Wonking Out – Proposed Tax Legislation Creates More Issues than it Solves

In my last column I reviewed how the proposed tax legislation treats Intentionally Defective Grantor Trusts (IDGTs) as being owned by the grantor at his or her death rather than outside of the estate for estate tax purposes. (You can read that column here.) Today I’m going to wonk-out and describe why the proposed legislation creates more issues than it solves.

To fully understand why I say this, we must first review why the grantor trust rules were enacted. In the 1950s the top income tax rate was 91%. High-bracket taxpayers saw an opportunity to shift income by dividing their investment assets among dozens (and in some cases hundreds or even thousands) of trusts that could claim to be separate taxpayers, each with their own set of lower marginal rates.

To combat this practice, the Internal Revenue Code of 1954 included a set of rules under which a trust would be ignored for income tax purposes where the grantor retained certain powers over the trust assets, (see Sections 671-678) resulting in the trusts being conglomerated on the grantor’s individual tax return. That’s for federal income tax purposes.

At the same time, certain retained powers will not result in trust assets being included in the grantor’s estate for federal estate tax purposes. This asymmetry is the source of the current problem. By treating grantor trust income differently for income rather than for estate tax purposes, clever estate planning attorneys found several ways to take advantage.

A parent, for example, can create a trust that pays income to children and grandchildren, yet the parent is taxed on that income, creating the means to transfer additional wealth, as the payment of tax for the children is not treated as a gift. Further, a trust that is ignored for income tax purposes is free to loan and/or a purchase assets with its grantor, or both, without the economic impact of those transactions being subject to income or capital gains tax. Therefore, a parent can “sell” an asset to an IDGT that benefits his children, taking back a promissory note, and that parent won’t recognize any capital gains or interest income, yet he transfers the asset and the future appreciation out of his estate for estate tax purposes.

Consequently, creating irrevocable trusts that are respected for gift and estate tax purposes but ignored for income tax purposes became a staple of estate planning and wealth transfer. Combine these with valuation discounts and IRS qualified below-market interest rates, IDGTs have been used to help facilitate the transfer of substantial amounts of wealth to younger generations without gift or estate tax. I frequently use these strategies for my clients in my practice.

These are the strategies that Congress is trying to eliminate.

Does the proposed legislation achieve their goals? Yes, but they also raise unresolved issues. The proposed law would make all grantor trusts included in the grantor’s estate for federal estate tax purposes. This would include, for example, a life insurance trust that uses any income, past or present, to pay policy premiums.

There are other ambiguities as well. The current grantor trust rules, for example, provide that an IDGT is a disregarded entity and treated as if it were the grantor. The legislation would contradict this treatment by saying that a grantor trust will not be disregarded in the context of a transfer of property between a grantor trust and its grantor. Presumably the purpose is to cause a taxable recognition of gain on any sale or exchange between a grantor and a grantor trust. But what if the grantor trust is the one with the gain? Doesn’t the trust now pay its own tax on that gain? Or is the carve out just for the recognition of gain and not for the payment of tax? What is the effect when the grantor pays the tax?

These are as much income tax questions as gift/estate tax questions.

What about a swap power? The Code now provides that a trust is a grantor trust if the grantor has the power to reacquire the trust assets by substituting other property of an equivalent value. I use this frequently to swap appreciated property (that have large, unrealized capital gains) for cash so that on the grantor’s death, there is a step-up in tax cost basis on the appreciated property. The proposed law, if enacted, would eliminate this strategy.

Grantor Retained Annuity Trusts (GRATs) and Qualified Personal Residence Trusts (QPRTs) might also be at risk despite having specific Code Sections authorizing their use. Unlike the grantor trust statutes that appear in the income tax section of the Code, GRATs and QPRTs are found in the transfer tax (gift, estate, generation skipping transfer) section of the Code. Would they be eliminated or not?

Which brings us to the $64,000 question. What exactly is Congress trying to do? Is the goal to stop taxpayers from taking advantage of the asymmetry between the income and transfer tax rules or is the goal to sweep away the use of many types of trusts commonly used as estate planning tools?

As happens most often, in writing sweeping changes to the tax laws, Congress creates as many conundrums as it solves.

©Craig R. Hersch learn more at

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