Basis Basics

Take-Away: One of the big questions that no one seems to be able to comfortably answer is:  “What is the income tax basis is in grantor trust’s assets when the grantor of the trust dies?”

Background: There is an on-going debate among commentators with regard to the income tax basis of assets that are held in a grantor trust on the death of the trust’s grantor. Going back to 2002, some highly regarded estate planning attorneys and a law professor wrote an article that concluded that the assets held in a grantor trust, which is irrevocable for federal estate tax purposes, but not for federal income tax purposes, should receive an income tax basis step-up on the trust grantor’s death. As the years passed, other law professors disagreed with the estate tax value/step-up in basis conclusion associated with a grantor trust. Theses second opinions were that the grantor trust assets retained their original income tax basis if the assets transferred to the grantor trust were gifted by the grantor, or the basis remained the sales-price cost if the grantor sold the assets to the grantor trust in exchange for an installment promissory note, i.e. the commonly referred to estate planning strategy of a sale-to-a-defective-grantor-trust (IDGT.) While an installment sale to a defective grantor trust is not all that common, consider a donative transfer to a spousal lifetime access trust (SLAT) which is currently in vogue to exploit the transferor-spouse’s temporarily large basic exclusion amount, where the SLAT is taxed as a grantor trust. [IRC 677, a trust created for the settlor’s spouse.]

IRS Silence: What is surprising is that there has been no definitive ruling from the IRS over the decades as to the income tax basis of assets held in a grantor trust when the trust grantor dies.  For several years this income tax basis question with regard to assets held in a grantor trust appeared on the IRS’s Priority Guidance list, but no answer was provided. The topic  then disappeared for a few years. The most recent Priority Guidance issued by the IRS on November 4, 2022 finds that this income tax basis question back before the IRS as a priority, but when the IRS actually gets around to answering the question remains begs the question. I suspect that the reappearance of the grantor trust’s basis in its assets on the grantor’s death as a priority topic was precipitated by a March 8, 2022 letter from U.S. Representative Bill Pascrell to the Department of Treasury in which he requested that Treasury publish Regulations that clarify the phrase bequest, devise, or inheritance in IRC 1014(b)(1) does not apply to the termination of grantor trust status upon the grantor’s death or to the transfer of an irrevocable grantor trust’s property on the grantor’s death. [More on that below.]

Basic Basis Rules: This income tax basis confusion (or debate) prompts a short review of the Tax Code’s income tax basis rules, and in particular what rules might apply when the grantor of a grantor trust (irrevocable for transfer tax purposes, but not for income tax purposes) dies. A short summary of those basic basis rules that could be applied in the debate as to what income tax basis rule applies to the grantor trust assets on the grantor’s death follows:

Argument #1- IRC 1014: If the grantor’s transfer to the grantor trust is viewed as a bequest or devise, then IRC 1014 will apply to cause the trust’s basis to equal the date of the grantor’s death fair market value, a step-up (or down) basis.

Argument #2- IRC 1012: If the grantor’s transfer to the grantor trust is viewed as a sale, then IRC 1012 will apply to cause the trust’s basis to equal the original purchase price, i.e. a cost basis.

Argument #3- IRC 1015: If the grantor’s transfer to the grantor trust is viewed as a gift, then IRC 1015 will apply to cause the trust’s basis to be the same as the grantor’s income tax basis at the time of his/her transfer to the trust, i.e. a carryover basis.

Estate Inclusion Argument: The 2002 aggressive interpretation is that the assets titled in the grantor trust are treated as a bequest, thus causing the value of the grantor trust’s assets to be adjusted to date-of-death. [IRC 1014(b)(9).] That Tax Code provision provides, in part:

1.  Except as otherwise provides in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be- (1) the fair market value of the property at the date of the decedent’s death;[ (2)-(4) omitted]
2. For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent: (1) Property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent. [emphasis added.]

IRS Response: It should come as no surprise that the IRS takes issue with the estate inclusion/basis step-up position maintained in argument #1 with regard to a grantor trust  when its grantor dies. In ECC 200937028, the IRS National Office stated this disagreement with the estate inclusion/step-up interpretation.

“We strongly disagree with taxpayer’s contention. In this case, the taxpayer transferred assets into a trust and reserved the power to substitute assets.

Section 1014(b)(1)-(10) describes the circumstances under which property is treated as having been acquired from the decedent for purposes of the section 1014 step-up rule. Since the decedent transferred the property into trust, section 1014(b)(1) does not apply. Sections 1014(b)(2) and (b)(3) apply to transfers in trust, but do not apply here, because the decedent did not reserve the right to revoke or amend the trust. None of the other provisions appear to apply at all in this case.

Quoting from section 1.1014-1(a) of the Regulations: ‘The purpose of section 1014 is, in general, to provide a basis for property acquired from a decedent which is equal to the value placed upon such property for purposes of the Federal estate tax. Accordingly, the general rule is that the basis of property acquired from a decedent is the fair market value of such property at the date of the decedent’s death….Property acquired from the decedent includes, principally,… property required to be included in determining the value of the decedent’s gross estate under any provision of the Internal Revenue Code.’”

This IRS’s strongly disagree  position is based on an intentionally defective grantor trust where the grantor intentionally retains the power to substitute assets of equivalent value. But what about a conventional SLAT where the settlor-spouse may not retain the power to substitute assets of equivalent value with the irrevocable trust he/she creates, but the trust is nonetheless classified as a grantor trust merely because their spouse is the trust’s beneficiary, i.e. not a sale, but a gift-transfer?

The Question: For Federal estate tax purposes, unless property is expressly included by the Tax Code in a deceased individual’s gross estate, e.g. IRC 2031-2045, the property is not included in the decedent’s gross estate for federal estate tax purposes. Consequently, if an interest in property is not expressly included in the gross estate by reference to a specific section of the Tax Code, that interest in the property is not included in the decedent’s gross estate, or as one commentator recently coined it, the property interest escapes the ‘gravity of the estate tax solar system.’ The moment before the grantor’s death the decedent-grantor owns the property and is required to report income and gain from the trust’s property, and the moment after the grantor’s death, a non-grantor trust owns the property. Arguably something happened to shift ownership; that ‘something’ shifted the incidence of taxation from the deceased-grantor to a trust. The trigger event for this shift is the grantor’s death. The issue then is whether that ‘mythical’ transformation on the deceased-grantor’s death is a bequest, devise, or inheritance, or by the decedent’s estate from the decedent. One hopes is that this metaphysical transformation will soon be answered by the IRS in its promised priority guidance.