Take-Away: The sale of appreciated assets to a grantor trust in exchange for an installment note is a popular estate planning technique that is used to remove appreciating assets from the seller’s taxable estate, but without incurring a capital gain tax on the sale to the trust. Unfortunately, a couple of questions still remain unanswered with the settlor’s sale of an appreciating asset to his/her grantor trust in exchange for an installment promissory note. Because these questions have not been readily answered by the IRS, it would be best for the grantor trust to pay off the promissory note in full before the settlor dies.

Background: The sale of an appreciating asset by its owner to a grantor trust in exchange for an installment promissory note is a well-known estate planning strategy. The sale is to what is called an IDGT, or intentionally defective grantor trust, since the seller intends that he/she will continue to pay the income taxes generated by the assets held in the grantor trust, and because of the seller’s intention to not trigger capital gain recognition on that sale. Such a sale is not a taxable gift, assuming that the exchange (asset for note) is for fair market value. The settlor continues to be liable to pay the grantor trust’s income tax liability, which enables the assets held in the trust to grow in a (sorta) tax-free environment (with the settlor paying the income tax liability but not have that payment be treated as a taxable gift to the trust beneficiaries.)

No Capital Gain Recognition: Because the sale is deemed to be with oneself (settlor sells to grantor trust), no capital gain is recognized as the settlor is viewed as having sold the appreciating asset to himself/herself. In effect, the sale is ignored for capital gains tax reporting purposes. [Revenue Ruling 85-13.]

Interest Paid Not Taxable Income: Moreover, the interest paid on the installment note that the grantor trust gives to its settlor is also not taxable, as the interest paid is treated as being paid to oneself.

Income Tax Payments: As noted, the settlor pays the trust’s income tax liability which is not treated as a taxable gift by the settlor. Those tax payments will also reduce the size of the settlor’s estate when it comes to paying federal estate taxes, sometimes called an estate burn.

Open Questions: While these are important benefits to be derived from an IDGT transaction which many individuals use as part of a sophisticated estate plan to freeze the size of their taxable estate, what is surprising to learn is that a couple unanswered questions remain with regard to an IDGT transaction, especially when the settlor-grantor dies while the installment note given in exchange for the appreciating asset remains outstanding. Making things even more interesting is that many commentators hold/argue various interpretations of what ‘should happen’ when the settlor dies holding the installment note given by their grantor trust, yet there is no consensus on the tax treatment resulting from the settlor-grantor’s death. A brief review of those BIG, albeit unanswered, questions with regard to an IDGT on the settlor’s death follows.

  1. Unsatisfied Promissory Note on Grantor’s Death: The question arises when the settlor-grantor dies, since their death terminates the trust’s grantor trust income tax status. On the grantor’s death the trust is no longer classified as a grantor trust for income tax reporting purposes- it  becomes a separate tax paying entity. [Revenue Ruling 77-402; Regulation 1.1001-2(c), Example (5).] Is the settlor’s death treated as a transfer of the assets and liabilities of the trust to the IDGT at that time? The settlor’s death will cause tax consequences, but neither the Tax Code nor the Regulations explain those tax consequences, thus leaving them open to debate. One Tax Court decision clearly says, though, that the loss of grantor trust status while the settlor is alive is a taxable event as to the settlor. Madorin v. Commissioner, 84 Tax Court 667 (1985). The question then is whether this same taxable event result applies when the settlor dies, thus causing the trust to no longer be a grantor
  2. What is the Income Tax Basis of the Trust Assets on the Grantor’s Death? One argument goes that there is no gain realized on the settlor’s death. The reasoning is that the termination of the grantor trust status on the settlor/grantor’s death is, in effect, a testamentary transfer at the moment of the settlor’s death with a deemed testamentary transfer of all of the trust assets, and all of the trust’s liabilities, by the settlor to the irrevocable trust on his/her death. Thus, under this deemed testamentary transfer theory, IRC 1001 does not apply- it is a transfer-on-death, not a lifetime transfer, which results in an income tax basis adjustment. But the question of what is the income tax basis of the trust’s assets following the settlor’s death is still unclear.  Three or four distinct theories have been floated by law professors and commentators, each with its own set of proponents:
  • the transfer is a deemed testamentary transfer by the deceased settlor is a bequest or devise which applies to cause the income tax basis in the trust’s assets to be equal to the settlor’s date of death fair market value [IRC 1014, step-up in basis on death of owner.] This theory leads to a new income tax basis equal to the date of death fair market value, even though the trust’s assets are not included in the settlor’s gross estate for federal estate tax purposes [I call this the ‘have your cake and eat it too’ theory;] or
  • the transfer is viewed as a sale by the deceased settlor to the trust at the moment of his/her death [IRC 1012, purchase price paid is the new tax basis]; under this theory, the trust’s assets will receive an adjusted income tax basis equal to the original purchase price along with the gain being recognized on the sale [but it is hard to imagine the settlor selling assets when he/she is already dead]; or
  • the transfer is viewed as a gift by the deceased settlor to the trust on death, even though the settlor is dead, which results in the same income tax basis for the transferred assets that they held while the settlor was alive [IRC 1015, carry-over basis]; [but how can the settlor make a gift after he/she had died]; or
  • A possible fourth possibility is that there is no change in the income tax basis of the trust’s assets on the settlor’s death, as the ‘transaction’ is a nullity for income tax reporting purposes. [Revenue Ruling 85-13.]
  1. What is the Income Tax Basis of the Installment Note in the Settlor’s Estate? Disagreement also exists with regard to how to answer this question with regard to the deceased settlor’s outstanding promissory note and how it is treated on death.
  • Some believe that gain is recognized on the settlor’s death and that the basis of the promissory note included in the settlor’s estate would not be adjusted to its fair market value on the date of death, or the alternate valuation date, because it constitutes income in respect of a decedent (IRD). Gain would be recognized to the extent that the balance due on the promissory note exceeded the settlor’s basis in the ‘sold’ assets immediately prior to death, increased by any adjustment allowable under IRC 691(c) for the estate tax attributable to the IRD [but the note principal is not income as defined by the Tax Code;] or
  • Others believe that gain is not realized on the settlor’s death and that the promissory note is not IRD because no sale actually occurred during the settlor’s lifetime. Because the IDGT is a grantor trust, no payments on the promissory note during the settlor’s lifetime can constitute taxable income to the seller, including interest that is paid on the promissory note, as one cannot pay taxable interest to oneself. [Revenue Ruling 85-13.] Thus, the absence of IRD results in the note acquiring a new income tax basis equal to the value at which it is included  (and reported) in the settlor’s gross estate. [IRC 1014.]

This is probably an easier question to answer than the impact on the income tax basis of the grantor trust’s assets. That is because the note is actually owned by the deceased settlor, not the grantor trust. Consequently, the promissory note is clearly included in  the settlor’s gross estate as a probate asset (if not held in the name of the settlor’s revocable trust). [IRC 2033 or IRC 2038.] In short, the disregarded promissory note (it is not recognized for income tax purposes) should be given a new adjusted income tax basis that is equal to fair market value as of the date of death. [IRC 1014.] Yet the debate continues on this topic.

Summary: The best guess in answering these unanswered questions are:

  1. No Gain Recognition: There is no gain to be recognized on the settlor (seller’s) death with regard to the trust assets;
  2. Trust Assets’ Basis Remains Unchanged: The income tax basis of the assets held in the grantor trust is unchanged by virtue of the settlor’s death; and
  3. Promissory Note Basis Adjusted: The promissory note held by the settlor is included in the settlor’s gross estate and therefore it takes on a fair market value after the settlor’s death.[IRC 1014.]

Conclusion: These unanswered questions with regard to IDGTs tend to cast a pall on the clear benefits that arise from the sale of an appreciated asset to the IDGT. It would seem that the best solution is to ensure that the settlor is fully paid and the promissory note is cancelled prior to the settlor’s death, if possible. The grantor trust could also purchase life insurance on the settlor to provide immediate liquidity on the settlor’s death to fully pay the promissory note held by the settlor in order to  eliminate these lingering questions. Even if the promissory note is fully paid during the settlor-seller’s lifetime, the trust will continue as a grantor trust that would require the settlor to pay the trust’s income tax liability, thus permitting the assets held in the trust to grow in a tax-free environment (acknowledging that the settlor continues to actually pay the trust’s income tax liability, but it is not treated as a taxable gift by the settlor.) Hopefully the IRS will get around to someday to answering these questions with regard to the settlor dying while the note from his/her grantor trust remains unpaid.