) and (b) in the Internal Revenue Code of 1954, P.L. 83-591.
17 Eganhouse, "Stone Turning to Sand: Grantor Trusts Have a Shaky Legal Foundation," paper, American College of Trust and Estate Counsel Foundation, at 21 (2010).
18 Ascher, "The Grantor Trust Rules Should Be Repealed," at 887.
19 Id. at 895.
20 Cunningham and Cunningham, "Tax Reform Paul McDaniel Style: The Repeal of the Grantor Trust Rules," Cardozo Legal Studies Research Paper No. 328, at 4-5 (April 6, 2011).
21 Ascher, "The Grantor Trust Rules Should Be Repealed," at 887.
22 Lucas v. Earl, 281 U.S. 111 (1930).
23 See also Helvering v. Horst, 311 U.S. 112 (1940).
24 Lucas, 281 U.S. at 115.
25 See Burnet v. Wells, 289 U.S. 670, 675 (1933): "By the creation of trusts, incomes had been so divided and subdivided as to withdraw from the government the benefit of the graduated taxes and surtaxes applicable to income when concentrated in a single ownership."
26 Eganhouse, "Stone Turning to Sand: Grantor Trusts Have a Shaky Legal Foundation," at 7.
27 Burnet, 289 U.S. at 676.
28 Revenue Act of 1924, P.L. 68-176.
29 Corliss v. Bowers, 281 U.S. 376, 378 (1930) (where the taxpayer created a trust providing income to his wife for life, with the remainder to their children. Instead of making it a complete gift, the taxpayer retained the power to revoke the trust).
30 Helvering v. Clifford, 309 U.S. 331, 339 (1940) (Justice Owen Roberts's dissent).
31 See Clifford, 309 U.S. at 334. The Court relied on Sec. 22(a) of the Revenue Act of 1934 (the predecessor to current Sec. 61), finding that "the broad sweep" of the statute's language "indicates the purpose of Congress to use the full measure of its taxing power."
32 Clifford, 309 U.S. at 337, quoting DuPont, 289 U.S. 685, 689 (1933).
33 Eganhouse, "Stone Turning to Sand: Grantor Trusts Have a Shaky Legal Foundation," at 10.
34 Id. at 9.
35 Ascher, "The Grantor Trust Rules Should Be Repealed," at 893, fn. 40, citing Kohnstamm v. Pedrick, 153 F.2d 506, 510 (2d Cir. 1945): "The test is impalpable enough at best; but if it is to be continually refined by successive distinctions, each trifling in itself, we shall end in a morass from which there will be no escape."
36 Eganhouse, "Stone Turning to Sand: Grantor Trusts Have a Shaky Legal Foundation," at 25, fn. 47, citing Morss, 159 F.2d 142 (1st Cir. 1947): "Since, in the application of the Clifford doctrine, 'no one fact is normally decisive' . . . it is not surprising that that case has given rise to a considerable volume of litigation. Courts have felt their way from case to case, drawing distinctions and invoking analogies, in an effort to give concreteness to the general proposition that a grantor of a trust remains taxable on the trust income under §22(a) [now Sec. 61] where the benefits directly or indirectly retained by him blend imperceptibly 'with the normal concepts of full ownership.'"
37 Soled, "Reforming the Grantor Trust Rules," 76 Notre Dame L. Rev. 375, 386 (2001).
38 Eganhouse, "Stone Turning to Sand: Grantor Trusts Have a Shaky Legal Foundation," at 10.
39 See Ascher, "The Grantor Trust Rules Should Be Repealed," at 907: "The grantor trust rules were developed by the Treasury, working 'under the gun,' to staunch the hemorrhage of judicial resources caused by the cannon Justice Douglas had loosed on deck just a few years earlier in Helvering v. Clifford."
40 Eganhouse, "Stone Turning to Sand: Grantor Trusts Have a Shaky Legal Foundation," at 5.
41 Soled, "Reforming the Grantor Trust Rules," at 387.
42 Id. at 388.
43 Id. at 12.
44 Tax Reform Act of 1986, P.L. 99-514; Eganhouse, "Stone Turning to Sand: Grantor Trusts Have a Shaky Legal Foundation," at 27, fn. 105, citing Huffaker and Kessel, "How the Disconnect Between the Income and Estate Tax Rules Created Planning for Grantor Trusts," 100 J. Tax'n 206 (2004).
45 Soled, "Reforming the Grantor Trust Rules," at 397. See also Akers, Blattmachr, and Boyle, "Creating Intentional Grantor Trusts," 44 Real Prop. Tr. & Est. L.J. 207, 211 (Summer 2009): "The tax savings goal no longer is achieved by avoiding grantor trust status; rather, it is achieved by obtaining grantor trust status with an 'intentional grantor trust,' and that has become a holy grail of tax and estate planning."
46 See Secs. 1(e) and (j)(2)(E).
47 Joulfaian, "Minimizing Taxes: Keeping It All in the Family" paper, SSRN, at 2 (April 1, 2018).
48 Ascher, "The Grantor Trust Rules Should Be Repealed," at 888.
49 See Rev. Proc. 2020-45. The threshold in tax year 2021 for the top rate on a return by married taxpayers filing jointly is $628,300, while the threshold for the top rate on a trust/estate return is $13,050.
50 Soled, "Reforming the Grantor Trust Rules," at 398.
51 Ascher, "The Grantor Trust Rules Should Be Repealed," at 901.
52 Soled, "Reforming the Grantor Trust Rules," at 397.
53 Id. at 397.
54 Ascher, "The Grantor Trust Rules Should Be Repealed," at 912.
55 Dell'Anno, "Tax Evasion, Tax Morale and Policy Maker's Effectiveness," 38 The Journal of Socio-Economics 988 (2009).
56 Furman, "The Concept of Neutrality in Tax Policy," testimony before the U.S. Senate Committee on Finance hearing on "Tax: Fundamentals in Advance of Reform" (April 15, 2008).
57 See Ascher, "The Grantor Trust Rules Should Be Repealed," at 936.
58 Id. at 937 (fn. 258), citing, e.g., Blattmachr, Gans, and Jacobson, "Income Tax Effects of Termination of Grantor Trust Status by Reason of the Grantor's Death," 97 J. Tax'n 149, 159 (2002) ("We believe that Congress will eventually be required to address these issues").
59 Ascher, "The Grantor Trust Rules Should Be Repealed," at 937.
60 Schmolka, "FLPs and GRATs: What to Do?," 86 Tax Notes 1473, 1490, n. 77 (March 13, 2000).
61 Ascher, "The Grantor Trust Rules Should Be Repealed," at 937.
62 Ricks, "I Dig It, But Congress Shouldn't Let Me: Closing the IDGT Loophole," at 658.
63 Id.
64 Id.
65 Id. at 662.
66 Eganhouse, "Stone Turning to Sand: Grantor Trusts Have a Shaky Legal Foundation," at 18.
67 Ricks, "I Dig It, But Congress Shouldn't Let Me: Closing the IDGT Loophole," at 660-661.
Contributor |
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| Jesse Hubers, CPA, J.D., LL.M., is a corporate and tax attorney with Williams, Parker, Harrison, Dietz & Getzen PLLC in Sarasota, Fla. For more information about this article, contact thetaxadviser@aicpa.org.
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