Does an intentionally defective grantor trust get a step up in basis

By Christopher D. Wright  |  June 28, 2021

Grantor trust status was a focus of discussion at the Heckerling Institute on Estate Planning held in May 2021, a week-long gathering of estate planning professionals sponsored by Marks Paneth. The annual Institute brings together practitioners to discuss high-level issues related to current trends and potential legislative changes.

A planning tool often used by high-net-worth individuals, grantor trusts are a frequent topic at the Institute, and this year were discussed in several of the seminars.

Current legislative proposals have made this discussion more relevant - if enacted, they could significantly change how grantor trusts are utilized. A few of the proposed changes are highlighted below:

• Grantor Retained Annuity Trusts would have a required 10-year minimum life.

• Assets in a grantor trust would be included in the grantor’s estate (for trusts created after the enactment date).

• Distributions from a grantor trust during the life of the grantor would be considered a taxable gift. (This applies to transfers to current trusts after enactment).

• The assets of a grantor trust will be a gift if grantor status toggled off during the grantor’s lifetime. (This applies to transfers to current trusts after enactment).

The good news is that most of these proposals would not impact current grantor trusts unless post-enactment additions were made to a trust.

Grantor trusts are a favorite tool of most estate planners because they not only remove the assets contributed to the trust, including appreciation, from the grantor’s estate, but the estate is further reduced by the continuing tax obligation of the grantor while the trust is a grantor trust. There are two significant consequences of grantor trust status: 1) The grantor is deemed to own all the assets of the trust for all federal income tax purposes, and 2) any transaction between the grantor and the grantor trust will be ignored for all federal income tax purposes. This allows the grantor to sell assets to the trust without any income tax impact and since it is a sale it is also not a gift.

So why would you want to turn (toggle) off grantor trust status? The primary reason grantor trust status is toggled off is the burden of the grantor paying the tax on the trust income outweighs the other benefits of the grantor trust status, or when a significant income realization, such as a sale, is anticipated in the near future. Grantor trust status also automatically terminates upon the death of the grantor.

Turning Off Grantor Trust Status During the Grantor’s Lifetime

To toggle off grantor trust status the powers that created the grantor trust status must be released. The most common power that creates grantor trust status is the power to substitute assets in a non-fiduciary capacity with assets that have the same fair market value as the assets in the trust. To toggle off grantor trust status the grantor must release this power. When the power is released, the trust will not be taxed as a non-grantor trust.

When the grantor trust status is terminated during the grantor’s lifetime, the grantor is deemed to have transferred the assets to the trust for federal income tax purposes on the date the grantor trust status ended. In the year of termination of grantor trust status, the grantor will continue to be taxed on the income up to the date of termination and the trust will be the taxpayer for the remainder of the year.

Care must be taken when terminating grantor trust status. There are times when the termination of grantor trust status can create taxable income to the grantor:

1. If the trust holds an interest in a partnership that has liabilities in excess of the basis in the partnership, gain will be realized by the grantor for the amount of liabilities in excess of the basis in the partnership.

2. If the trust has non-recourse liabilities to a third party that are secured by the assets of the trust, then the grantor will recognize gain to the extent liabilities exceed the basis in the asset.

3. The grantor may also recognize capital gain if the trust owes the grantor money (such as the case of a sale to a grantor trust using an installment note), because the trust may be deemed to have received the secured asset from the grantor in exchange for the debt to the grantor.

The basis of the assets in the non-grantor trust will be either 1) the carryover basis if no gain is recognized on the termination of the grantor trust status or 2) the gain recognized on termination plus the basis in the asset at the time of termination.

Termination of Grantor Trust Status at Death

Grantor trust status automatically terminates at the death of the grantor and, therefore, the grantor is no longer considered the owner of the trust property for income tax purposes as of the date of death. While there is no direct authority, it appears that there is no deemed sale, and accordingly, no gain is recognized by the trust or the grantor’s estate at the death of the grantor.

While there are some opinions to the contrary, the basis of the assets in the trust is the carryover basis as of the date of death under IRC § 1015. Under current law assets in a grantor trust do not receive a step up in basis upon the grantor’s death and are not included in the taxable estate of the grantor. However, one of the current proposals put forth by Sen. Bernie Sanders, D-VT, is to have the assets of a grantor trust be part of the gross estate of the grantor.

Other Implications of Terminating Grantor Trust Status

If the trust owns an interest in a closely held business, toggling off grantor trust may have other complications.

1. Trust income is subject to narrower income tax brackets.

   Trust income is taxed at the highest marginal rate much sooner than if the same income was taxed at the individual level. If the grantor is in the highest tax bracket, switching a non-grantor trust may cause the trust to pay the highest tax rate, thus not resulting in any real tax savings and depleting the trust assets.

2. S Corporation ownership restrictions.

   In general, trusts are not permissible shareholders of S Corporations. One of the exceptions is if the trust is taxed as a grantor trust. Terminating grantor trust status may inadvertently also cause any S Corporation status of the underlying S Corporation to also be terminated. When switching to a non-grantor trust, care must be taken to ensure that the trust can qualify to be either an Electing Small Business Trust (“ESBT”) or a Qualified S Corporation Trust (“QSST[WC6] ”).

3. Net Investment Income Tax

   While a grantor trust, the income of the trust that is taxed to the grantor may not be subject to the Net Investment Income Tax (NIIT). This is especially true where the grantor may be considered a real estate professional or where the grantor materially participates in the real estate activity, thus the income is active trade or business and therefore not subject to the NIIT. Upon the termination of grantor trust status, the trust may not be able to meet these same tests and, thus, the income will now be subject to NIIT at 3.8% in addition to the tax already incurred.

While shifting the tax burden from the grantor to the trust may be appealing, in some cases this may cause the trust to pay more income taxes than if the income is taxed on the grantor’s tax return.

We are here to help you if you are considering terminating your grantor trust status, and we can assist you in determining the income and estate tax impact.

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