Terminating a Trust- The Hidden Capital Gain Tax Trap

Take-Away: With the recent focus on obtaining an income tax basis ‘step-up’ to assets on an individual’s death, there is a lot of discussion with regard to terminating existing credit shelter trusts and returning trust assets to the lifetime beneficiary of that trust, so that upon the beneficiary’s subsequent death those distributed trust assets will receive an income tax basis increase. While a trust’s termination may be a sound strategy to explore when ‘free-basing’, the IRS just created a new risk to consider when a trust is commuted, imposing a deemed income- capital gain tax liability for some of the trust beneficiaries of the terminated trust, but with no tax basis to offset the capital gain recognition on that deemed sale.

Background: With the currently high federal estate tax exemptions ($11.4 million per person) and the portability of a deceased spouse’s unused federal estate and gift tax exemption amount, much of estate planning is no longer focused on saving federal estate taxes, but rather exposing assets held by a decedent to federal estate taxation, where their large transfer tax exemption is used to shelter their larger taxable estate. The goal from that estate ‘inclusion’ is to obtain a new (higher) income tax basis in those assets. [IRC 1014.]

This unique tax opportunity has prompted many to look for ways to have an older individual ‘own’ low income tax basis assets, so that upon the owner’s death those low income tax-basis assets will obtain a new, higher, income tax basis equal to their date-of-death values. If an existing trust was created years ago, and it now holds low income tax-basis assets, the planning motive is to ‘unwind’ or terminate that trust, return its low-basis assets to the lifetime beneficiary of that trust, and expose those low-basis assets to federal estate taxation on the former income beneficiary’s death, and thus obtain a new, higher, income tax basis to be enjoyed by the trust’s former remainder beneficiaries.

All of this makes sense if the trust’s income beneficiary’s available federal estate tax exemption is large enough to prevent any additional federal estate taxes to be paid, even when the distributed trust assets are added to the income beneficiary’s own assets. Hence, the current estate planning approach to ‘unwind’ or terminate existing trusts in order to intentionally expose its assets to estate taxation in exchange for a higher income tax basis in the trust’s assets on the distributee’s subsequent death.

Along Comes the IRS: The IRS recently published ten new related Private Letter Rulings (PLRs) that address the income tax implications of commutating, or terminating, an existing trust. As a broad generalization, under current Tax Code provisions, the proposed trust termination will trigger capital gains on the commutation of each of the respective beneficial interests in the trust. In addition, the IRS will also deny the trust’s income beneficiary any basis to reduce his/her recognized gain, thus imposing a tax on the entire value of the income beneficiary’s share of the trust’s commuted assets. While trust commutations are prohibited in certain types of trusts under the Tax Code, such as GRATs and QPRTs [Treas. Regulation 25.2702-5(c)(6)], most irrevocable trusts can be terminated either by the agreement of the trust beneficiaries and/or the consent of a local probate court. This ‘tax trap’ outcome is probably something that most trust beneficiaries do not consider when ‘free-basing’ motivates them to terminate their existing irrevocable trust. So how did the IRS come to this result in these PLRs?

PLRs: 2019-32001 to 2019-32010:

Trust Terms: The facts behind the IRS’ ruling are pretty complex, but I will try to keep them simple through the use of an example, since the amounts distributed were not identified in the PLRs. The trust was created prior to September 25, 1985, so the trust was ‘grandfathered’ from the federal generation skipping transfer tax (GST). As a result, ignore any GST implications or concerns. The trustee was directed to pay to the settlor’s son all net income from the trust, but there was no trustee discretion for the distribution of any trust principal to the son; the son only had an income interest. The remainder of the trust was to be distributed on the son’s death to the son’s issue per stirpes, outright, i.e. no continuing trusts for their interests. If a child of the son died before the son, that grandchild’s (of the settlor) interest in the trust then passed to his/her issue (the settlor’s great-grandchildren.) The decision was made to terminate the trust as the son ‘did not need the income from the trust.’

Commutation: The trust beneficiaries agreed to terminate the trust early, according to the actuarial value of the respective interests of the son, his four children, and the son’s eight grandchildren. These trust beneficiaries went to the local probate court to approve their settlement agreement and to terminate the trust. The trust’s termination was a commutation that was permitted by state law, so long as no material purpose of the trust was frustrated when it was terminated. The local court approved the settlement, but that judicial approval was contingent on the IRS ruling on a couple of questions, including the beneficiaries’ concern that with the commutation of their respective trust interests that (i) there would be no GST implications on the distribution of assets from the trust, and (ii) the termination and proposed distribution of trust assets would not cause either the son or his four children to recognize any unrealized appreciation of the assets that they were all to receive on the trust’s termination. The proposed trust termination did not create any GST problems since the trust had been ’grandfathered’ due to its existence prior to September 25, 1985. The IRS’ answer to the capital gain question was an entirely different matter, which will leave heads scratching.

Hypothetical Distribution and Tax Consequence: These PLRs do not include any values to describe the capital gain tax implications on the trust’s termination. Consequently, an example is used to provide a context to explain the IRS’s analysis. Since the trust was formed prior to 1985, there was substantial appreciation in the trust’s assets over the decades. Thus, assume the trust’s corpus is now worth $20.0 million on the eve of its termination. Assume, further, a $5.0 million income tax basis in the trust corpus’ $20.0 million fair market valuation. The son’s actuarial interest in the trust is worth $8.0 million. The four grandchildren’s collective actuarial interest in the trust’s corpus is worth $11.0 million. The great-grandchildren’s collective actuarial interest in the trust is worth $1.0 million; the great-grandchildren’s interest in the trust is a relatively small value because they will receive nothing if their parent (grandchild) survives the son, when the trust is set to terminate. In short, a fairly conventional trust, with lots of appreciation of its assets.

Uniform Basis Allocation: The trust’s $5.0 million in income tax basis is divided following the Uniform Basis Rules contained in the Tax Code. The son’s basis will be set at $2.0 million. The grandchildren’s collective basis will be set at $2.75 million. The great-grandchildren’s collective basis will be set at $250,000.
Son’s Tax Consequences: Following the facts used in the example along with the uniform basis allocations, the son will pay long-term capital gains tax at 20%, plus the 3.8% net investment income tax, and also any state income tax [for our example, assume Michigan’s at 4.25%] on his $8.0 million distribution. However, the son cannot use his $2.0 million share of the trust’s basis, which will be explained below. The great-grandchildren will pay long-term capital gains on the $1.0 million distributed to them, but they are permitted to use their $250,000 share of the trust’s uniform basis allocated to them to offset their recognized gain; thus, they will incur $750,000 of long-term capital gain.
Grandchildren are a Deemed Buyer: As the deemed buyer under the Tax Code’s uniform basis rules, rather than as a seller, the four grandchildren do not pay tax on their receipt of their commuted share of the trust’s corpus on its termination. The commutation transaction triggers a tax to the four grandchildren on the $9.0 million of assets that are distributed to the son and to the great-grandchildren to purchase their shares, less the $2.25 million of basis attributed to those assets [$9.0 million less $2.25 million = $6.75 million, net long-term capital gain.]
Tax Obligation from the Trust’s Termination: In sum, the total gain triggered on the trust’s termination among the entire family is $11.5 million: [$8.0 million + $750,000 + $6.75 million.] If there is an effective combined tax rate imposed of 28.05% [20% federal + 4.25% state + 3.8% NIIT federal = 28.05%] the total tax on this $11.5 million of gain recognized is $3,225,750. Yes, that will be the tax liability on an in-kind distribution of trust assets on its termination in a commutation of all of the beneficiaries’ interests in the trust.
Big Picture Take-Away: According to the IRS, by terminating the trust early, there is a $3.225 million tax bill. If the trust had continued until the son’s death, there would be no capital gain tax due on the trust’s termination. Note, too, that the $8.0 million in assets, less the capital gains taxes paid by son, will be included in son’s taxable estate at his death, where, depending upon the year of his death, there may (or may not) be any federal estate tax exposure, but there will be a basis ‘step up’ in those assets on Son’s death.

IRS View of Capital Gains on Trust Termination:

Deemed Sale: The key phrase in the IRS’s response in the PLRs was the following: “Although the proposed transaction takes the form of a distribution of present values of the respective interests of Son, the Current Remaindermen [settlor’s grandchildren] and the Successor Remaindermen [the settlor’s great grandchildren], in substance it is a sale of Son’s and the Successor Remaindermen’s interests to the Current Remaindermen [settlor’s grandchildren.] …In addition, to the extent that a Current Remainderman [grandchild] exchanges property, including property deemed received from the trust, for the interests of Son and Successor Remaindermen [great-grandchildren], the Current Remainderman [grandchild] will recognized gain or loss on the property exchanged. Accordingly, based on the facts submitted and representations made, for purposes of determining gain or loss, the amount realized by each Current Remainderman [grandchild] will be equal to the amount of cash and fair market value of the trust interests received in exchange for the transferred assets. Section 1.1001-1(a) and Revenue Ruling 69-486.”

Commutation of Beneficial Interests is a ‘Sale’: The IRS also assumes that a commutation is a sale by reference in a long-standing revenue ruling that concerns non-pro rata distributions. “ In Rev. Ruling 69-486, a non-pro rata distribution of trust property was made in kind by the trustee, although the trust instrument and local law did not convey authority to the trustee to make a non-pro rata distribution of property in kind. The distribution was effected as a result of a mutual agreement between the trustee and beneficiaries. Because neither the trust instrument nor local law conveyed authority to the trustee to make a non-pro rata distribution, Rev. Ruling 69-486 held that the transaction was equivalent to a pro rata distribution followed by an exchange between the beneficiaries, an exchange that required recognition of gain under IRC 1001. Although the proposed transaction takes the form of a distribution of the present values of the respective interests of Son, the Current Remaindermen [grandchildren] and Successor Remaindermen [great-grandchildren], in substance it is a sale of Son’s and the Successor Remaindermen’s [great-grandchildren’s] interests to the Current Remaindermen [grandchildren.]” In short, in the view of the IRS, any commutation/termination of a trust is a sale or exchange in substance, regardless of what authority was granted under the trust instrument or state law. An agreed upon distribution of trust assets to a trust’s income beneficiary, followed by a gift of those assets to the remainder beneficiaries of their commuted value of the trust, will probably be treated the same since, in substance, it would be a sale and exchange, even if the form of the transaction was a lawful distribution of the corpus by the trustee followed by a gift.

Not All Beneficiaries are ‘Selling’: Note that these PLRs produce a very strange result. Both the Son and great-grandchildren are treated as selling their interests in the trust when their interests are commuted, yet the grandchildren [remainder beneficiaries] are not treated as being involved in a ‘sale’ of their interests resulting from the same commutation of their trust interests. As such, some beneficiaries are faced with paying capital gains taxes while other trust beneficiaries are not faced with a current capital gain tax liability that they must pay.

The ‘Case of the Disappearing Basis’: The tax result for the son is because the son’s basis in the trust’s assets is effectively destroyed. This is a function of IRC 1001(e)(1). IRC 1001(e)(1) deems the sale of a trust income interest to have a zero ($0.00) tax basis. That Code section provides: “In determining gain or loss from the sale or other disposition of a term interest in property, that portion of the adjusted basis of such interest which is determined pursuant to sections 1014, 1015 or 1041 (to the extent that such adjusted basis is a portion of the entire adjusted basis of the property) shall be disregarded.” While there is a statutory exception to this rule when the sale is part of a transaction in which the entire interest in property is transferred to any person [IRC 1001(e)(3)], a commutation, per the IRS, does not fit within the wording of the exception to IRC 1001(e)(3), because trust beneficiaries in a commutation are not transferring ‘their’ property to another in the traditional sense. As a result of this Code provision, the son’s basis in the trust’s assets disappears, and thus it is not available to off-set any gain recognition at the time of his deemed sale.

Conclusion: Back to the example. The son must pay long-term capital gains tax on the entire amount of his commuted interest in the trust that is distributed to him, with no amount of the allocable income tax basis available to offset that recognized gain. The great-grandchildren must pay long-term capital gains tax on the amount that they receive from the trust, but their allocable share of the trust’s basis as determined actuarially under the ‘uniform basis rules’ is available to mitigate to a degree the capital gain on which they must pay a tax. The grandchildren will only pay tax to the extent of the unrealized appreciation that is triggered on the amounts that are distributed to the son and the great-grandchildren for their shares or interests in the trust.

By being deemed to have purchased the son’s and great-grandchildren’s shares in the trust, the grandchildren consequently will receive a ‘seller’s’ basis in the trust’s assets. The IRS deems the grandchildren to have purchased the basis, even though the grandchildren did not actually pay anything either to the son or to the great-grandchildren for their interests in the trust. Rather than preserve the disappearing basis for the grandchildren (to perhaps use later when the distributed in-kind appreciated trust assets are sold by them) the IRS probably will take the position that the grandchildren will only have their pro rata carry-over uniform basis in their remaining trust assets after the distribution.

Income tax basis planning will persist with the early terminations of existing irrevocable trusts in the search for basis ‘step-up’ on the death of a former trust beneficiary. Balanced against that ‘free-basing’ estate planning strategy, however, will be these PLRs, which create a significant income tax danger to the early termination of an irrevocable trust. (This bizarre tax result might even be applied to a major trust reformation.)

How can a trust be terminated without triggering IRC 1001(e) and its ‘disappearing basis’ rule in a deemed sale by the trust income beneficiary? Maybe the income beneficiary could gift or disclaim his/her interest in the trust to the remainder trust beneficiaries, but even then that gift might cause the IRS to view the gift/disclaimer transaction as a deemed sale. I guess the key message here is be very careful in making the decision to terminate an existing irrevocable trust in the search of a ‘free-basing’ opportunity.