Although the federal estate tax is not extinct, with the combined marital exemption now north of $10 million, it is an endangered species. Recently, Governor Cuomo signaled his intent — likely to be affirmed by State Republicans — to increase the New York estate tax exemption to perhaps the federal level. With the threat of high federal estate taxes no longer a concern for the vast majority of taxpayers, attention has turned to the income tax, which has enjoyed a resurgence under the Obama Administration. An important objective in estate planning is now to preserve the step up in basis at death. This will provide heirs with the ability to sell inherited assets without incurring a capital gains tax.
For the past decade or so, an arrow in the quiver of estate planners seeking to reduce eventual estate taxes has been to sell or gift assets to a grantor trust. The objective of the sale was to make a complete transfer for transfer (estate and gift) tax purposes, but to retain enough powers such that the transfer was incomplete for income tax purposes. The mechanism seemed to be perfect: appreciation of the assets sold to the trust was forever out of the grantor’s estate, and the grantor would remain liable (if he wished, since he could be reimbursed) for the yearly income tax liability. This would result in a tax-free ““gift” by the grantor to the trustee of the trust of the income tax liability of the trust. Trust assets would thereby grow unimpeded by an annual income tax. So far so good.
The catalyst that made possible the dichotomy in tax treatment for income tax and estate tax purposes was in substantial part the interpretation of the grantor trust rules in Revenue Ruling 85-13. There, the IRS found that the “sale” by the grantor of assets to a grantor trust was not a realization event for income tax purposes since the grantor was deemed to be making a sale to himself. The ability to draft a trust constituting a grantor trust for income tax purposes, yet be irrevocable, so that for transfer tax purposes the sale was complete, was the linchpin of the technique. Many candidates emerged for making a trust a grantor trust. The ability to borrow from the trust without adequate security (IRC §675(2))was one provision. Another was the ability to substitute assets of the trust in a nonfiduciary capacity for assets of equal value (IRC §675(4)(C)).
This latter “swap” power became the most popular provision to accomplish grantor trust status. The provision had another serendipitous benefit: if low basis assets had initially been sold to the trust, they could (presumably) later be swapped out with higher basis assets. This would enable the grantor’s estate to receive a valuable step up in basis at the grantor’s death. All seemed fine. With the federal exclusion now so high, selling assets to grantor trusts is now less common; gifting assets to such trusts is now in vogue. The purpose of the gift may now be to utilize the federal exemption of the surviving spouse — which now includes the ported DSUE amount — in order to remove appreciation from the estate of the surviving spouse. The desired objective of swapping out low basis assets later in the life of the surviving spouse is to achieve basis step up to fair market value at his or her death.
The ability to substitute assets and obtain a basis step up is lauded by numerous tax authorities. However, anecdotal evidence seems to indicate that few practitioners have actually undertaken such swaps; certainly, the IRS has not ruled on the issue, and no cases have discussed whether the swap works. Some would dogmatically maintain that the swap clearly accomplishes the tax objective of accomplishing an ameliorative basis shift. However, reliance on dogma itself in this context could be risky. How the IRS would learn of such a swap is debatable. Apparently, the swap would not be required to be reported on any tax return. However, one must assume, as is almost always the case, the IRS would find out. Given, then, the paucity of guidance on this issue, and its importance, a closer look at whether the technique is unassailable, is in order.
II. IRC Section 675(4)(C)
Section 675(4)(C) provides that
[a] power of administration is exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity. For purposes of this paragraph, the term “power of administration” means any one or more of the follower powers . . . (C) a power to reacquire the trust corpus by substituting other property of an equivalent value.
Although not drafted particularly clearly, Section 675 is stating that if any person acting in a nonfiduciary capacity, can direct any person acting in a fiduciary capacity, to substitute trust assets of equal value, the trust will be grantor trust, to the extent of the power. We note as an initial matter that the statute uses the term “substitut[e] property of an equivalent value.” It appears that Congress was not contemplating basis implications when drafting Section 675. However, there is no reason to believe that the same immunization against income tax would not also apply to the swap. This is why estate planners believe that the assets swapped will carry their respective bases with them.
Now, let us look at an example. Suppose in the context of a gift or sale to a grantor trust, the grantor takes back a promissory note bearing adequate interest at the applicable federal rate. Later on, someone acting in a nonfiduciary capacity directs the trust to substitute higher basis assets with the grantor. The rationale for the substitution is to preserve the step up. Is it clear that Revenue Ruling 85-13 and IRC §675(4)(C) unimpeachably allow the grantor to accomplish this tax result? Most have assumed that it would. However, if this assumption is wrong, then dire income tax consequences could ensue. It is therefore important to prove (or disprove) the validity of this assumption. To test the hypothesis, we first consult Revenue Ruling 85-13 itself. We next consider ancillary sources, such as rulings promulgated in the context of qualified personal residence trusts, court decisions, and Section 1031, which provides for tax-free exchanges of certain property in certain contexts.
III. Revenue Ruling 85-13
In Revenue Ruling 85-13, the Service explained that where the grantor reacquired the corpus of the trust for an unsecured promissory note pursuant to the terms of the trust, IRC §675(3) and Treas. Regs. §1.675-1 “treat the grantor as the owner of [the] trust.” This is because administrative control is exercisable primarily for the benefit of the grantor. Revenue Ruling 85-13 interpreted IRC §675(3), which provides that the grantor trust status will arise where the grantor his “directly or indirectly borrow[ed] the corpus or income and has not completely repaid the loan, including any interest, before the beginning of the [next] taxable year.The Ruling concluded that “[b]ecause A is treated as the owner of the entire trust, A is considered to be the owner of the trust assets for federal income tax purposes.” [Citations omitted]. Revenue Ruling 85-13 mentions basis only once:
A’s basis in the shares received from T will be equal to A’’s basis in the shares at the time he funded T because the basis of the shares was not adjusted during the period that T held them. See Rev. Rul. 72-406, a ruling involving the determination of the grantor’s basis in property upon the reversion of that property to the grantor at the expiration of the trust’s term.
Apparently, most planners have blithely assumed that the basis implications provided for in Revenue Ruling 85-13, which involved a loan, and a reversion, would also extend to situations involving a substitution. While perhaps not an implausible or unjustified assumption, the nexus of this perceived connection must be examined. Loans by their very nature do not constitute taxable events. The argument would apparently be that since a substitution of assets is also not considered a taxable event, the basis of assets received by the grantor in such a swap would be a substituted basis of those assets. However, the authority for treating a loan as a nontaxable event is doctrinal, whereas the authority for treating the swap as a nontaxable event emanates merely from IRS guidance.
Is it correct, or reasonable, to assume that the basis implications for assets received through an IRC §675(3) loan are identical to those that result from an IRC §675(4) swap? Further inquiry is necessary. A first line of inquiry will be to consider qualified personal residence trusts, which have spawned similar basis issues, and later, an austere Treasury response.
IV. Qualified Personal
Residence Trusts & Swaps
Qualified personal residence trusts (QPRTs), not yet quite in the dustbin of estate planners, but getting there, boast a statutory lineage. Also grantor trusts, they have been used to reduce gift and estate taxes. In creating a QPRT, the grantor transfers his personal residence to a trust, retains the right to live in the residence for a term of years, and makes a gift of the remainder interest. For the technique to work, the grantor must live to the trust term. If the term of the QPRT is 10 years, the grantor is deemed to make a gift of the remainder interest in the trust corpus to trust beneficiaries. Reflecting the lengthy term of the QPRT, the amount of the gift would presumably be small, since most of the value of the trust principal would be locked up with the retained life estate of the grantor. The residual gift would tend to be small, because of its low present value.
However, as interest rates have declined, the present value of the remainder interests created by QPRTs has increased, thereby resulting in larger gifts to remainder beneficiaries. This, coupled with the massive increase in the federal gift tax exemption, and the decline in residential values, has made QPRTs rather unattractive today in most estate planning situations. [Some estate planners still advocate the use of QPRTs, although those planners are in the distinct minority. Without unduly digressing, it should be noted that QPRTs do possess some attractive nontax attributes, such as asset protection.] Returning to our inquiry, we note that astute estate planners saw an opportunity to ameliorate adverse income tax basis problems by enabling the grantor of the QPRT to repurchase the residence prior to the expiration of the QPRT term. In response to a flood of grantors repurchasing residences to gain an increase in basis at death, Treasury promulgated Reg. §25.2702-5(c)(9) for trusts created after May 16, 1996.
Those regulations require that the governing instrument of the trust include a provision prohibiting the trust from selling or transferring the residence to the grantor, the grantor’s spouse, or an entity controlled by either. The rationale for the regulation was well articulated in CCH Financial and Planning Guide (2009), at ¶2315.03:
This requirement prohibiting a sale or transfer prevents families using personal residence trusts or QPRTs from realize large income tax savings. If the grantor leaves the residence in trust until expiration of its term, the remainder beneficiaries will acquire the property with a carryover basis from the grantor, often leaving them with a large built-in gain. On the other hand, if the grantor were allowed to repurchase the residence just before the end of the term, more favorable tax results could be obtained. No gain would be recognized to the grantor on the repurchase, and at the end of the trust term, the beneficiaries would receive flat-basis cash. Further, the residence would return to the grantor, would be included in the grantor’s gross estate, and would receive a step-up basis under Code Sec. 1014.
What Treasury addressed in Reg. §25.2702-5(c)(9) is essentially a rather close variation of the problem we are addressing. Now we must ask the question: Is it plausible that IRS would not object to a swap of assets by the grantor shortly before death if the principal purpose was to create a basis step up? Revenue Rulings, now less common than they were in 1985, are pronouncements issued by the Service of its own accord. In contrast to Private Letters Rulings, taxpayers may rely on Revenue Rulings. (In practice, taxpayers rely on Private Letter Rulings as well). Assuming taxpayers can safely rely on Revenue Ruling 85-13, we then ask, does it unassailably support the proposition that the taxpayer may accomplish in the realm of a grantor trust swap what the Service forbade in the context of a QPRT? And even if it does, can the Service reverse itself; or worse, could Treasury enact regulations that could foreclose the technique? And if Treasury could so enact regulations, could those regulations be retroactive?
Ascertaining the likelihood of these various unpleasant scenarios should inform us of the risk we take should we advise our clients of the feasibility of substituting assets pursuant to IRC §675(4)(C) to achieve favorable basis results. Undeniably, Revenue Ruling 85-13, standing alone, clearly supports the proposition that an ill grantor may shortly before death swap out low basis trust assets in order to achieve a basis step up at death.
Treas. Reg. §25.2702-5(c)(9), which applies in the case of QPRTs, was a “fix” implemented by Treasury to stop a technique perceived by Treasury as abusive. Notably, the regulations do not themselves purport to alter the income tax consequences of the technique in the context of QPRTs — they only forbid the taxpayer from executing a trust that permits the forbidden transaction.
Presumably, were the taxpayer to violate the regulation and the IRS to learn of it, the Service could argue in Tax Court — perhaps with success — that the QPRT failed. Whatever tax consequences this conclusion would entail, they would certainly not be pleasant. Therefore, all but the most uninformed planners would draft a QPRT containing such language. If such language were to inadvertantly appear, prudence would dictate that the power should lay dormant, so as not to increase the risk already attendant with the errant provision. The Tax Court deciding such a case would not necessarily be required to decide whether the mere presence of the forbidden language in the QPRT — or an actual forbidden repurchase — would have achieved its intended result for tax purposes but for the regulation. Most likely, the Tax Court would not reach this issue, since the violation of the regulation forbidding the repurchase would suffice to decide the case. The question then becomes what would occur if Treasury attempted to impede the desired swap through the implementation of regulations, as it did with QPRTs which attempted to accomplish the same objective?
V. The Swap Power
With the foregoing in mind, we return to IRC §675(4)(C), which provides that the grantor is treated as owner of any portion of a trust if any person in a nonfiduciary capacity exercises a power to “reacquire the trust corpus by substituting other property of an equivalent value.” Let us compare IRC §675(4)(C) with IRC §675(1) — the subject of Revenue Ruling 85-13 — which provides that grantor trust status will ensue where the grantor or a nonadverse party purchases, exchanges or otherwise deals with the or disposes of the corpus or income of the trust without adequate consideration in money or money’s worth. Since IRC §675(4)(C) uses the term “reacquire,” it must be the grantor to whom the statute is referring as the person who substitutes the assets. Are the income tax consequences of a later “substitution” of property comparable to the initial sale of property to the trust? If they are, does that similarity arise from doctrinal sources, such as the grantor trust rules themselves? Or, could Congress enact regulations seeking to curtail the desired tax result?
A grantor trust becomes a nongrantor trust when the grantor dies. Tax attorneys are sharply divided concerning the income tax consequences arising on the death of the grantor of a trust trust holding appreciated property. There are three camps: One camp, the majority, believes that no realization event occurs, and no basis step up results. The second camp believes that a recognition event occurs, a captial gains tax is imposed, and a basis step up occurs. The third camp, a distinct minority, believes that no realization or recognition event occurs, but that the beneficiares receive a basis step up. It is clear that no consensus exists as to what income tax rules govern the grantor trust when it becomes a nongrantor trust at the death of the grantor.
Similarly, no known adverse authority (by “authority,” we expand the definition beyond what the IRS considers as authority, to include tax attorneys) exists which considers the possibility that the IRS could reverse course and attempt to limit the QPRT-like technique which we find in a substitution of assets to achieve a basis step up. Yet as noted, the IRS or the Treasury could conceivably attempt to forbid this transaction, and could possibly make the rule retroactive without violating the Constitution. With that in mind, we next consider a swap of assets under IRC §1031. Section 1031 provides for nonrecognition of gain in the context of certain exchanges of property held for productive use in a trade or business or for investment. The statute and regulations governing like kind exchanges fastidiously require deferred basis to be later reported in the event of a taxable sale. Why should Congress be less concerned with basis consequences in the case of a swap of assets involving a grantor trust than in, for example, an exchange of assets under Section 1031? It is therefore Section 1031 that we shall turn for guidance as to how Congress views the taxation of swaps in other contexts.
VI. IRC Section 1031
Section 1031 enables taxpayers to sell assets and defer gain provided their investment continued unabated in identical, or nearly identical form. A formal examination is beyond the scope of this Note, and is, more importantly, unnecessary. One of the basic precepts of Section 1031 is that a taxpayer cannot exchange property with himself. This rule was articulated in Bloomington Coca-Cola v. Com’r, 189 F.2d 14 (7th Cir. 1951) where Coca Cola conveyed land and cash to a contractor in exchange for the construction of a bottling plant on other land owned by Coca Cola.
Of course, a grantor who exchanges property with a grantor trust pursuant to the Section 675(4)(C) swap power is not engaging in a Section 1031 exchange. This is because the grantor trust is a disregarded entity. But with whom is the grantor exchanging property? Is it not the trustee, who is the legal owner of the trust? If this is the case, is not the transaction actually between two different legal entities, and would this not possibly implicate Section 1031? Perhaps the income tax rules, like the Heisenberg Uncertainty Principle, can change, depending upon the reason one is looking at them. Take, for example, the Pierre case, where the IRS argued that fractional discounts should not be allowed to a single member LLC since the entity is disregarded for income tax purposes. A sharply divided Tax Court held that even though the entity was disregarded for income tax purposes, it was a separate legal entity, and thus the taxpayer was entitled to take a valuation discount. Pierre v.Com’r, 133 T.C. No. 2 (8/4/09)
Consider as another example the rules governing exchange proceeds in a Section 1031 exchange. Even though the taxpayer is not deemed to be in constructive receipt of exchange funds for purposes of Section 1031 if a qualified intermediary is employed, the taxpayer is considered as receiving the exchange funds for other income tax purposes. IRC §468B, Treas. Regs. §1.468B. The point here is that while the basis consequences of the swap power may indeed be sanguine, one should not dogmatically assume such to be the case. Basis provisions for income and estate tax purposes are provided for in Sections 1011 through 1023 of the Code. Section 675(4)(C) makes no mention of basis.
The IRS issue no ruling with respect to the swap power in Section 675(4)(C) and any basis consequences attaching to such a swap. It is somewhat disconcerting to realize that we may have inadvertently assumed that the Service would forever interpret Revenue Ruling 85-13 in the manner to which we have become accustomed. Quite conceivably, the IRS could come to view these swaps as it did grantors who repurchased assets from QPRTs to gain a basis advantage. In conclusion, the Section 675(4)(C) power of substitution is an excellent choice for conferring grantor trust status on a trust. However, those who view the transaction as also conferring upon the grantor a later ability to shift basis may do so at their own peril. In this sense, Revenue Ruling 85-13 could be a Trojan Horse, inviting the taxpayer to reap substantial tax benefits only to incur unwarranted tax risks in doing so. Even if the IRS does not challenge the transaction, the victory — removing the appreciation from the grantor’s estate — may be pyrrhic if, as many believe, the estate tax is eventually eliminated.