Texas Tech Law Review Shell Document

443

IMPLICATIONS OF TERMINATION OF GRANTOR

TRUST STATUS

Arielle M. Prangner

I. INTRODUCTION ................................................................................... 444

II. GRANTOR TRUST TREATMENT ........................................................... 446

A. Grantor Trust Rules ..................................................................... 446

1. Section 672: Definitions and Rules ....................................... 446

2. Section 673: Reversionary Interests ...................................... 447

3. Section 674: Power to Control Beneficial Enjoyment ........... 448

a. Power to Apply Income to Support Descendant ............. 449

b. Power Affecting Beneficial Enjoyment Only After

Occurrence of Event ....................................................... 449

c. Power Exercisable Only by Will ..................................... 449

d. Power to Allocate Among Charitable Beneficiaries ....... 450

e. Power to Distribute Corpus Subject to Reasonably

Definite Standard or to Advance Principal ..................... 450

f. Power to Withhold Income Temporarily ......................... 450

g. Power to Withhold Income During Disability of

Beneficiary ...................................................................... 451

h. Power to Allocate Between Principal and Income ......... 451

4. Additional Exceptions ............................................................ 451

5. Section 675: Administrative Powers...................................... 452

6. Section 676: Power to Revoke ............................................... 452

7. Section 677: Income for Benefit of Grantor .......................... 453

8. Section 678: Persons Other than Grantor Treated as

Substantial Owners ................................................................ 453

9. The Portion Rules .................................................................. 454

B. Common Types of Grantor Trusts ................................................ 455

1. Revocable Trusts ................................................................... 455

2. Grantor Retained Interest Trusts ........................................... 456

3. Spousal Lifetime Access Trusts ............................................. 457

4. Irrevocable Life Insurance Trusts ......................................... 457

5. Intentionally Defective Grantor Trusts.................................. 458

C. Termination of Grantor Trust Status ........................................... 459

III. TAX IMPLICATIONS OF TERMINATION OF GRANTOR TRUST

STATUS ............................................................................................... 460

A. Tax Reporting Requirements While Grantor Trust ...................... 460

* Attorney with Davis & Willms, PLLC in Houston, Texas. J.D., University of Texas School of

Law, 2008, with honors; B.S., Special Education, Texas A&M University, 2005, summa cum laude.

444 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

1. Filing a Form 1041 ............................................................... 460

2. Optional Reporting Methods ................................................. 461

a. One Grantor .................................................................... 461

b. More than One Grantor .................................................. 462

B. Change in Reporting After Termination of Grantor Trust

Status ............................................................................................ 463

1. EIN After Termination ........................................................... 463

2. Income Tax Reporting After Termination .............................. 464

3. Code Section 645 Election ..................................................... 465

C. Federal Income Tax Imposed at Trust Level................................ 467

1. Tax Rates ............................................................................... 468

2. Net Investment Income Tax ................................................... 468

a. Material Participation Test ............................................. 469

D. State Income Tax Implications ..................................................... 471

IV. ASSETS REQUIRING SPECIAL CONSIDERATION .................................. 472

A. S Corporation Stock ..................................................................... 472

1. Qualified Subchapter S Trusts ............................................... 473

2. Electing Small Business Trusts .............................................. 473

3. Allocation of Income from S Corporation in Year of

Termination ........................................................................... 474

B. Outstanding Promissory Notes Payable to Grantor .................... 475

1. Termination as the Result of the Grantor’s Death ................ 476

2. Termination of Grantor Trust Status During Life of

Grantor .................................................................................. 479

C. Life Insurance .............................................................................. 480

V. ACTIONS TO BE CONSIDERED BEFORE TERMINATION ........................ 481

A. Swaps of Assets with Differing Basis ............................................. 481

B. Transfer of Life Insurance to Trust .............................................. 483

C. Sale of Principal Residence ......................................................... 484

VI. CONCLUSION ...................................................................................... 485

I. INTRODUCTION

A grantor trust is a trust under which the grantor or someone other than

the grantor is treated as the “owner” of the trust assets for federal income tax

purposes under Subpart E of Part I of Subchapter J of the Internal Revenue

Code of 1986, as amended (the Code).

To the extent that a trust is treated as

a grantor trust, the grantor trust rules override the general rules of trust

taxation.

As a result, all items of income, deduction, expenses, and credits

associated with the grantor trust portion of the trust are attributed to the

grantor (or someone treated as the grantor) and are reported directly by the

grantor (or person treated as the grantor) on his or her individual income tax

. See I.R.C. § 671.

. See id.

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 445

return.

Grantor trusts can serve as an effective method for transferring

wealth from one generation to the next while minimizing transfer tax costs

and have become a popular tool among estate planning practitioners.

When grantor trust treatment is proposed, an oft-touted attribute is that

grantor trust treatment can always be “turned off,” at which point the trust

will be taxed under the general rules of trust taxation and the grantor will no

longer bear the trust’s income tax liability.

Of course, things are seldom that

easy.

Although in some cases the actual act of terminating grantor trust status

may be simple, the implications of the change are vast.

It is essential for

estate planners to have an understanding of those implications.

This article is not intended to be comprehensive with respect to grantor

trusts.

There are a multitude of articles and treatises that have been published

for that purpose.

Instead, it is meant to serve as a resource to highlight issues

that require consideration when termination of grantor trust status has

occurred, is being contemplated, or is foreseeable, and hopefully can help an

estate planner formulate a checklist of items to analyze and discuss with

clients in connection with the termination.

The article will briefly outline the grantor trust rules, common types of

grantor trusts, and termination of grantor trust status.

Income tax issues that

arise as a result of the termination will then be addressed.

In addition to

general tax implications, particular assets that may present challenges or

require additional planning will be highlighted.

Lastly, actions that may be

considered before termination of grantor trust status will be presented.

. Id.

. See generally Steve R. Akers, Planning with Grantor Trusts–Structuring a Grantor Trust to

Maximize the Benefits and Minimize the Risk, 2009 ALI-ABA 687 (detailed information on structuring

and use of grantor trusts).

. See id. at 715.

. See Zaritsky, Taxation of Trusts, Grantors, and Beneficiaries, 2021 TAX PLAN. FAM. WEALTH

TRANS. ANALYSIS FORMS ¶ 3.02[1][a] at 50–51.

. See id.

. See infra note 10 and accompanying text.

. See generally Akers, supra note 4 (comprehensive information on grantor trusts); Westfall &

Mair, Taxation of Trust Grantors, 2020 EST. PLAN. L. & TAX. ¶ 17.02 (information about grantor trusts

and related taxation).

. See infra Parts III–V.

. See infra Sections II.A–C.

. See infra Sections III.A–D.

. See infra Sections IV.A–C.

. See infra Sections V.A–C.

446 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

II. GRANTOR TRUST TREATMENT

A. Grantor Trust Rules

Termination of grantor trust status cannot be addressed without an

understanding of the grantor trust rules.

A practitioner advising a client

about termination must be familiar with the various interests or powers (the

“triggers”) that may cause grantor trust treatment in order to assess when the

treatment no longer applies.

The grantor trust rules are organized like a list of prohibited powers and

interests.

The underlying inquiry of the grantor trust rules is whether the

grantor has left so many strings attached to a trust, enjoys benefits of the trust,

or has retained so much control over the trust that it is fair that the grantor be

treated as the true owner of the trust property for income tax purposes.

1. Section 672: Definitions and Rules

Code Section 672 sets out the general definitions and rules for

implementing the subsequent sections containing the grantor trust rules.

frequently encountered concept in the grantor trust rules relates to powers

exercisable by the grantor without the consent of an “adverse party.”

adverse party is any person who has a substantial beneficial interest in the

trust that would be adversely affected by the exercise or nonexercise of the

power.

Conversely, a “nonadverse party” is any person who is not an

adverse party.

A “related or subordinate party” is any nonadverse party who is one of

the following: the grantor’s spouse (if living with the grantor); father, mother,

issue, brother, or sister; an employee of the grantor; a corporation or any

employee of a corporation in which the stock holdings of the grantor and the

trust are significant from the viewpoint of voting control; or a subordinate

employee of a corporation in which the grantor is an executive.

The concept

. See I.R.C. §§ 673–77.

. See Jeffrey N. Pennell, Income Tax Consequences on Death of Grantor or Otherwise

Termination of Grantor, 2015 ALI-CLE 31.

. See I.R.C. §§ 672–77.

. See Ellen K. Pittman, Planning with Grantor Trusts, 2004 ALI-ABA 513, at 522.

. See I.R.C. § 672.

. See, e.g., id. §§ 674(a) (general rule for power to control beneficial enjoyment), 675(1)–(2)

(administrative powers to (1) deal for less than adequate and full consideration; and (2) power to borrow

without adequate interest or security), & 677 (income for benefit of grantor).

. Id. § 672(a).

. Id. § 672(b).

. Id. § 672(c).

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 447

of a related or subordinate party is integral to determining whether a trustee

is independent.

Code Section 672(d) makes clear that even if the exercise of a power is

subject to a requirement that notice be given or if it takes effect only on the

expiration of a certain period of time after the exercise, the person in question

will still be considered to have the power for purposes of the grantor trust

rules.

The rule in Code Section 672(e) is frequently referred to as the “spousal

attribution” or “spousal unity” rule and was added to the Code in 1986.

provides that a grantor is treated as holding any power or interest held by the

grantor’s spouse, if the spouse was married to the grantor at the time of the

creation of such power or interest.

The grantor will also be treated as

holding a power or interest held by a person who becomes the spouse of the

grantor after the creation of the power, but only with respect to the periods

after the marriage.

Accordingly, for transfers made to a trust after March 1,

1986, when reading the grantor trust rules, every reference to the “grantor”

can effectively be read “grantor or the grantor’s spouse.”

However, for

purposes of the spousal attribution rule, an individual legally separated from

his or her spouse under a decree of divorce of separate maintenance is not

considered to be married.

Lastly, in general, only a U.S. citizen, resident, or domestic corporation

will be taxable as the owner of a trust under the grantor trust rules.

2. Section 673: Reversionary Interests

If the grantor creates a trust but retains a reversionary right to the

property when the trust terminates, the trust may be treated as a grantor trust

under Code Section 673.

If the transfer to the trust was made after March

1, 1986, the grantor is treated as the owner of any portion of a trust in which

the grantor has a reversionary interest in either the corpus or the income

therefrom, if, as of the inception of that portion of the trust, the value of such

interest exceeds five percent (5%) of the value of such portion.

For transfers

made to the trust on or before March 1, 1986, the grantor was treated as the

. Compare I.R.C. § 674(c) (prevents application of I.R.C. § 674(a) if the power is solely

exercisable by a trustee or trustees, none of whom is the grantor, and not more than half of whom are

related or subordinate parties who are subservient to the wishes of the grantor), with I.R.C. § 675(3)

(provides a similar exception with respect to a loan to the grantor of trust funds).

. See id. § 672(d).

. See Act of Oct. 22, 1986, P.L. 99-514, § 1401, 100 Stat. 2085, I.R.C. § 672(e).

. See I.R.C. § 672(e)(1)(A).

. See id. § 672(e)(1)(B).

. See id.

. See id. § 672(e)(2).

. See id. § 672(f).

. See id. § 673(a).

. See id.

448 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

owner of the trust unless the reversionary interest would not vest in present

possession within a term of ten years or within the life of the income

beneficiary.

As a result of the prior rule, many trusts created when it was in

effect were structured to last for some period longer than ten years (e.g., ten

years and one day or eleven years).

In most cases, the event triggering the reversion will be something like

the death of a person, such as the beneficiary of a trust.

In such events, the

value of the reversion can be determined actuarially.

Code Section 2037

incorporates a similar five percent test, so presumably a reversion under Code

Section 673 would be valued the same way, using the Code Section 7520 rate

and actuarial tables.

However, in this low interest rate environment, there

is no way for a grantor to retain any significant reversion without triggering

grantor trust treatment.

Code Section 763(b) provides an additional safe

harbor if the reversion occurs because of the death of a lineal descendant who

holds all of the present interest in any portion of the trust before the

descendant attains age twenty-one.

In such a scenario, however, the trust

would likely be excepted from grantor trust treatment under the five percent

rule anyway, based on the likelihood of the lineal descendant dying before

attaining age twenty-one.

3. Section 674: Power to Control Beneficial Enjoyment

The general rule of Code Section 674 is that that the grantor will be

treated as owner of any portion of the trust in respect of which the beneficial

enjoyment of the corpus or the income therefrom is subject to a power of

disposition, exercisable by the grantor or a nonadverse party (acting without

approval or consent of any adverse party).

A power of disposition includes

any power that can affect the beneficial enjoyment of the trust property.

Nearly all trusts permit trustees to control beneficial enjoyment of trust

property without the consent of the beneficiaries, but Code Section 674

outlines several broad exceptions that, while technically powers of

. For the effective date of the change from the ten-year rule to the five percent test, see P.L. 99-514,

§ 1402(c), 100 Stat. 2085 (1986).

. See Stephen T. Dyer, Planning with Grantor Trusts, SALT LAKE EST. PLAN. COUNCIL Nov. 15

(2018), https://www.saltlakeestateplanners.org/assets/Councils/SaltLake-UT/library/Dyer-SLEPC%2020

18%20Outline-Planning%20With%20Grantor%20Trusts.pdf [https://perma.cc/GW6N-WPBX].

. Jeffrey D. Scibetta, Grantor Trusts Explained: Trusts You Can’t Trust, KNOX LAW (Oct. 2017),

https://www.kmgslaw.com/knox-law-institute/publications/grantor-trusts-explained-trusts-you-cant-trust

[https://perma.cc/JC26-E4HN].

. See id.

. See I.R.C. § 673(b).

. See Scibetta, supra note 37.

. See I.R.C. § 674(a).

. See Treas. Reg. § 1.674(a)-1(a) (1960).

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 449

disposition, will not cause the trust to be treated as a grantor trust.

The

excepted powers that will not trigger grantor trust treatment are outlined in

the following sections.

a. Power to Apply Income to Support Descendant

A power in the trustee or the grantor, acting in a fiduciary capacity,

allows the use or apply trust income to discharge the grantor’s legal

obligation of support.

However, grantor trust treatment will apply to the

extent the trust income is actually used to discharge the support obligation

under Code Section 677(b), as discussed below.

b. Power Affecting Beneficial Enjoyment Only After Occurrence of Event

A power to affect the beneficial enjoyment of the trust property that only

arises after the occurrence of an event, but only to the extent the power is

postponed for a period which, were it a reversionary interest, would be less

than five percent of the value of the trust under Code Section 673.

c. Power Exercisable Only by Will

A power exercisable only in a person’s Will, unless the power is to

appoint income that has been accumulated for such disposition by the grantor

or may be so accumulated in the discretion of the grantor or a nonadverse

party without the consent or approval of any adverse party.

Thus the grantor

may retain a testamentary power of appointment over the trust principal (but

not income) without causing grantor trust status.

However, if a trust

instrument provides that the income is payable to another person for the life

of the grantor, but the grantor retains a testamentary power of appointment

over the remainder, and under the trust instrument and local law capital gains

are added to the corpus, the grantor is treated as the owner of a portion of the

trust and capital gains and losses are included in that portion.

In addition, if

the grantor is able to appoint the trust principal to the grantor’s creditors or

to the grantor’s estate, the power could be deemed to be a reversionary

interest causing grantor trust treatment under Code Section 677(a) discussed

below.

. See I.R.C § 674(b).

. See infra Sections II.A.3.a.–h.

. See I.R.C. § 674(b)(1).

. See id.

. See id. § 674(b)(2).

. See id. § 674(b)(3).

. See id.

. See Treas. Reg. § 1.674(b)-1(b)(3) (1960).

. See id.

450 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

d. Power to Allocate Among Charitable Beneficiaries

A power to determine beneficial enjoyment of the corpus or the income

if such corpus or income is irrevocably payable to a charitable beneficiary for

a charitable purpose as described in Code Section 170(c) or in an employee

stock ownership plan in a qualified gratuitous transfer.

e. Power to Distribute Corpus Subject to Reasonably Definite Standard or

to Advance Principal

A power to distribute corpus to or for a beneficiary or beneficiaries or

to or for a class of beneficiaries (whether or not income beneficiaries)

provided that the power is limited by a reasonably definite standard set out

in the trust instrument (often referred to as an “ascertainable standard”).

ascertainable standard includes the power to distribute corpus for the

education, support, maintenance, or health of the beneficiary; for the

beneficiary’s reasonable support and comfort; or to meet an emergency of

the beneficiary.

Additionally, a power to make distributions to current

income beneficiaries when such distributions are charged against those

beneficiaries’ proportionate shares of the trust principal.

If, however, the

grantor or a nonadverse party has one of the powers listed above and any

person has the power to add beneficiaries of the trust other than after-born or

after-adopted children, then the trust will be treated as a grantor trust.

f. Power to Withhold Income Temporarily

A power to distribute or apply income to or for any current income

beneficiary or to accumulate income for the beneficiary, provided that any

accumulated income must ultimately be payable to the beneficiary, to the

beneficiary’s estate, to the beneficiary’s appointees subject to a power of

appointment (provided the power of appointment does not exclude from the

class of possible appointees any person other than the beneficiary, his estate,

his creditors, or the creditors of his estate); or, on the termination of the trust,

or with current principal distributions, to the current income beneficiaries in

shares irrevocably specified in the trust instrument.

This exception does not

apply if any person has a power to add beneficiaries to the trust other than

after-born or after-adopted children.

. See I.R.C. § 674(b)(4).

. See id. § 674(b)(5)(A).

. See Treas. Reg. 1.674(b)-1(b)(5)(i) (1960).

. See I.R.C. § 674(b)(5)(B).

. See id. § 674(b)(5).

. See id. § 674(b)(6).

. See id.

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 451

g. Power to Withhold Income During Disability of Beneficiary

A power to withhold income from a beneficiary during the existence of

any legal disability or until the beneficiary reaches the age of twenty-one.

This exception does not apply if any person has a power to add beneficiaries

to the trust other than after-born or after-adopted children.

Note that if the

income is accumulated under this Section, it is not necessary that the

accumulated income ultimately paid to the beneficiary as with the exception

under Code Section 674(b)(6).

The income may be added to corpus and

eventually paid to other beneficiaries.

h. Power to Allocate Between Principal and Income

A power to allocate receipts and disbursements as between corpus and

income, even if expressed in broad language.

4. Additional Exceptions

In addition to the exceptions listed above, the general rule of Code

Section 674(a) will not apply if an “independent” trustee has the power to

distribute, apportion, or accumulate income to or for a beneficiary or

beneficiaries, or to, for, or within a class of beneficiaries, or to pay out corpus

to or for a beneficiary or beneficiaries or to or for a class of beneficiaries

(whether or not income beneficiaries).

The trustee is independent so long

as it is not the grantor and if no more than half of the trustees are related or

subordinate parties who are subservient to the wishes of the grantor.

Again,

this exception does not apply if any person has a power to add beneficiaries

to the trust other than after-born or after-adopted children.

Another exception exists for trustees other than the grantor and the

grantor’s spouse.

Grantor treatment will not apply if a trustee (without the

approval or consent of any other person) holds the power to distribute,

apportion, or accumulate income to or for a beneficiary; in addition, grantor

treatment will not apply if the power is limited by an ascertainable standard.

As with most exceptions to the general rule of Code Section 674, this

. See id. § 674(b)(7)(A), (B).

. See id. § 674(b)(7).

. See id.

. See Treas. Reg. § 1.674(b)-1(b)(7) (1960).

. See I.R.C. § 674(b)(8).

. See id. § 674(c).

. See id.

. See id. § 674(d).

452 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

exception does not apply if any person has a power to add beneficiaries to the

trust other than after-born or after-adopted children.

5. Section 675: Administrative Powers

Under Code Section 675, a trust is treated as a grantor trust if certain

administrative powers are present.

These prohibited powers include a

power in the grantor or a nonadverse party (without the consent of an adverse

party) to purchase, exchange, or otherwise deal with, dispose of, or exchange

either income or principal for less than full and adequate consideration.

power exercisable by the grantor or a nonadverse party, or both, that enables

the grantor to borrow from the trust without adequate interest or security will

also cause grantor trust treatment, unless a trustee other than the grantor may

do so if authorized under a general lending power to make loans to any person

without regard to interest or security.

Additionally, the actual borrowing,

whether directly or indirectly, of any portion of the trust by the grantor that

has not completely been repaid, including any interest, before the beginning

of the taxable year will trigger grantor trust status, unless the loan is made for

adequate interest and security and is made by an independent trustee.

Lastly, any of the following powers in the grantor or a nonadverse party

(without the consent of the trustee) acting in a nonfiduciary capacity will

trigger grantor trust status: the power to vote or direct voting in a corporation

in which the aggregate holdings of voting stock by the grantor and the trust

are “significant;” the power to control the investment of the trust funds by

directing investments or vetoing proposed investments, to the extent that the

trust holds securities in a corporation in which the aggregate holdings of

voting stock by the grantor and the trust are “significant;” and the power to

reacquire the trust corpus by substituting property of equivalent value.

6. Section 676: Power to Revoke

If the grantor or any other nonadverse person retains the power to revest

the title to the trust assets in the grantor, then Code Section 676 provides that

the trust will be treated as a grantor trust.

Under the law of most states, a

trust by default is irrevocable, but this is not universally the case.

For

. See id.

. See id. § 675.

. See id. § 675(1).

. See id. § 675(2).

. See id. § 675(3).

. See id. § 675(4)(A)–(C).

. See id. § 676.

. Legal Match, Revocation and Modification or Irrevocable Trusts, LEGAL MATCH, www.legalma

tch.com/law-library/article/revocation-and-modification-of-irrevocable-trusts.html (last visited Feb. 1,

2021) [https://perma.cc/U3ZS-UANY].

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 453

example, under Texas law a grantor may revoke the trust unless it is made

irrevocable by the express terms of the instrument creating it.

7. Section 677: Income for Benefit of Grantor

Code Section 677 imposes grantor trust treatment when the income of a

trust, may be, or actually is, used either directly or indirectly for the benefit

of the grantor or the grantor’s spouse.

Also, grantor trust status results if

income, without the consent of an adverse party or at the discretion of the

grantor and nonadverse party, is distributed to the grantor or the grantor’s

spouse;

held or accumulated for future distribution to the grantor or the

grantor’s spouse;

or used to pay premiums on life insurance on the life of

the grantor or the grantor’s spouse.

Generally, if a trustee has the discretion

to distribute or accumulate the trust income in order to discharge a legal

obligation of the grantor or the grantor’s spouse, then the grantor trust status

will be imposed; however, Code Section 677(b) provides an exception to this

rule by limiting application of grantor trust status to the amount that income

is actually so applied or distributed.

8. Section 678: Persons Other than Grantor Treated as Substantial Owners

Code Section 678 acts to confer grantor trust status on persons other

than the grantor of the trust.

A trust will be deemed to be a grantor trust as

to a person if the person has the power, exercisable solely by the person, to

vest income in the trust corpus in the person alone.

Note that if such a power

is held in conjunction with another person, even if that person is not an

adverse party, grantor trust treatment will not be invoked.

A trust will also

be deemed to be a grantor trust as to a person if the person has previously

partially released or modified a power exercisable solely the person to vest

the corpus or the income the person alone, and after the release or

modification retains such control as would, within the principals of Code

Sections 671-677, subject a grantor of a trust to treatment as the owner

thereof.

A common source for exposure under Code Section 678 is when a

beneficiary is given a Crummey withdrawal right over gifts to a trust to ensure

that the beneficiary has a present interest in the gift in order to qualify for a

. See TEX. PROP. CODE ANN. § 112.051(a).

. See I.R.C § 677(a).

. See id. § 677(a)(1).

. See id. § 677(a)(2).

. See id. § 677(a)(3).

. See id. § 677(b).

. See id. § 678(a).

. See id. § 678(a)(1).

. See id.

. See id. § 678(a)(2).

454 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

federal gift tax annual exclusion under Code Section 2503(b), and the

withdrawal right is not exercised and lapses.

Treasury Regulation Section 1.678(a)-1(b) provides that Code Section

678(a)(1) imposes grantor trust status if a person has a power exercisable

solely by the person to apply the income or corpus for the satisfaction of the

person’s legal obligations, other than an obligation to support a dependent.

This rule is similar to the one that would cause grantor trust status to the

grantor under Code Section 677.

However, similar to the exception in Code

Section 677(b), if a person is acting in the capacity of trustee or co-trustee, a

power to apply the income of the trust to the support or maintenance of a

person whom the holder of the power is obligated to support or maintain will

give rise to grantor trust treatment only to the extent of amounts actually

applied for those purposes.

Notwithstanding the foregoing, a person will not be treated as the

grantor under Code Section 678(a) if such person’s power under Code

Section 678(a) is a power of income and if the grantor of the trust is treated

as the owner of the trust under Code Sections 671-677.

Code Section 678(d) provides for another exception to the rules

applicable under Code Section 678(a) if the power holder renounces or

disclaims the tainted power within a “reasonable time” after the power holder

becomes aware of its existence.

However, it should be noted that neither

the statute nor the regulations define the term “reasonable time.”

9. The Portion Rules

Grantor trust treatment may not apply with respect to an entire trust.

Depending upon the specific trigger that causes the grantor trust treatment,

the portion of the trust that is affected may vary.

Some triggers cause us to

treat the entire trust as a grantor trust (e.g., the revocation power under Code

Section 676), some cause the trust to only be a grantor trust as to fiduciary

accounting income (e.g., if the grantor or nonadverse party has unrestricted

. See id. §§ 678, 2503(b).

. See Treas. Reg. § 1.678(a)-1(b) (1960).

. Compare Treas. Reg. § 1.678(a)-1(b) (imposes grantor trust status on person with sole

exercisable power to apply the income or corpus for the satisfaction of the person’s legal obligations, other

than an obligation to support a dependent), with I.R.C. § 677 (causes grantor trust status whose income

may be distributed, held, or applied, without approval of adverse party).

. See I.R.C. § 678(c).

. See id.

. See id. § 678(d).

. See id. § 672.

. See Jeanne L. Newlon, Developments Involving Grantor Trusts, VENABLE LLP (Jan. 29, 2021,

2:39 PM), https://www.venable.com/-/media/files/publications/2010/08/developments-involving-grantor

-trusts/files/developments-involving-grantor-trusts/fileattachment/newlongrantor_trusts.pdf [https://perm

a.cc/QF2F-2WHM].

. See id.

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 455

powers over income under Code Section 674(a) and no exceptions apply),

some cause grantor trust treatment only as to principal, and some cause the

trust to be a grantor trust as to a fraction of the income or corpus (e.g., if the

grantor retains a right to a portion of the corpus or a reversion of a portion of

the corpus).

Additionally, grantor trust status can be applied to both income

and principal and to specific assets of the trust (e.g., if a grantor retains the

right to substitute particular assets under Code Section 675(4)).

Treasury

Regulation Section 1.671–3 discusses the so-called “portion rules.”

100

However, in many instances application of the portion rules is not

straightforward. It is generally desirable for a trust to be a grantor trust as to

the entirety of the trust, and this article will focus on trusts that are “wholly

owned” grantor trusts.

101

B. Common Types of Grantor Trusts

Any trust can be a grantor trust if a power or interest that would cause

grantor trust status applies to the trust.

102

However, there are several types of

trusts that are consistently structured as grantor trusts.

103

1. Revocable Trusts

The defining feature of revocable trusts, which are often used to avoid

probate and for disability planning, is the grantor’s power to revoke the trust,

and thus causes grantor trust treatment under Code Section 676(a).

104

Generally revocable trusts also provide that income of the trust may be

payable to the grantor, which causes grantor trust treatment under Code

Section 677.

105

It is important to note that a trust may be revocable by the

trust instrument’s express terms.

106

For example, Texas law provides that a

trust is revocable unless made irrevocable by the express terms of the trust

instrument.

107

Revocable trusts are typically not used for transfer tax

avoidance.

108

Because the trust is revocable, contributions to the trust are not

. See I.R.C §§ 676, 674(a). Note any reference to “ordinary income” in Subpart E of Subchapter

J of the Code means “fiduciary accounting income.” Treas. Reg. § 1.671-2(b).

. See I.R.C § 675(4).

100

. See Treas. Reg. § 1.671-3.

101

. See infra Section II.B.

102

. See Scibetta, supra note 37.

103

. See id.

104

. See I.R.C. § 676(a).

105

. See id. § 677.

106

. See Travis Peeler, Types of Trusts, LEGALMATCH (Jan.29, 2021, 2:00 PM), https://www.legal

match.com/law-library/article/types-of-trusts.html [https://perma.cc/HSR7-ZKFB].

107

. See TEX. PROP. CODE ANN. § 112.051(a).

108

. See The Benefits and Shortcomings of Revocable Trusts, FIDUCIARY TR. INT’L (Jan 29, 2021,

2:00 PM), https://www.fiduciarytrust.com/insights/commentary?commentaryPath=templatedata/gw-con

tent/commentary/data/en-us/en-us-ftci/trust-estate/benefits_and_shortcomings_of_revocable_trusts&co

456 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

completed gifts for gift tax purposes, and at the grantor’s death the assets are

included in the grantor’s gross estate for federal estate tax purposes.

109

2. Grantor Retained Interest Trusts

Several trusts in the estate planner’s toolkit involve irrevocable trusts in

which the grantor retains some interest for a term of years, during which the

trust is taxed as a grantor trust.

110

At the end of the term, unless another

grantor trust trigger applies, the grantor trust terminates.

111

Grantor retained annuity trusts (“GRATs”), grantor retained unitrusts

(“GRUTs”), and grantor retained interest trusts (“GRITs”) all operate

similarly.

112

The grantor creates the trust and provides that for a specified

term of years, an amount is paid to the grantor each year, either in the amount

of a fixed sum (in the case of a GRAT), a fixed percentage of the trust corpus

(in the case of a GRUT), or income of the trust (in the case of a GRIT).

113

The value of the initial gift to the trust for gift tax purposes is only the

remainder interest.

114

If the grantor survives the term of the trust, any

remaining assets in the trust pass to the remainder beneficiaries free of

additional gift tax, and the grantor excludes it from their taxable estate.

115

Generally, GRATs, GRUTs, and GRITs are taxed as grantor trusts under

Code Sections 673(a) or 677 for the specified term of years.

116

However, it is

not uncommon for these trusts to contain an additional grantor trust trigger

for the grantor to include to ensure their trust treatment after the term of years

expires.

117

When a qualified personal residence trust (“QPRT”) is created, the

grantor transfers a residence or portion of a residence into the trust, reserving

the right to occupy the residence rent-free for a specified term of years.

118

Any income of the trust must be distributed to the grantor not less frequently

mmentaryType=TRUST%20&%20ESTATE%20PLANNING [https://perma.cc/MT76-HM4U].

109

. See id.

110

. See Newlon, supra note 96.

111

. See id.

112

. See Garrett Ham, GRATs and GRUTs, GARRETTHAM.COM (Jan. 29, 2021, 2:57 PM), https://

www.garrettham.com/grats-gruts/ [https://perma.cc/6AKH-F9RG].

113

. See id.

114

. See I.R.C. § 2702(a)(2)(A)–(B). To qualify for this treatment, a GRAT must meet the

requirements set out in Treasury Regulation Sections 25.2702-3(b) and (d) and a GRUT must meet the

requirements set out in Treasury Regulation Sections 25.2702-3(c) and (d). See Treas. Reg. § 25.2702-3.

Note, however, that for a GRIT, if the remainder beneficiary is a member of the grantor’s family as defined

in Treasury Regulation Section 25.2702-2(2), then the retained interest will be valued at zero because it

is not a “qualified interest” and accordingly the value taxed for gift tax purposes will be the entire value

of the amount contributed to the trust. See I.R.C. § 2702(a)(2)(A).

115

. See supra note 114 and accompanying text.

116

. See I.R.C. §§ 673(a), 677.

117

. Julia Kagan, Grantor Trust Rules, INVESTOPEDIA (Jan. 29, 2021, 2:21 PM), https://www.

investopedia.com/terms/g/grantortrustrules.asp [https://perma.cc/YWF2-3ZHF].

118

. See Treas. Reg. § 25.2702-5(c)(3).

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 457

than annually.

119

At the time of the transfer to trust, only the value of the

remainder interest is taxed for gift tax purposes (if the QPRTs meets the

requirements set out in Treasury Regulation Section 25.2702–5(c)).

120

At the

expiration of the term, the property is transferred to the remainder

beneficiaries without additional gift tax consequences, and the value is

excluded from the grantor’s taxable estate at death.

121

A QPRT will generally

be taxed as a grantor trust under Code Sections 673(a) or 677 for the specified

term of years.

122

3. Spousal Lifetime Access Trusts

A spousal lifetime access trust (“SLAT”) is a trust created by one spouse

(the “donor spouse”) for the benefit of the other spouse (the “beneficiary

spouse”).

123

The trust can also be structured to benefit persons other than the

beneficiary spouse, such as children or other descendants.

124

The donor

spouse uses his or her gift tax exemption to make a gift to the SLAT.

125

While

the donor spouse gives up his or her right to the property transferred to the

trust, the beneficiary spouse maintains access to the property, and

accordingly, the donor spouse may indirectly benefit.

126

If structured

correctly, the value of the SLAT is excluded from the done spouse’s taxable

estate at death.

127

SLATs are generally grantor trusts under Code Section

677.

128

4. Irrevocable Life Insurance Trusts

An irrevocable life insurance trust (“ILIT”) is an irrevocable trust

created during the life of an insured to own insurance on the life of the

insured.

129

If drafted and administered properly, the proceeds of the life

insurance are not included in the insured’s gross estate for federal estate tax

purposes, thereby allowing the full amount of the policy proceeds to pass to

119

. See id.

120

. See id. § 25.2702-5(c)(3).

121

. See id.

122

. See I.R.C §§ 673(a), 677.

123

. See Joylyn Ankeney, Marcy Lantz, Unprecedented Opportunities in Gift Planning, TAX

ADVISER (Jan. 29, 2021, 12:12 PM), https://www.thetaxadviser.com/issues/2020/dec/opportunities-gift-

planning.html [https://perma.cc/S6L8-FKPV].

124

. See id.

125

. See id.

126

. See Wealth Strategy: Spousal Lifetime Access Trusts (SLATs), CALAMOS WEALTH MGMT. (Jan.

29, 2021, 12:19 PM), https://wm.calamos.com/newsinsights/wealth-strategy-insights/spousal-lifetime-

access-trusts-slats/ [https://perma.cc/XT7A-7G8V].

127

. See I.R.C. § 677(b).

128

. See id. § 677.

129

. See C. Daniel Yates & Michael O. Chenoweth, Estate Planning: The Use of Irrevocable Life

Insurance Trusts, 23 IND. L. REV. 517, 517 (1990).

458 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

the beneficiaries of the trust free of estate taxes.

130

ILITs are generally treated

as grantor trusts under Code §677(a)(3).

131

5. Intentionally Defective Grantor Trusts

An intentionally defective grantor trust (“IDGT”) would not otherwise

be taxed as a grantor trust but for the intentional inclusion of a trigger that

causes grantor trust status.

132

The goal of an IDGT is for the grantor to be

treated as the owner of the trust for income tax purposes, but not treated as

the owner for gift, estate, or generation-skipping transfer tax purposes.

133

When the grantor pays income tax that would otherwise be owed by the

trust, the grantor can essentially make additional tax-free gifts to the trust,

thus decreasing the value of the grantor’s gross estate and increasing the

amount available to the beneficiaries of the trust.

134

When the trust assets do

not have to be used to cover income tax liability, they can appreciate faster

than they would have if the tax was paid directly from the trust.

135

Moreover, since the sale of property from a grantor to a grantor trust

will not give rise to gain since the grantor and trust are treated as being the

same person, additional estate planning opportunities are available.

136

For

example, a grantor may sell assets to a grantor trust with no gift tax and no

income tax consequence.

137

The transaction can be structured as an

installment sale, so that income of the trust can be used to pay the trust’s

obligation to the grantor.

138

Again, because the grantor and trust are treated

as being the same person, any interest payments from the trust to the grantor

are ignored for federal income tax purposes.

139

This type of sale can

effectively shift wealth to the beneficiaries of the trust, since the amount

includable in the grantor’s estate is a promissory note with a fixed value,

while the trust receives assets that may appreciate in value.

140

For these

reasons, IDGTs are popular implements and are frequently recommended to

clients by estate planning practitioners.

141

130

. See id. at 519–20.

131

. See I.R.C. § 677(a)(3).

132

. See Nicole Hart, What is an Intentionally Defective Grantor Trust (IDGT)?, WEALTHSPIRE (Jan.

27, 2020), https://www.wealthspire.com/guides-whitepapers/intentionally-defective-grantor-trusts-idgt/

[https://perma.cc/63E7-4JTW].

133

. See id.

134

. See id.

135

. See id.

136

. See Rev. Rul. 85-13, 1985-1 CB 184.

137

. See Hart, supra note 132.

138

. See Lou Vlahos, Sale to IDGTs: The Death of the Grantor, FARRELLFRITZ ATTY’S (Aug. 17,

2015), https://www.taxlawforchb.com/2015/08/sale-to-idgts-the-death-of-the-grantor/ [https://perma.cc/

H7RB-EMS5].

139

. See Hart, supra note 132.

140

. See id.

141

. See id.

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 459

Another attribute of IDGTs is that the grantor trust trigger that is used

to activate grantor trust status is generally one that can be “turned off” if the

grantor so desires.

142

At some point it may become too burdensome for the

grantor to continue paying the income tax liability for the trust or the grantor

may desire to terminate the grantor trust status for some other reason.

143

When the goal is to cause grantor trust status without estate tax

inclusion, the following are a few commonly used grantor trust triggers:

power to add charitable beneficiaries under Code Section 674(b)(4), power

to reacquire assets under Code Section 675(4)(C), and power to lend trust

assets to the grantor under Code Section 675(2).

144

C. Termination of Grantor Trust Status

In some cases, it may not be possible to convert a grantor trust to a

nongrantor trust during the grantor’s lifetime.

145

When it is possible,

termination of grantor trust status can happen in a variety of ways depending

upon the trigger causing grantor trust status.

146

The change in status may be

intentional or unintentional; it may be inevitable, or it may be planned.

147

In some events, as in the case with a revocable trust, grantor trust

treatment will cease because of the death of the grantor.

148

For other trusts,

the change will occur upon the happening of an event such as the expiration

of a term of years during which provisions of the trust resulted in grantor trust

treatment (e.g., a GRAT or a QPRT).

149

In yet other instances, grantor trust

status will terminate as the result of changing trustees such that the new

trustee is an independent trustee who may have the grantor trust causing

power without causing grantor trust status.

150

Turning off the grantor trust

status will sometimes be as easy as a release of the power or beneficial

interest that caused the grantor trust treatment (e.g., releasing a power to

reacquire trust property under Code Section 675(4)(C)), or payment of an

outstanding loan by the grantor before the start of the trust’s taxable year

(thus avoiding grantor trust treatment under Code Section 675(3)).

151

142

. See Walter Q. Impert, A Review of Grantor Trusts, DORSEY & WHITNEY, L.L.P. (2014),

https://www.dorsey.com/~/media/Files/NewsResources/Publications/2014/11/A-Review-of-Grantor-Tru

sts_2014Fall5_Walter_Impert [perma.cc/S35K-KSQL].

143

. See id. at 9.

144

. See I.R.C §§ 674(b)(4), 675(4)(C), 675(2).

145

. See Impert, supra note 142, at 9.

146

. See id.

147

. See id.

148

. See id.

149

. See id. at 12–13.

150

. See, e.g., I.R.C. § 674(c) (exception for certain powers of independent trustees).

151

. See id. §§ 675(3) & 675(4)(C) (In instances where grantor trust status can be turned “off,” it can

often be turned back “on” again. However, a discussion about the effect of this kind of “toggling” is

outside the scope of this article).

460 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

In many circumstances, in order to determine how to terminate grantor

trust status or whether grantor trust status has been terminated, it is necessary

to be familiar with the trust instrument, the parties involved and their

relationships to each other, and specific circumstances surrounding the trust,

its assets, and its administration.

152

III. TAX IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS

A. Tax Reporting Requirements While Grantor Trust

During the time it is treated as a grantor trust, a trust may be reporting

income to the IRS in one of several ways.

153

The current rules for income tax

reporting requirements of grantor trusts can be found in Treasury Regulation

Section 1.671-4.

154

In some cases, a grantor trust will not be required to file

an IRS Form 1041, “U.S. Income Tax Return for Estates and Trusts.”

155

grantor trust may not even be required to obtain a taxpayer identification

number (“EIN”).

156

However, once the grantor trust status has terminated, its

reporting method, and even its EIN, if any, may change.

157

The way it will

change will depend on the manner in which the trust was reporting income

before the termination, the type of trust, and how the grantor trust status

terminated.

158

1. Filing a Form 1041

The general method of income tax reporting for a trust is that the trustee

files a Form 1041.

159

If the trust is treated as a grantor trust as to any portion

of the trust, the items of income, deduction, or credit attributable to the

portion of the trust that is treated as being owned by the grantor or another

person are not reported on the Form 1041, but are shown on a separate

statement to be attached to that form.

160

If a grantor trust uses this traditional

reporting method and files a Form 1041, it will already have a tax

identification number.

161

152

. See Impert, supra note 142, at 9.

153

. See Treas. Reg. § 1.671-4 (2006).

154

. See id.

155

. See id. § 1.671-4(a).

156

. See id. § 1.671-4(b)(2).

157

. See id. § 1.671-4(h)(2).

158

. See id.

159

. See I.R.C. § 6012(a)(4).

160

. See Treas. Reg. § 1.671-4(a).

161

. See id.

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 461

2. Optional Reporting Methods

However, the Treasury regulations provide for alternate reporting

methods that may be used in the case of “[a] trust all of which is treated as

owned by one or more grantors or other persons and that is not one of the

following: (i) a common trust fund as defined in Code Section 584(a); (ii) a

trust that has its situs or any of its assets located outside of the United States;

(iii) a trust that is a qualified subchapter S trust; (iv) a trust all of which is

treated as owned by one grantor or other person whose taxable year is a fiscal

year; (v) a trust all of which is treated as owned by one grantor or one other

person who is not a United States person; or (vi) a trust all of which is treated

as owned by two or more grantors or other persons, one of whom is not a

United States person.

162

A trust treated as being owned by one grantor or

other person who is an exempt recipient for information reporting purposes

is also prohibited from utilizing the reporting methods in the Treasury

regulation.

163

However, under certain circumstances a trust treated as owned

by two or more grantors or other persons, one or more of whom are exempt

recipients may use the reporting method.

164

If one of the optional methods of

reporting is used, the trust is not required to file a Form 1041.

165

The optional reporting methods that are available depend on whether

the trust is treated as owned by only one person or by more than one person.

166

For these purposes, a married couple who files jointly under Code Section

6013 is considered to be owned by one grantor.

167

a. One Grantor

A trust treated as owned by one grantor or one other person can use one

of two optional methods for reporting under Treasury Regulation Section

1.671-4(b)(2).

168

The first method is referred to as “Optional Method 1” in the

instructions to Form 1041.

169

Under Optional Method 1, the trustee may

furnish the name and EIN of the grantor or other person treated as owner of

the trust and the address of the trust to each payor of income during the

taxable year.

170

If the grantor or other person treated as the owner of the trust

is not the trustee or a co-trustee of the trust, the trustee must also give the

162

. See id. § 1.671-4(b)(6).

163

. See id. § 1.671-4(b)(7)(i).

164

. See id. § 1.671-4(b)(7)(ii).

165

. See id.

166

. See id. § 1.671-4(b)(7)(ii).

167

. See id. § 1.671-4(b)(8).

168

. See id. § 1.671-4(b)(2).

169

. See Instructions for Form 1041 and Schedules A, B, G, J, and K-1, DEP’T TREASURY I.R.S.,

https://www.irs.gov/pub/irs-pdf/i1041.pdf [https://perma.cc/2VVS-YEPS].

170

. See Treas. Reg. § 1.671-4(b)(2)(i)(A).

462 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

grantor or other person a statement showing all items of income, deduction,

and credit of the trust for the taxable year; identifying the payor of each item

of income; providing the information necessary to take the items into account

in computing that person’s taxable income; and informing the grantor or

other person treated as the owner that the items of income, deduction, and

credit and other information shown on the statement must be included in

computing the taxable income and credits of that person on his or her income

tax return.

171

The trustee does not need to file anything with the IRS.

172

Optional Method 1 is utilized, the trust does not have to obtain a tax

identification number.

173

The second reporting method available for a trust treated as being owned

by one grantor or one other person is referred to as “Optional Method 2” in

the Instructions to IRS Form 1041.

174

Under Optional Method 2, the trustee

may furnish the trust’s name, EIN, and address to all payors of income during

the year.

175

The trustee must then file with the IRS the appropriate Forms

1099 reporting the income or gross proceeds paid to the trust during the

taxable year, and showing the trust as the payor and the grantor or other

person as the owner of trust as the payee.

176

Unless the grantor or the person

treated as a grantor is the trustee or a co-trustee of the trust, the trustee must

also furnish to the grantor or person treated as the grantor a statement

showing all items of income, deduction, and credit of the trust for the taxable

year; providing the information necessary to take the items into account in

computing that person’s taxable income; and informing the grantor or other

person treated as the owner that the items of income, deduction, and credit

and other information shown on the statement must be included in computing

the taxable income and credits of that person on his or her income tax

return.

177

If a grantor trust was reporting under Optional Method 2, it will

already have an EIN.

178

b. More than One Grantor

With respect to a trust all of which is treated as owned by two or more

grantors or other persons, an alternate reporting method referred to in the

Instructions to IRS Form 1041 as “Optional Method 3” is available.

179

Similar to Optional Method 2, the trustee of the trust furnishes the trust’s

name, EIN, and address to all of the payors of the trust during the taxable

171

. See id. § 1.671-4(b)(2)(ii)(A).

172

. See id. § 1.671-4(b)(2)(ii)(b).

173

. See id.

174

. See Instructions for Form 1041 and Schedules A, B, G, J, and K-1, supra note 171.

175

. See Treas. Reg. § 1.671-4(b)(2)(i)(B).

176

. See id. § 1.671-4(b)(2)(iii)(A).

177

. See id. § 1.671-4(b)(2)(iii)(B).

178

. See id.

179

. See Instructions for Form 1041 and Schedules A, B, G, J, and K-1, supra note 171.

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 463

year.

180

The trustee must then file with the IRS the appropriate Forms 1099

reporting the items of income paid to the trust attributable to the portion of

the trust treated as owned by each grantor or other person, and showing the

trust as the payor and each grantor or other person as the owner of trust as the

payee.

181

The trustee must then provide each grantor or person treated as the

grantor a statement showing all items of income, deduction, and credit of the

trust for the taxable year attributable to the portion of the trust treated as

owned by that person; providing the information necessary to take the items

into account in computing that person’s taxable income; and informing the

grantor or other person treated as the owner that the items of income,

deduction, and credit and other information shown on the statement must be

included in computing the taxable income and credits of that person on his or

her income tax return.

182

If the grantor trust was reporting under Optional

Method 3, it will already have an EIN.

183

B. Change in Reporting After Termination of Grantor Trust Status

1. EIN After Termination

If a grantor trust was utilizing the Optional Method 1 reporting method

and an EIN was never obtained for the trust, then when grantor trust status is

terminated, the trustee will be required to obtain an EIN.

184

A trustee may

obtain an EIN by completing and filing an IRS Form SS-4, “Application for

Employer Identification Number.”

185

If a trust already has an EIN and the grantor trust status terminates by

any reason other than the death of the grantor or person treated as a grantor

as to all of the trust, then after the termination of the grantor trust status, the

same EIN can continue to be used by the trust.

186

However, if a trust was wholly a grantor trust with respect to one grantor

or person treated as a grantor (the “decedent”) and the grantor trust status

terminates because of the decedent’s death, different rules apply.

187

If the

trust continues after the death of the decedent, a new EIN must be obtained

for the trust, regardless of whether the trust had previously been assigned an

EIN.

188

180

. See Treas. Reg. § 1.671-4(b)(3)(i).

181

. See id. § 1.671-4(b)(3)(ii)(A).

182

. See id. § 1.671-4(b)(3)(ii)(B).

183

. See id.

184

. See id. § 301.6109-1(a)(2)(i)(B) (2013).

185

. See EIN Assistant, I.R.S., https://sa1.www4.irs.gov/modiein/individual/index.jsp [perma.cc/9G

66-6S2Q].

186

. See Treas. Reg. § 301.6109-1 (2013).

187

. See id. § 301.6109-1(a)(3)(i).

188

. See id.

464 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

On the other hand, if only a portion of a trust was treated as being owned

by the decedent, then after the decedent’s death, the trust can continue to

report under the EIN previously used by the trust as long as the portion of the

trust treated as being owned by the decedent remains part of the original trust

and the other portions continue to be treated as being owned by the other

grantors.

189

An example of this would be a dual-grantor revocable trust for

which an EIN had already been obtained.

190

At the death of one of the

grantors, as long as the trust does not terminate, and as long as the other

grantor continues to be treated as owner of one-half of the trust under the

grantor trust rules, the same EIN can be used for the trust after the decedent’s

death.

191

2. Income Tax Reporting After Termination

In the event of the death of the grantor or person treated as the grantor

(the “decedent”), the Treasury regulations clarify that the trust or portion of

the trust treated as being owned by the decedent can continue reporting in

accordance with Treasury Regulation Section 1.671-4 for the taxable year

that ends with the decedent’s death, but may not do so for subsequent

years.

192

Although the Treasury Regulations are silent as to termination of

grantor trust status because of any reason other than the grantor’s death,

presumably the same rules apply in those circumstances.

193

In the event that the trust was reported by filing a Form 1041 with an

attached statement indicating the trust income allocable to the decedent, the

Form 1041 due for the taxable year ending with the decedent’s year of death

will be due the fifteenth day of the of the fourth month following the close of

the twelve-month period that began with the first day of the decedent’s

taxable year.

194

If the trust was deemed to be entirely owned by the decedent,

then the return must also indicate that it is the final return to be filed under

the EIN assigned during the decedent’s lifetime.

195

If the trust was reported using Optional Method 1, the trustee will need

to furnish a new Form W-9 or an acceptable substitute containing the name,

EIN, and address of the trust to all payors of income following the death of

the decedent.

196

If the trust was reported using Optional Method 2, then the

trustee must indicate on each Form 1096, “Annual Summary and Transmittal

189

. See id. § 301.6019-1(a)(3)(i)(B).

190

. See id.

191

. See id.

192

. See id. § 1.671-4(h)(2).

193

. See id. § 1.671-4 (1963).

194

. See id. §§ 1.671-4(h)(3)(i), 1.6702-1(a)(2)(i).

195

. See id. § 1.671-4(h)(3)(i).

196

. See id. § 301.6109-1(a)(3)(ii).

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 465

of U.S. Information Returns,” that it files for the last year in which that

reporting method is used, that it is the final return of the trust.

197

If before the decedent’s death the trust had been treated as owned

entirely by two or more grantors and had been filing pursuant to Optional

Method 3, the trust cannot report using that method if any portion of the trust

has a short taxable year due to the decedent’s death and the portion deemed

to have been owned by the decedent did not terminate at the decedent’s

death.

198

Continuing with the example above with respect to a dual-grantor

revocable trust, if the decedent died on any day other than the last day of the

taxable year of the trust, the portion of the trust taxed to the decedent will

have a short taxable year.

199

Accordingly, even though the trust’s pre-death

EIN can continue to be used, for that year the trust cannot report using

Optional Method 3, and would instead have to file a Form 1041.

200

After termination of grantor trust status, the trustee must start filing a

Form 1041 to report the items of income, deductions, and credits applicable

to the period after the termination.

201

Notwithstanding the foregoing, if the

trust in question is a certain kind of revocable trust and if grantor trust status

terminates because of the death of the decedent, the trust has another

option.

202

3. Code Section 645 Election

With respect to a “qualified revocable trust,” at the death of the grantor,

the trustee and the appointed executor, if any, may elect to treat the trust as

part of the decedent’s estate (and not as a separate trust) for income tax

purposes.

203

A “qualified revocable trust” is defined as a trust that, during the

life of the grantor, was treated as a grantor trust because of the grantor’s right

of revocation under Code Section 676.

204

The election must be made on the

estate’s first timely filed income tax return (including extensions), and once

the election is made, is irrevocable.

205

If an executor has been appointed, the

executor and trustee of the trust make the election by signing and filing IRS

Form 8855, “Election to Treat a Qualified Revocable Trust as Part of an

Estate.”

206

If there is no executor, the trustee of the trust files the election

form.

207

197

. See id. § 1.671-4(h)(3)(ii).

198

. See id. § 1.671-4(h)(3)(iii).

199

. See id.

200

. See id. § 1.671-4(h)(3).

201

. See id. § 1.671-4(i).

202

. See id.

203

. See I.R.C. § 645(a).

204

. See id. § 645(b).

205

. See id. § 645(c).

206

. See Treas. Reg. § 1.645-1 (1963).

207

. See id. § 1.645-1(c)(2).

466 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

Even if the so-called “645 election” is made, the trust must still obtain

a new EIN at the death of the decedent.

208

If it is anticipated that a 645 election will be made, the executor of the

decedent’s estate and the trustee of the trust may treat the trust as an “electing

trust” (one which has made a 645 election) from the decedent’s date of death

until the due date for the section 645 election.

209

In that event, the trustee is

not required to file a Form 1041 for the trust for the short taxable year

beginning with the decedent’s date of death and ending December 31st of

that year.

210

However, if the trust is treated as an electing trust from the

decedent’s date of death until the due date for the 645 election but a 645

election is ultimately not made for the trust, the trust will be subject to

penalties and interest for failing to timely file a Form 1041 and pay the tax

due thereon.

211

If a Form 1041 is filed for the short taxable year after the

decedent’s death and a 654 election is ultimately made, the trust’s Form 1041

must be amended.

212

If there is an executor of the decedent’s estate, the effect of the 645

election is that during the election period the trust is treated as part of the

related estate for all purposes of Subtitle A of the Code.

213

A single Form

1041 is filed annually under the name and EIN of the estate for the combined

electing trust and the related estate and a separate Form 1041 does not need

to be filed for the trust.

214

If there is no executor of the estate, then during the

election period the trustee treats the trust as an estate for all purposes of

Subtitle A of the Code and a Form 1041 is filed for the trust using its EIN

and treating the trust as an estate.

215

The election applies from the date of the decedent’s death until the

earlier of the day on which both the electing trust and related estate, if any,

have distributed all of their assets, or the day before the applicable date.

216

no Form 706 “United States Estate (and Generation Skipping Transfer) Tax

Return” is due, the applicable date is the day before two years after the date

of the decedent’s death.

217

If a Form 706 is required to be filed, the applicable

date is the later of the day that is two years after the date of the decedent’s

death, or the day that is six months after the date of the final determination

of the liability for estate tax.

218

Generally, the date of final determination of

liability is the date that is six months after the date the closing letter is

208

. See id. §§ 1.645-1(d)(1), 301.6109-1(a)(3)(i).

209

. See id. § 1.645-1(d)(2)(i).

210

. See id.

211

. See id.

212

. See id. § 1.645-1(d)(2)(ii).

213

. See id. § 1.645-1(e)(2)(i).

214

. See id. § 1.645-1(e)(2)(ii).

215

. See id. § 1.645-1(e)(3).

216

. See id. § 1.645-1(f)(1).

217

. See I.R.C. § 645(b)(2)(A); Treas. Reg. § 1.645-1(f)(2)(i).

218

. See Treas. Reg. § 1.645-1(f)(2)(ii).

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 467

issued.

219

Therefore, the 645 election will terminate one day less than twelve

months after issuance of the closing letter.

220

There can be several benefits to making a 645 election, including

simplifying the number of income tax returns, the availability to report using

a fiscal year, avoiding the requirement of making estimated tax payments for

two years after the decedent’s death, and the ability to hold S corporation

stock for the duration of the administration of the estate, without meeting

special trust rules.

221

On the other hand, if a 645 election is not made, the

estate and trust each get a separate run up the tax bracket ladder and maintain

the benefit of separate exemptions ($600 for the estate, and either $100 or

$300 for the trust).

222

C. Federal Income Tax Imposed at Trust Level

After the termination of grantor trust status, the general rules of income

taxation of trusts will apply to the trust. The general principal of those rules

is that the taxable income of a trust or estate is computed in the same manner

as in the case of an individual, except as set forth in Part I of Subchapter J of

the Code.

223

Subpart A of Part I of Subchapter J contains general rules for

taxation of trusts and estates, Subpart B provides specific rules relating to

trusts that distribute current income only, Subpart C deals with trusts and

estates that may accumulate income or distribute corpus, Subpart D provides

the rules for excess distributions by trusts, of course Subpart E governs the

rules for grantor trusts, and Subpart F deals with miscellaneous provisions

relating to limitations on charitable deductions, income of a trust or estate in

the case of divorce, and taxable years to which the provisions of Subchapter

J are applicable.

224

These rules have vast implications, and the subject of

income taxation of trusts and estates is dense enough to fill a semester-long

law school course.

225

Accordingly, a detailed discussion of income taxation

of trusts and estates is outside the scope of this article.

226

Broadly, once grantor trust status has terminated, the trust will be

subject to what is often referred to as “conduit” taxation.

227

This means that

a trust will be taxed only to the extent it receives and retains taxable income

219

. See id. § 1.645-1(f)(2)(ii)(A) (but see id. §§ 1.645-1(f)(2)(ii)(B)–(E) regarding circumstances

when the date of final determination of liability may be later).

220

. See id. § 1.645-1(f)(2)(ii)(A).

221

. See id. § 1.645-1(e)(3)(i).

222

. See I.R.C. §§ 1(e), 642(b).

223

. See id. § 641(b).

224

. See Treas. Reg. § 1.641(a)-0(a).

225

. See id.

226

. See Mickey Davis & Melissa Willms, Income Taxation of Trusts and Estates, The Center for

American and International Law 55th Annual Short Course on Estate Planning (Jan. 30, 2020).

227

. See Allison Pedrazzi, Guess What? The Laws HAVE Changed—Avoiding a Conduit Trust

Catastrophe After the SECURE Act, JD SUPRA (May 4, 2020), https://www.jdsupra.com/legalnews/

guess-what-the-laws-have-changed-59537/ [https://perma.cc/25GY-TRD8].

468 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

in the taxable year.

228

If the trust makes a distribution to a beneficiary, or is

required to make a distribution to a beneficiary, then the trust is allowed a

deduction to the extent of the distribution.

229

Any distributions from the trust

are treated as being made first from income (even if what was distributed was

corpus).

230

The income is allocated to the beneficiary and taxed to the

beneficiary, retaining the same character that it had in the trust.

231

Accordingly, to the extent that distributions are required to be made or are

actually made to beneficiary, the income will flow through the trust to the

beneficiary.

232

1. Tax Rates

Once grantor trust status is terminated, if taxable income of the trust is

taxed at the trust level (and does not flow through to beneficiaries of the

trust), income tax is imposed based on the income tax brackets for trusts.

233

Trusts share most of the same income tax brackets as individuals.

234

Although

trust income tax brackets don’t include a 12%, 22%, or 32% tax rate, they

have the same highest tax bracket of 37% as individuals.

235

The most notable

difference between the brackets for individuals and those for trusts is that the

brackets are much more compressed for trusts.

236

For example, in 2020, trusts

reach the highest bracket at $12,950 of income, while single individuals reach

the highest bracket at $518,000, and married persons filing jointly reach the

highest bracket at $622,050.

237

Accordingly, trust income may be taxed at a

much higher rate than it would have if the trust were still a grantor trust.

238

2. Net Investment Income Tax

Internal Revenue Code Section 1411 imposes a net investment income

tax of 3.8% on the unearned income of individuals, estates, and trusts

commonly referred to as the “Net Investment Income Tax” or “Medicare

228

. See id.

229

. See Jeffrey Levine, Restructuring Conduit Trust Beneficiaries of Retirement Accounts to Avoid

the SECURE Act’s 10-Year Rule, KITCES (Mar. 4, 2020), https://www.kitces.com/blog/secure-act-see-

through-conduit-trust-stretch-ira-10-year-non-eligible-designated-beneficiary/#:~:text=Conduit%20Trus

ts%20force%20the%20almost,no%20longer%20protected%20by%20it) [https://perma.cc/FR89-EFNN].

230

. See id.

231

. See id.

232

. See id.

233

. See Rev. Proc. 2019-44, 2019-47 I.R.B 1093.

234

. See I.R.C. § 1(j)(2) (In the last quarter of each year, the IRS issues a Revenue Procedure that

provides the inflation-adjusted numbers for a variety of items, including income tax brackets. For 2020,

the updated numbers can be found in Revenue Procedure 2019-44). See Rev. Proc. 2019-44.

235

. See I.R.C. § 1(j)(2)(E).

236

. See id.

237

. See id.

238

. See id.

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 469

Tax.”

239

For individuals, the tax is equal to 3.8% of the lesser of (i) the

individual’s net investment income for the year, or (ii) the individual’s

modified adjusted gross income for that taxable year in excess of a threshold

amount ($200,000 for single individuals and $250,000 for married

individuals filing jointly).

240

For estates and trusts, the tax is equal to 3.8%

times the lesser of (i) the estate’s or trust’s undistributed net investment

income, or (ii) the estate’s or trust’s adjusted gross income (as defined in

Code Section 67(e)) for that taxable year in excess of the dollar amount at

which the highest income tax bracket begins ($12,950 for 2020).

241

Note that

the threshold for trusts and estates is based on the highest income tax bracket

for each, and accordingly the threshold is indexed each year.

242

In contrast,

there is no indexing for individuals.

243

The net investment income tax is not imposed on grantor trusts.

244

Instead, each item of income or deduction is treated as if it had been received

by or paid directly by the grantor (or person treated as the grantor) for

purposes of calculating the individual net investment income of the grantor

(or person treated as the grantor).

245

Again, a detailed discussion of the net investment income tax is outside

of the scope of this article.

246

However, it is important to note that when

grantor trust status is terminated, one test for determining whether income is

subject to the net investment income tax will change.

a. Material Participation Test

Net investment income consists of three categories of income, each

using the term “trade or business” as that term is defined in Code Section

162.

247

A trade or business to which the tax will apply includes one that is a

passive activity within the meaning of Code Section 469.

248

Accordingly, it

is imperative to determine what constitutes a passive activity in order to

determine when the net investment income tax will be applied.

249

Activity is

passive within the meaning of Code Section 469 if the taxpayer does not

materially participate in the trade or business.

250

In order for a taxpayer to

239

. See id. § 1411.

240

. See id. § 1411(a)(1).

241

. See id. § 1411(a)(2).

242

. See id.

243

. See id. § 1411(a)(1).

244

. See id. § 1411(c).

245

. See Treas. Reg. § 1.1411-3(b)(1)(v) (1963).

246

. Davis & Willms, supra note 226.

247

. See I.R.C. § 1411(c)(1)(A); Treas. Reg. § 1.1411-1(d)(12).

248

. See I.R.C. § 1411(c)(2); Treas. Reg. § 1.1411-5.

249

. See I.R.C. § 1411(c)(2).

250

. See id. § 469(c)(1).

470 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

materially participate in an activity, the taxpayer’s involvement in the

operations of the activity must be regular, continuous and substantial.

251

Treasury regulations list seven ways in which an individual can

materially participate, but no regulations exist addressing material

participation of a trust.

252

During the period in which a trust is treated as a

grantor trust, the participation of the grantor or person treated as the grantor

are evaluated to determine whether the material participation test is met.

253

However, when grantor trust status is terminated, how the test will be applied

is unclear.

254

The IRS has taken the position that for purposes of a nongrantor trust,

the trustee’s actions are the only appropriate measure of whether the material

participation test is met.

255

In Mattie K. Carter Trust v. United States, which

was a case of first impression on the issue, the Court concluded that material

participation is determined by reference to all persons who conduct business

on behalf of a trust, whether employees or fiduciaries.

256

The IRS has rejected

the Court’s position in Mattie K. Carter Trust and has continued to advance

the argument that the IRS will look solely to the activities of the trustee.

257

the most recent case to address the material participation issue with respect

to a trust, Frank Aragona Trust v. Commissioner, the Tax Court held that

under the narrow circumstances of that case, activities of a trustee who is also

an employee of a trust can be used to assess whether a trust materially

participates in an activity.

258

With no treasury regulations under Code Sections 1411 or 469 to

address the issue of material participation for trusts, it is difficult for

practitioners to give guidance to clients regarding how to determine material

participation by nongrantor trusts and whether such trade or business income

may be non-passive, thereby avoiding imposition of the net investment

income tax.

259

However, if a trust derives income from a trade or business, it

is important to evaluate whether the grantor’s participation renders the

251

. See id. § 469(h)(1).

252

. See Treas. Reg. § 1.469 (2021).

253

. See JOINT COMM. ON TAX’N, 115TH CON., GENERAL EXPLANATION OF PUBLIC LAW 115-97 242,

n.33 (Comm. Print 2018).

254

. See id.

255

. See I.R.S. Tech. Adv. Mem. 200733023 (Aug. 17, 2007); I.R.S. Priv. Ltr. Rul. 201029014 (Aug.

23, 2010); and I.R.S. Tech. Adv. Mem. 201317010 (Apr. 26, 2013); See also e.g., Mattie K. Carter Trust

v. United States, 256 F. Supp. 2d 536 (N.D. Tex. 2003) (IRS has rejected the Court’s position and only

looks at activities of the trustee).

256

. See Mattie K. Carter Trust, 256 F. Supp. 2d at 536.

257

. See I.R.S. Tech. Adv. Mem. 200733023 (Aug. 17, 2007); I.R.S. Priv. Ltr. Rul. 201029014 (Aug.

23, 2010); and I.R.S. Tech. Adv. Mem. 201317010 (Apr. 26, 2013).

258

. Frank Aragona Trust v. Commissioner, 142 TC 165 (2014).

259

. See Michael T. Donovan & Timothy G. Stewart, Material Participation by Trusts: Questions

Remain after Frank Aragona Trust, LEWISRICE (Oct. 3, 2014), https://www.lewisrice.com/publications/

material-participation-by-trusts-questions-remain-after-frank-aragona-trust/.

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 471

income non-passive, and whether that may change once the grantor trust

treatment ceases.

260

D. State Income Tax Implications

As a practitioner in Texas where no state income tax is imposed on

trusts, it is sometimes easy to forget that trusts may be subject to state income

tax in addition to federal income tax.

261

However, when evaluating the

consequences of terminating grantor trust status, any potential state income

tax implications should be considered as well.

262

Generally, states may tax all

income of their residents but only source income of non-residents.

263

The

basis upon which a trust will be considered a resident varies from state to

state.

264

In some states, residency of a trust is based on the domicile of a

grantor at the time when an irrevocable trust is created (e.g., New York).

265

Other states determine residency by reference to the domicile of the trustee

(e.g., Arizona), or the principal place of administration (e.g., Colorado), the

place where the beneficiaries reside (e.g., Tennessee), or some combination

of factors (e.g., California).

266

If a trust is a grantor trust for federal income tax purposes, it is usually

ignored as a separate taxpayer for state tax purposes as well, and accordingly

most states look to the state of residence of the grantor (or person treated as

the grantor) to determine residency for state income tax purposes.

267

As a

result, the residency of the trust may be determined differently when grantor

trust status terminates.

268

Therefore, if the trust has a nexus with any other

state at the time that termination of grantor trust status is being contemplated,

260

. See id.

261

. Gregory A. Bergmann & Eric L. Johnson, Selected Issues Concerning the State Income Taxation

of Nonresident Trusts and Estates, TAXADVISER (Sept. 1, 2011), https://www.thetaxadviser.com /issues/20

11/sep/salt-sep2011.html [https://perma.cc/A2YW-LBXT].

262

. See id.

263

. See id.

264

. See id.

265

. See id.

266

. A helpful table containing a summary of tax rules and rates for trusts in each state can be found

in the current ACTEC State Survey. See Richard W. Nenno, Bases of State Income Taxation of Nongrantor

Trusts for 2018, ACTEC, https://www.actec.org/assets/1/6/Nenno_state_nongrantor_tax_survey (updated

through August 14, 2019) [https://perma.cc/9D3M-42FL].

267

. See Ed Morrow, State Residency and Source Income Factors for State Income Taxation of

Irrevocable Non-Grantor Trusts, ACTEC, https://www.actec.org/assets/1/6/Morrow_State_Residency_

and_Source_Income_Factors_for_Taxation_of_Irrevocable_Non-Grantor_Trusts.pdf [https://perma.cc/

9RV8-2WVZ]. This is a companion chart to Incomplete Gift, Non-Grantor Trusts - Not Just for State

Income Tax Avoidance and Spousal Lifetime Access Non-Grantor Trusts, CLE/article/ webinars, compiled

by Ed Morrow, J.D., LL.M. (tax), CFP (2019); see, e.g., Cal. Rev. & Tax. Code §§ 17742–44 (trust

residency factors: fiduciary, beneficiary, testator).

268

. See Ed Morrow, Geoff Germane & David Bowen, Ed Morrow, Geoff Germane and David Bowen

on the Art of Using Trusts to Avoid Utah Income Tax, LIEMBERG INFO. SERVS., INC. (Apr. 17, 2017),

http://leimbergservices.com/all/LISIMorrowGermaneBowen4_17_2017.pdf [https://perma.cc/CHP2-

9ATB].

472 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

it would be wise to examine the law of each such state to determine whether

the termination will result in income taxation in that state.

269

IV. ASSETS REQUIRING SPECIAL CONSIDERATION

In addition to the general income tax implications of termination of

grantor trust status, if the trust owns certain assets, different rules may be

triggered with respect to the assets themselves or because of the existence of

the assets.

270

A. S Corporation Stock

If a trust owns stock in a small business corporation that has elected to

be taxed under Subchapter S of the Internal Revenue Code, terminating

grantor trust status may have drastic results.

271

In order to elect S corporation

status, the business must qualify as an eligible small business.

272

To qualify

as such, a corporation may not have more than 100 shareholders, all of whom

must be individuals (or estates or certain eligible trusts), and none of whom

are nonresident aliens.

273

If stock is transferred to a trust that is not an eligible

shareholder, the S election of the corporation will be terminated.

274

Under Code Section 1361(c)(2)(A)(i), a grantor trust is a permissible

shareholder of S corporation stock, without the need for any special elections,

if the grantor is a permitted S corporation shareholder.

275

A grantor trust may

hold stock for up to two years after the death of the grantor.

276

However, if

grantor trust treatment ceases for any reason other than the death of a grantor,

the same grace period does not apply.

277

After the two year period if grantor trust status terminates at the

grantor’s death, or immediately after the termination in any other event, a

trust will not be an eligible shareholder unless it is a Qualified Subchapter S

Trust (“QSST”) or an Electing Small Business Trust (“ESBT”).

278

269

. See id.

270

. See Scibetta, supra note 37.

271

. See id.

272

. See I.R.C. § 1361(b).

273

. See id.

274

. See id. § 1362(d)(2)(A).

275

. See id.

276

. See id. § 1361(c)(2)(A)(ii).

277

. See id. § 1361(d)(3)(A)(i)–(iv).

278

. See id. § 1361(b)(1)(B); Treas. Reg. § 1.1361-1(e)(1) (However, a decedent’s estate qualifies as

an S corporation shareholder for the entire period of administration and counts as only one shareholder

for the purposes of ensuring that the corporation has no more than 100 shareholders). I.R.C. § 645; Treas.

Reg. § 1.645-1(f)(2). If the trustee of a qualified revocable trust and the appointed executor (if any) of the

decedent’s estate have made a 645 election in order to treat the revocable trust as part of the estate for

income tax purposes, it becomes eligible to hold the S corporation stock as an estate, and can do so for as

long as the election can be in place. I.R.C. § 645; Treas. Reg. § 1.645-1(f)(2).

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 473

election for a trust to be treated as a QSST or an ESBT must be made within

two months and fifteen days after the expiration of the two-year grace period

or the cessation of grantor trust treatment, as applicable, although late

election relief is available.

279

1. Qualified Subchapter S Trusts

A Qualified Subchapter S Trust (a “QSST”) is a trust with a single

income beneficiary.

280

No distributions of trust corpus may be made to

anyone other than that beneficiary.

281

The income interest of the beneficiary

must terminate on the earlier of the beneficiary’s death or the termination of

the trust, and upon the termination of the trust during the beneficiary’s

lifetime, all of the trust assets must pass to the beneficiary.

282

Additionally,

all of the fiduciary accounting income of the trust must be distributed to the

beneficiary.

283

The current income beneficiary of the trust must make the

election for the trust to be treated as a QSST and agree to be taxed on the

income of the S corporation.

284

The election is made by filing a statement

providing the information outlined in Treasury Regulation Section

1.1361-1(j)(6).

285

In most cases, when a trust owns stock in an S corporation

and the income beneficiary makes an election to have the trust treated as a

QSST, because the beneficiary is treated as the owner of the stock for income

tax purposes, all income from the S corporation which is attributable to the

QSST will be taxed to the beneficiary.

286

2. Electing Small Business Trusts

An Electing Small Business Trust (“ESBT”) may have more than one

beneficiary, but all beneficiaries must be eligible individuals, estates, or

certain charities.

287

No interest in the trust may be acquired by purchase.

288

The trustee of the trust must make the election for the trust to be treated as an

ESBT by submitting a letter to the IRS center where the corporation files its

income tax return and providing the information outlined in Treasury

Regulation Section 1.1361-1(m)(2).

289

If the election is made, the trust is

treated as the taxpayer and, with respect to the S corporation, is taxed at the

279

. See I.R.C. § 1361(c)(2) & (d)(2); see also Rev. Proc. 2013-30, 2013-36 IRB 173.

280

. See I.R.C. § 1361(d)(3)(A).

281

. See id.

282

. See id.

283

. See id. § 1361(d)(3)(B).

284

. See id. § 1361(d)(2).

285

. See Treas. Reg. § 1.1361-1(j)(6).

286

. See id. § 1.1361-1(j)(7).

287

. See I.R.C. § 1361(e)(1)(A).

288

. See id. § 1361(e)(1)(A)(ii).

289

. See id.

474 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

highest marginal federal income tax rate, regardless of whether its income is

distributed.

290

3. Allocation of Income from S Corporation in Year of Termination

Another issue that arises in connection with stock in an S corporation is

how items of income and expense will be allocated between the grantor and

the nongrantor trust in the taxable year that grantor trust status is

terminated.

291

If there is a change of ownership in S corporation stock, items

of income and expense for the entire year of the ownership change are divided

by the number of days in the S corporations’ taxable year to calculate a per

diem amount allocable to the shareholders on each day.

292

This may be an

issue if the grantor is seeking to terminate grantor trust status because he or

she does not want to bear the income tax liability of a realization event with

respect to the S corporation.

293

If the grantor trust status is terminated before

the realization event but in the same taxable year as the realization event, the

total pre-change income and post-change income is spread evenly over the

total days in the taxable year.

294

In that event, the grantor would be taxed on

a portion of the income attributable to the realization event, even though the

termination occurred before that date.

295

In the event of a complete termination of a shareholder’s interest, an

election is available under Code Section 1377(a)(2) which results in the

calculation of a shareholder’s share of income and expense as if the year

consisted of two tax years: one before the termination and the other after the

termination.

296

This closing of the books causes the income and expense for

a period to be allocated only to shareholders owning shares during that

period.

297

The shareholder whose interest is terminated, all shareholders to

whom such shareholder has transferred shares during the taxable year, and

the corporation must agree to the election.

298

The election must be made by

attaching a statement to the S corporation’s timely filed original or amended

income tax return for the taxable year during which a shareholder’s entire

290

. See id. § 641(c).

291

. See Treas. Reg. § 1.1377-1(a)(1).

292

. See id. § 1.1377-1(a)(1). See also id. § 1.706-1(c)(2)(ii) (The treatment of disposition of a

partner’s entire interest in a partnership, in which case allocation of income is made by an interim closing

of the partnership’s books unless the partners agree to allocate income on per diem or other reasonable

basis).

293

. See id. § 1.1377-1(a)(1).

294

. Mark Marquez & Anthony Scuotto, Elections Available to S Corporations with Significant

Owner Changes, TAXADVISOR (Nov. 30, 2010), https://www.thetaxadviser.com/issues/2010/dec/clinic-

dec2010-story-09.html [https://perma.cc/N2LL-RU4E]

295

. See I.R.C. § 1377(a)(2).

296

. See id.

297

. See id.

298

. See id.

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 475

interest is terminated containing the information set out in Treasury

Regulation Section 1.1377-1(b)(5).

299

A shareholder’s entire interest is “terminated” if the shareholder’s entire

stock ownership in the S corporation ceases, including a sale, exchange, or

other disposition of all of the stock held by the shareholder; a gift of all the

shareholder’s stock; a spousal transfer of all the shareholder’s stock; a

redemption of all the shareholder’s stock, and the death of the shareholder.

300

The applicable Treasury regulations provide that when during the tax year of

an S corporation, if a trust that is an eligible shareholder of the S corporation

converts from one type of eligible trust (including a grantor trust, post-death

grantor trust, QSST, or ESBT) to another type of eligible trust for the

remainder of the year, the trust is not treated as terminating its entire interest

in the S corporation for purposes of the election, unless the trust was a

post-death grantor trust or testamentary trust receiving stock under a Will.

301

Accordingly, unless the grantor trust status terminates because of the death

of the grantor, it appears the election under Code Section 1377(a)(2) will not

be available.

302

Therefore, if the grantor desires to terminate grantor trust status to avoid

paying income tax that will become due as the result of a realization event,

then the termination should occur in the taxable year of the S Corporation

before the realization event, if possible.

303

B. Outstanding Promissory Notes Payable to Grantor

As noted previously, a popular estate planning technique is for a grantor

to create an intentionally defective grantor trust and sell assets to the trust in

return for an installment note.

304

If structured and administered correctly, the

assets of the trust will not be includable in the grantor’s gross estate for

federal estate tax purposes.

305

The sale to the trust will not be treated as a gift

since the grantor receives full consideration for the transfer, and therefore

will not be subject to a gift tax.

306

For income tax purposes, the sale of

property to the trust will not give rise to gain because the grantor and trust

are treated as one person.

307

However, if the promissory note is still

outstanding at the time that the grantor trust status terminates, several

299

. See Treas. Reg. § 1.1377-1(b)(5)(i).

300

. See id. at § 1.1377-1(b)(4).

301

. See id. § 1.1377-1(a)(2)(iii).

302

. See id.

303

. See id.

304

. See Installment Sales to Intentionally Defective Grantor Trusts, BLANK ROME LLP, https://www

.blankrome.com/siteFiles/PrivateClient-IDGTs.pdf (last visited, Feb. 2, 2021) [https://perma.cc/8GTA-

7WTW].

305

. See id. at 1.

306

. See id.

307

. See id.

476 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

questions arise regarding tax treatment of the transaction, the note, and the

asset purchased by the trust.

308

1. Termination as the Result of the Grantor’s Death

In the event the trust ceases to be a grantor trust because of the grantor’s

death and any portion of the note is still outstanding, the income tax

implications as to the grantor and the trust are unclear.

309

No authority

addresses the situation directly, and commentators have vigorously debated

the topic.

310

Three issues, which are interrelated, are in question in the event that a

grantor dies and a debt is still owed to the grantor.

311

The first issue is whether

death is a recognition event such that the grantor or the grantor’s estate must

recognize gain or loss.

312

The second issue is whether the outstanding note constitutes a right to

receive an item of income in respect of a decedent (“IRD”) under Code

Section 691.

313

Very broadly, IRD is comprised of items that would have

been taxable income to the decedent if he or she had lived but are not properly

includable in a pre-death income tax return of the decedent.

314

The most

common example of IRD is an IRA.

315

Beneficiaries who receive payments

that constitute IRD are taxed on those payments, which is an exception to the

general rule that an inheritance is income-tax free.

316

The third issue is the trust’s basis in the asset sold to the trust by the

grantor.

317

The general rule is that the basis of an asset is the cost of the

308

. See id. at 2.

309

. See id.

310

. See Dunn & Handler, Tax Consequences of Outstanding Trust Liabilities When Grantor Trust

Status Terminates, 95 J. TAX’N 49 (2001); Cantrell, Gain Is Realized on Death of the Grantor With an

Outstanding Installment Note, Trusts & Estates (Feb. 2010); Manning & Hesch, Deferred Payment Sales

to Grantor Trusts, GRATs, and Net Gifts: Income and Transfer Tax Elements, 24 TAX MGMT. EST., GIFTS,

& TR. J. 3 (1999); Hatcher & Manigault, Using Beneficiary Guarantees in Defective Grantor Trusts, 92

J. TAX’N 152, 161–64 (2000); Blattmachr, Gans & Jacobson, Income Tax Effects of Termination of

Grantor Trust Status by Reason of the Grantor’s Death, 97 J. TAX’N 149 (Sept. 2002); Blattmachr &

Gans, No Gain at Death, Trusts & Estates (Feb. 2010).

311

. See I.R.C. § 691; see also Leo J. Cushing & Luke C. Bean, Revocable Grantor Trusts and IDGTs

After the Death of the Trustor: Avoiding Gain Triggers, Navigating Basis Calculations, STRAFFORD, 18

(Tuesday, Feb. 14, 2017, 12:00 PM) http://media.straffordpub.com/products/revocable-grantor-trusts-

and-idgts-after-the-death-of-the-trustor-avoiding-gain-triggers-navigating-basis-calculations-2017-02-14

/presentation.pdf; Julia Kagan, Income in Respect of a Decedent (IRD), INVESTOPEDIA, (Oct. 30, 2020),

https://www.investopedia.com/terms/i/income_ respectof_decedent.asp [https://perma.cc/P2ZU-WCFX].

312

. See Cushing & Bean, supra note 311.

313

. See id. at 13; I.R.C. § 691.

314

. See I.R.C. § 691(a)(1).

315

. See Kagan, supra note 311.

316

. See Treas. Reg. § 1.691(a)-1(b); I.R.C. § 102(a).

317

. See Topic No. 703 Basics of Assets, I.R.S. (Jan. 25, 2021), https://www.irs.gov/taxtopics/tc703

[https://perma.cc/4KUL-FNWE].

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 477

asset.

318

While the trust is a grantor trust, no sale is deemed to have occurred

because the grantor and trust are treated as one person.

319

Accordingly, while

the trust is a grantor trust, the asset retains the grantor’s basis.

320

If property

is “acquired from a decedent,” however, a different rule applies.

321

If property

is acquired from a decedent, in most instances the basis is the value of that

property for federal estate tax purposes.

322

This rule is sometimes referred to

as a “step-up” in basis, which is often the case, but the asset may also receive

a “step-down” in basis.

323

Property acquired from a decedent includes

property passing from the decedent by bequest, devise, or inheritance;

property held in a revocable trust; property in which the decedent retained

the right to control beneficial enjoyment; property subject to a general power

of appointment by the decedent; and other property includable in the

decedent’s gross estate for federal estate tax purposes.

324

However, not all

property acquired from a decedent is subject to the basis adjustment.

325

Property which constitutes IRD does not receive a new cost basis.

326

Another

rule applies to property acquired by gift under Code Section 1015(a), which

provides that the basis in the hands of the transferee is generally the same as

it was in the hands of the transferor (called “carryover basis”).

327

Code

Section 1015(b) governs basis in the event of a transfer in trust (other than

by a transfer in trust by a gift, bequest, or devise), in which case basis will be

the same as it would be in the hands of the grantor, increased in the amount

of gain or decreased in the amount of loss recognized to the grantor on such

transfer under the law applicable to the year in which the transfer was

made.

328

As to the first issue, most practitioners believe that the death of the

grantor is not a realization event, and accordingly, no gain or loss is realized

at the grantor’s death.

329

Similarly, most take the position that the note does

not constitute IRD.

330

As to the question of basis, one argument is that the

trustee of the trust has acquired the asset by bequest or devise, and

accordingly Section 1014 will determine basis and the asset will receive a

basis adjustment equal to its fair market value at the grantor’s death.

331

The

318

. See id.

319

. See Rev. Rul. 85-13, 1985-1 CB 184.

320

. See id. at 3.

321

. See I.R.C. § 1014(a)(1).

322

. See id.

323

. See id. § 1014(b).

324

. See id.

325

. See id.

326

. See id.

327

. See id. § 1015(a).

328

. See id. § 1015(b).

329

. See id. § 1014(b).

330

. See id.

331

. See id. § 1015(a).

478 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

more popular view seems to be that the trust will take a carry-over basis equal

to the grantor’s adjusted basis under Code Section 1015(a).

332

However, some argue that at the grantor’s death, recognition is

triggered, and a sale is treated as having occurred either immediately before

the grantor’s death or immediately after the grantor’s death.

333

If the sale is

treated as having occurred immediately before the grantor’s death, the

grantor would recognize gain on the excess of the note amount over the

grantor’s adjusted basis in the asset and would report it on the grantor’s final

1040.

334

The note would not constitute IRD.

335

The trust’s basis in the asset

would be the grantor’s adjusted basis plus any gain recognized (under Code

Section 1015(b) governing transfers in trust other than by a gift, bequest, or

devise).

336

If the sale is treated as having occurred immediately after the grantor’s

death, the grantor’s estate would recognize loss on the excess of the fair

market value of the asset at the grantor’s death over the note amount (or if

the note amount exceeds the value at death, would recognize gain in the

amount of the excess), and the loss or gain which would be reported on the

first Form 1041 filed for the grantor’s estate.

337

Because the transaction is not

treated as having occurred until after the grantor’s death, the note is IRD.

338

The trust’s basis in the asset would be the amount of the outstanding balance

of the note (under Code Section 1012 providing the general rule that the basis

of an asset is the cost of the asset).

339

Another theory is that the transaction is “part sale-part gift” occurring

on the last day of the grantor’s taxable year.

340

In that case, the grantor would

realize gain on the excess of the note amount over the grantor’s basis in the

asset.

341

However, the gain would not be reportable on the grantor’s Form

1040.

342

Instead, the theory is that the note constitutes IRD, and the estate of

the grantor or the beneficiaries of the grantor’s estate will be taxed when the

subsequent note payments are collected.

343

The trust’s basis in the asset

would then be the greater of the balance of the note at the decedent’s death

332

. See Danielle T. Zaragoza & Sonja K. Johnson, Morrison & Foerster LLP: Distribution of

Liabilities from a Grantor Trust Likely Causes the Grantor to Recognize Gain, LEXIS (Sept. 2, 2011),

https://www.lexisnexis.com/legalnewsroom/estate-elder/b/estate-elder-blog/posts/morrison-amp-foerster

-llp-distribution-of-liabilities-from-a-grantor-trust-likely-causes-the-grantor-to-recognize-gain [https://

perma.cc/NR64-7SGE].

333

. See id.

334

. See id.

335

. See id.

336

. See id.

337

. See id.

338

. See id.

339

. See id.

340

. See id.

341

. See id.

342

. See id.

343

. See id.

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 479

or the grantor’s basis in the asset on the date of death (under Code Section

1015 and Treasury Regulation Section 1.1015-4 with respect to part sale-part

gift transactions).

344

Needless to say, each of these approaches yields vastly different income

tax consequences, and since there is no clear authority on the issue it is

difficult for practitioners to advise clients when the situation arises.

345

2. Termination of Grantor Trust Status During Life of Grantor

Similarly, it does not appear there is any clear authority regarding the

income tax treatment when the grantor trust status terminates during the

grantor’s life and the trust continues to owe a debt to the grantor.

346

Some

practitioners posit that under those circumstances, the grantor will recognize

gain to the extent that the debt owed to the grantor exceeds the grantor’s basis

in the asset, and the trust’s basis in the asset will be equal to the amount of

the then-outstanding debt.

347

The release of a power that caused grantor trust status has been held to

be a gain or loss recognition event to recapture partnership losses previously

allowed to the grantor.

348

Accordingly there is precedent for the treatment of

termination of grantor trust status as a realization event that triggers gain or

loss.

349

Treasury Regulation Section 1.1001-2(a) provides generally that the

amount realized from a sale or other disposition of property includes the

amount of liabilities from which the transferor is discharged as a result of the

sale or disposition.

350

Example 5 of Treasury Regulation Section 1.1001-2(c)

applies this general rule of gain recognition in the context of a grantor trust.

351

In that example, the taxpayer transferred an asset encumbered by a liability

to a grantor trust and subsequently, the grantor released the power that caused

the trust to be treated as a grantor trust.

352

Example 5 sets out that at that time,

the grantor is considered to have transferred ownership of the asset to the

trust, and accordingly, gain must be recognized by the grantor to the extent

that the liability exceeds the grantor’s basis in the asset.

353

However, it is

important to note that in Example 5 the debt is not owed to the grantor, but

to a third party.

354

344

. See id.

345

. See id.

346

. See id.

347

. See, e.g., Dunn & Handler, Tax Consequences of Outstanding Trust Liabilities When Grantor

Trust Status Terminates, 95 J. TAX’N 49 (2001).

348

. See Mandorin v. Comm’r, 84 T.C. 667 (1985); Rev. Rul. 77-402, 1977-2 C.B. 222.

349

. See Zaragoza & Johnson, supra note 332.

350

. See id.

351

. See id.

352

. See id.

353

. See id.

354

. See id.

480 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

Similarly, in Technical Advice Memorandum 200011005, the grantor

created a GRAT and the GRAT borrowed money from a third party to pay

the annuity amounts.

355

The loans were still outstanding at the end of the

GRAT term, at which time the GRAT terminated and property of the GRAT

was distributed to beneficiary trusts, subject to the outstanding debt.

356

In that

case, the IRS concluded that the transaction was not distinguishable from

Example 5 of Treasury Regulation Section 1.1001-2(c), and thus, termination

of the GRAT should be treated as a disposition by the grantor for income tax

purposes and the grantor should realize gain on the disposition equal to the

amount of the outstanding debt over the grantor’s basis in the property.

357

Again, the liability in question was not to the grantor but to a third party.

358

Although there is no dispositive authority specifying the tax result when

grantor trust status is terminated during the grantor’s life and there is an

outstanding debt owed from the trust to the grantor, from the foregoing

discussion it can be reasoned that at termination of the grantor trust status,

the position of the IRS might be that gain would be recognized by the grantor

to the extent that the debt owed to the grantor exceeds the grantor’s basis in

the asset.

359

If this is the case, then it follows that the trust’s basis in the asset

would be the amount of the outstanding debt at the time of the termination.

360

Because of these potential tax consequences, it is typically

recommended that grantor trust status not be terminated while the debt to the

grantor remains outstanding if it can be avoided.

361

C. Life Insurance

If a grantor trust owns life insurance on the life of the grantor or the

grantor’s spouse, the existence of that asset in the trust may thwart attempts

to terminate grantor trust status.

362

If income of the trust is used to pay premiums on life insurance policies

on the life of the grantor or the grantor’s spouse, then it is clear that the

income actually used for that purpose will be taxable to the grantor.

363

Although the Code and the Treasury regulations indicate that grantor trust

status results if the income of a trust may be applied by the grantor or a

nonadverse party to pay such life insurance premiums (without the approval

or consent of any adverse party), there is conflicting guidance as to how that

355

. See id.

356

. See id.

357

. See I.R.S. Tech. Adv. Mem. 200011005 (Mar. 17, 2020).

358

. See id.

359

. See id.

360

. See I.R.C. § 1012 (providing the general rule that a taxpayer’s basis in an asset is its cost).

361

. See Dunn & Handler, supra note 347.

362

. See I.R.C. § 677(a)(3); Treas. Reg. 1.677(a)-1(b)(2)(iii) (1996).

363

. See I.R.C. § 677(a)(3); Treas. Reg. 1.677(a)-1(b)(2)(iii).

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 481

is applied.

364

One position is that if a trust does not actually own a life

insurance policy on the grantor’s life, the mere power to purchase an

insurance policy and pay premiums is not sufficient to trigger grantor trust

status.

365

When a trust already owns life insurance, some cases have held that

the grantor will only be treated as owner to the extent that income is actually

used to pay the premiums.

366

On the other end of the spectrum, the IRS has

taken the position that the mere power to pay premiums would cause the

entire trust to be a grantor trust.

367

Accordingly, unless the life insurance held by the trust is a fully paid-up

policy for which no further premiums will be required and the trust prohibits

the trustee from paying premiums, it may be problematic for a life insurance

policy to remain in the trust if the goal is that the grantor not be treated as

owner for income tax purposes.

V. ACTIONS TO BE CONSIDERED BEFORE TERMINATION

If termination of grantor trust status is foreseeable or planned, an

opportunity exists to take advantage of the benefits of grantor trust status

before the change.

368

The following techniques are all available at any time

that the trust is treated as a grantor trust, but it would be prudent to evaluate

whether any of them are appropriate and would be beneficial if implemented

before termination of grantor trust status, at which point the opportunity will

be lost.

369

A. Swaps of Assets with Differing Basis

Many grantor trusts are structured so that the assets of the trust are not

includable in the grantor’s gross estate at death. To the extent the assets are

not included in the grantor’s gross estate, the assets will not be eligible for

the basis adjustment under Code Section 1014(a).

370

In many circumstances

the grantor will have funded a grantor trust with rapidly appreciating assets

to attempt to maximize the benefit of the estate planning strategies utilizing

grantor trusts.

371

As a result, it is not uncommon for such trusts to hold

low-basis assets.

372

364

. See I.R.C. § 677(a)(3); Treas. Reg. 1.677(a)-1(b)(2)(iii).

365

. See Corning v. Comm’r, 104 F.2d 329 (6th Cir. 1939).

366

. See Weil v. Comm’r, 3 T.C. 579 (1944), 1944 C.B. 29; Iversen v. Comm’r, 3 T.C. 756 (1944);

I.R.S. Priv. Ltr. Rul. 6406221750A (June 22, 1964); Rev. Rul. 66-313, 1966-2 CB 245.

367

. See I.R.S. Priv. Ltr. Rul. 8852003 (Dec. 30, 1988); I.R.S. Priv. Ltr. Rul. 8014078 (Jan. 10, 1980).

368

. See I.R.S. Priv. Ltr. Rul. 8852003 (Dec. 30, 1988).

369

. See discussion infra Sections V.A-C.

370

. See I.R.C. § 1014(a).

371

. See id.

372

. See id.

482 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

If the low-basis asset is one that will likely not be sold before the

grantor’s death, and if the grantor has a power to reacquire assets under Code

Section 675(4)(C), the grantor might exercise the power by transferring

high-basis assets to the trust in exchange for the trust’s low-basis asset of the

same value.

373

If the grantor does not have the power to reacquire trust

property, the same result could be accomplished by the grantor purchasing

the low-basis assets from the trust.

374

If the low-basis assets are includable in

the grantor’s gross estate at his or her death, the assets will be subject to a

basis adjustment, effectively wiping out any built-in capital gain.

375

One

exception to the general rule of basis adjustment for property acquired from

a decedent is that any property given to the decedent within one year of death

that passes from the decedent back to the original donor (or to the spouse of

the donor) as the result of the decedent’s death does not receive a basis

adjustment.

376

However, even if the grantor dies within a year of the exchange

with the grantor trust, because the grantor is treated for income tax purposes

as the owner of all of the assets at the time of the exchange, the one-year

look-back of Code Section 1014(e) should not apply to limit the basis

adjustment of the exchanged assets.

377

If the fair market value of the low-basis asset cannot be easily

determined, it is important to take appropriate steps to determine the fair

market value of the asset, such as obtaining a formal appraisal, to ensure that

the exchange is for assets of an equivalent value.

378

If the reacquired asset is

valued at less than the value of the substituted assets, or if the amount paid

by the grantor for the asset is less than the value of the asset, the grantor will

have made a gift to the trust in the amount of the difference in value.

379

The power to reacquire assets may also be exercised to preserve capital

losses.

380

This may be helpful if the grantor does not have a long life

expectancy.

381

If the grantor owns an asset with a basis in excess of its fair

market value at the grantor’s death, the basis adjustment will act to wipe out

the built-in capital loss.

382

The asset could of course be sold before the

grantor’s death in order to generate the loss.

383

However, if the grantor does

not have enough capital gain to offset the capital loss, net capital losses are

not carried forward to the individual’s estate after death, and as a result, they

373

. See id. § 675(4)(C).

374

. See Rev. Rul. 85-13, 1985-1 CB 184 (Remember such a sale will not result in gain to the trust

because the trust and the grantor are treated as one person for income tax purposes).

375

. See I.R.C. § 1014(e).

376

. See id.

377

. See id.

378

. See id.

379

. See id.

380

. See id. § 675.

381

. See id.

382

. See id. § 1014.

383

. See id.

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 483

are simply lost.

384

Instead, the grantor can reacquire assets from the trust in

exchange for the asset with a basis in excess of its value.

385

The loss would

then presumably be reserved in the trust.

386

An argument might be made that

this type of loss-shifting is impermissible because Code Section 267 provides

that no deduction is allowed for any loss on the sale or exchange of property

between certain related persons, including between a grantor and a fiduciary

of any trust created by that grantor.

387

However, Revenue Ruling 85-13

expressly provides that “a transaction cannot be recognized as a sale for

federal income tax purposes if the same person is treated as owning the

purported consideration both before and after the transaction.”

388

Because the

grantor and the grantor trust are treated as the same person, there is no “sale

or exchange” between them for purposes of Code Section 267, and

accordingly, the loss-disallowance rule would not be triggered.

389

B. Transfer of Life Insurance to Trust

If an insured owns life insurance on his or her life, then at the insured’s

death the proceeds of the life insurance are includable in his or her gross

estate for federal estate tax purposes.

390

As a result, life insurance policies are

an attractive asset to give away during lifetime.

391

However, if an insured dies

within three years of the transfer of a life insurance policy, the proceeds of

the life insurance policy will be includable in the insured’s gross estate for

federal estate tax purposes despite the transfer.

392

However, the three-year

rule will not apply to any bona fide sale for an adequate and full consideration

in money or money’s worth.

393

Accordingly, if a grantor has the power to

reacquire property and exchanges a life insurance policy for other assets of

equivalent value owned by the trust, presumably, the three-year rule would

not apply because the exchange would have been a sale for full and adequate

consideration.

394

However, when a life insurance policy is sold, another issue arises.

395

Generally, the proceeds of life insurance are not included in the recipient’s

gross income for income tax purposes.

396

However, one exception to this

general rule is applied when a life insurance contract is transferred for

384

. Rev. Rul. 74-175, 1974-1 CB 52.

385

. See id.

386

. See id.

387

. See I.R.C. § 267(b)(4).

388

. See id.

389

. See id.

390

. See id. § 2042.

391

. See id.

392

. See id. § 2035(a).

393

. See id. § 2035(d).

394

. See id.

395

. See id.

396

. See id. § 101(a)(1).

484 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 13:443

valuable consideration.

397

Under this circumstance, when life insurance

proceeds are received, the gross income exclusion is limited to an amount

equal to the consideration paid for the policy and the premiums subsequently

paid by the transferee.

398

Accordingly, if the sale of a life insurance policy

resulted in a “transfer for value” under Code Section 101(a)(2), a large

portion of the death benefit might be subject to income tax on the death of

the insured.

399

However, this so-called “transfer for value” rule will not apply

if the policy is transferred to the insured.

400

Accordingly, grantor trusts

present a unique planning opportunity.

401

Because a grantor trust is not

recognized as a separate taxpayer capable of entering into a sales transaction

with a grantor for income tax purposes, the transfer for value rule will not

apply when a policy is transferred from a grantor to a grantor trust.

402

Accordingly, if a grantor owns a life insurance policy outright and there

is a concern that the grantor may not survive for the requisite three years

following the transfer of the policy, the grantor can exchange the policy for

other assets of equivalent value owned by the grantor trust or can sell the

policy to the trust, thereby removing the proceeds of the policy from his or

her gross estate for estate tax purposes while preserving the income tax free

nature of the proceeds once received by the trust.

403

However, if the policy is not a paid-up policy (where no additional

premiums will need to be paid), and trust income will need to be used to pay

premiums on the policy, the grantor will be taxed on any trust income actually

used to pay the premiums.

404

As discussed above, in some instances the IRS

has taken the position that even the power to pay premiums will cause the

entire trust to be a grantor trust.

405

Accordingly, the grantor must weigh the

benefits of transferring the policy to the trust against the possibility of

continued grantor trust treatment with respect to at least a portion of the

trust.

406

C. Sale of Principal Residence

Code Section 121 excludes from gross income up to $250,000 (for

single persons) or $500,000 (for married persons filing jointly) of gain on a

sale or exchange of property if, for at least two years during the preceding

five years, the taxpayer owned the property and used it as his or her principal

397

. See id. § 101(a)(2).

398

. See id.

399

. See id. § 101(a)(2).

400

. See id. § 101(a)(2)(B).

401

. See id.

402

. See id.

403

. See id.

404

. See Treas. Reg. § 1.644(a)-1(b)(2) (2006).

405

. See id.

406

. See id.

2021] IMPLICATIONS OF TERMINATION OF GRANTOR TRUST STATUS 485

residence.

407

Nongrantor trusts are not eligible for the gain exclusion.

408

However, if a grantor trust owns property, then if the grantor (or person

treated as the grantor) will be treated as owning the residence for purposes of

satisfying the two-year ownership requirement of section 121, and the sale or

exchange by the trust will be treated as if made by the grantor (or person

treated as the grantor).

409

Accordingly, if the trust owns property and is considering its sale, and

if the grantor (or person treated as the grantor) has used it as his or her

principal residence for at least two years during the preceding five years, the

trustee should consider selling the property before termination of grantor trust

status in order to be eligible for the gain exclusion.

410

VI. CONCLUSION

Although it is a common refrain that grantor trust status can simply be

turned off, the implications of the termination of grantor trust treatment

necessitate a deeper analysis then that would suggest.

411

The consequences of the termination will differ depending upon the type

of trust in question, the reason that grantor trust status terminated, how

income was reported while the trust was treated as a grantor trust, and assets

held by the trust when grantor trust treatment ceases.

412

When termination of

grantor trust status has occurred, is foreseeable, or is being contemplated, it

is necessary to determine the facts and circumstances at hand and to evaluate

the implications of the termination and actions to be taken as a result.

413

the change has not yet occurred, it is also prudent to assess whether any estate

planning techniques available while the trust is treated as a grantor trust

should be utilized before the termination.

414

407

. See I.R.C. § 121(a).

408

. See id.

409

. See Treas. Reg. 1.121-1(c)(3); Rev. Rul. 85-45, 1985-1 CB 183.

410

. See Treas. Reg. 1.121-1(c)(3); Rev. Rul. 85-45, 1985-1 CB 183.

411

. See supra Parts III-IV.

412

. See supra Parts I-V.

413

. See supra Parts I-V.

414

. See supra Parts I-V.