September 11, 2023

Dear Clients and Friends:

The Grantor Trust Debate

– Does the Death of the Grantor Cause a Cost Basis Adjustment to Fair Market Value? – 

This note is sent in advance of our Client Update, that you will receive in October.  The purpose of this alert is to address some developments associated with IRS and professional commentary (by tax law professors and practitioners) on the taxation of “grantor trusts” on the death of the grantor.  Many clients and others transferred wealth to irrevocable trusts for their spouse and families over the last decade in anticipation of tax reform intended to lower the estate, gift, and generation skipping tax exemptions. Many of these trusts (almost all if a spouse is a beneficiary), are characterized as “grantor trusts” for income tax purposes. The issue centers around whether the property in a grantor trust on the death of the grantor is adjusted to fair market value, resulting in an elimination of embedded capital gains tax (or loss) on the sale of the property.  The general estate and gift tax rule is that property passing from a decedent at death receives a cost basis adjustment to fair market value. The issue is whether property in a grantor trust is deemed to pass from the grantor on the grantor’s death, even though it is not included in the taxable estate for estate tax purposes.

Grantor trust status means the person who transfers the property is viewed as the owner of the transferred assets for income tax purposes, but not estate and gift tax purposes. For example, if I have properly transferred $12.92 million of property to a trust for my wife and children, I have removed that property from my taxable estate and the taxable estate of my wife. If the exemption is cut in half in 2026, as required under present law, I have succeeded in utilizing my exemption while it is higher and it cannot be clawed-back and reclaimed by the IRS. Furthermore, additional gift tax free transfers of wealth to my spouse and children occur by virtue of my obligation, as the grantor, to pay the income tax on the income of the trust.  The IRS has agreed that my payment of income tax is not an additional taxable gift to my family.

Recently the IRS published Rev. Rul. 2023-2 on their view on whether a fair market value cost basis adjustment occurs on property owned by a grantor trust on the death of the grantor.  The IRS believes a basis adjustment does not occur, but they failed to address authority to the contrary in their ruling.  Their position is that in the establishment of a grantor trust, the gift tax rules apply and that a “carryover basis” (the basis of the grantor) carries over with the property to the trust, before and after the death of the grantor. However, that is not supported by income tax rules and the basis adjustment at death is an income tax rule.  It is believed that the IRS published this ruling because of pressure from several Senators (Bernie Sanders and Ron Wyden) on Treasury Secretary, Janet Yellen, to dissuade taxpayers from seeking the basis adjustment. Several legislative proposals had sought to close this “loophole,” but the legislation never passed.

A position of the IRS in a Revenue Ruling has no precedential weight and only expresses the view of the IRS. It is no different than my view or the commentary of any other tax lawyer or tax law professor. Rev. Rul. 2023-2 did not cite current regulations or prior revenue rulings where the IRS deems the grantor to own the property of a grantor trust for “income tax purposes.”  The cost basis adjustment is an income tax rule, and not an estate, gift, or generation skipping tax rule.  Furthermore, the notion that the assets are owned by the grantor for income tax purposes are embedded in regulations under the Internal Revenue Code, which has precedential value, and some believe is substantial authority for the position that a cost basis adjustment to fair market value is required by law on the death of the grantor. The IRS argument is viewed as being based upon policy but not current law, and taxpayers are required to follow the law and not policies that have not yet become law. Ultimately a court will decide the issue and resolve the differences in opinion.  In this regard, courts have recently removed deference toward government agencies when resolving controversies with taxpayers and now base their decisions in law and not current policy views.  Those policies must first be enacted as law by Congress before courts are bound to follow them.

An alternative course of action to avoid debate with the IRS in a potential audit is for a grantor facing an imminent death to swap cash for property in the grantor trust. After the swap, the grantor will directly own the property that will receive a basis step-up at death, while cash is in the trust and doesn’t need one.  This can be done with most grantor trusts without any adverse income tax consequences.  The problem is raising and departing with sizeable amounts of cash.  We are suggesting that some clients secure a bank line of credit secured by the property in the grantor trust to accomplish the swap in advance of death. Immediately repaying the loan after the grantor’s death minimizes any cost of the financial facility, which is more than offset by the tax savings of the cost basis adjustment and elimination of IRS debate over this issue.

If you have any questions concerning this matter, please feel free to contact us.  We are pleased to be of service.

Best regards,

Joseph C. Kempe, Esq., LL.M.


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