The Treasury Department has released its Fiscal 2023 Green Book, Tax Analyst Doc. No. 2022-186, which contains fiscal year 2023 revenue proposals. The headings include “Reform the Taxation of Capital Income,” “Impose a Minimum Income Tax on the Wealthiest Taxpayers,” and “Modify Estate and Gift Taxation,” the last of which has “Modify Income and Estate Tax Rules for Certain Grantor Trusts,” “Require Consistent Valuation of Promissory Notes,” “Require Reporting of Estimated Tax Value of Trust Assets” and “Limit Duration of Generation-Skipping Transfer Tax Exemption.” Sections have headings “Current Law,” “Reasons for Change” and “Proposals.” With one exception for the “Promissory Notes” discussion, the following take-ins include only the Proposals, followed by a heading of our “Comments.” These proposals are more detailed than the ones from the Fiscal 2022 Green Book which were discussed in Issue 2021-2 at pages 16-19.
A change in the “applicable exclusion amount” (AEA) is not mentioned. For discussion purposes, we will assume a reduction to the “old” figure of about $5 million which is scheduled to take place on January 1, 2026.
1. REFORM THE TAXATION OF CAPITAL INCOME
Tax capital income for high-income earners at ordinary rates
Long-term capital gains and qualified dividends of taxpayers with taxable income of more than $1 million would be taxed at ordinary rates, with 37 percent generally being the highest rate (40.8 percent including the net investment income tax). The proposal would only apply to the extent that the taxpayer’s taxable income exceeds $1 million ($500,000 for married filing separately), indexed for inflation after 2023.
The proposal would be effective for gain required to be recognized and for dividends received on or after the date of enactment.
Treat transfers of appreciated property by gift or on death as realization events
Under the proposal, the donor or deceased owner of an appreciated asset would realize a capital gain at the time of the transfer. The amount of the gain realized would be the excess of the asset’s fair market value on the date of the gift or on decedent’s date of death over the decedent’s basis in that asset. That gain would be taxable income to the decedent on the Federal gift or estate tax return or on a separate capital gains return. The use of capital losses and carry-forwards from transfers at death would be allowed against capital gains and up to $3,000 of ordinary income on the decedent’s final income tax return, and the tax imposed on gains deemed realized at death would be deductible on the estate tax return of the decedent’s estate (if any).
Gain on unrealized appreciation also would be recognized by a trust, partnership, or other non-corporate entity that is the owner of property if that property has not been the subject of a recognition event within the prior 90 years. This provision would apply to property not subject to a recognition event since December 31, 1939, so that the first recognition event would be deemed to occur on December 31, 2030.
A transfer would be defined under the gift and estate tax provisions and would be valued at the value used for gift or estate tax purposes. However, for purposes of the imposition of this capital gains tax, the following would apply. First, a transferred partial interest generally would be valued at its proportional share of the fair market value of the entire property, provided that this rule would not apply to an interest in a trade or business to the extent its assets are actively used in the conduct of that trade or business. Second, transfers of property into, and distributions in kind from a trust, other than a grantor trust that is deemed to be wholly owned and revocable by the donor, would be recognition events, as would transfers of property to, and by, a partnership or other non-corporate entity, if the transfers have the effect of a gift to the transferee. The deemed owner of such a revocable grantor trust would recognize gain on the unrealized appreciation in any asset distributed from the trust to any person other than the deemed owner or the U.S. spouse of the deemed owner, not including distributions made in discharge of an obligation of the deemed owner. All of the unrealized appreciation on assets of such a revocable grantor trust would be realized at the deemed owner’s death or at any other time when the trust becomes irrevocable.
Certain exclusions would apply. Transfers to a U.S. spouse or to charity would carry over the basis of the donor or decedent. Capital gain would not be realized until the surviving spouse disposes of the asset or dies, and appreciated property transferred to charity would be exempt from capital gains tax. The transfer of appreciated assets to a split-interest trust would be subject to this capital gains tax, with an exclusion from that tax allowed for the charity’s share of the gain based on the charity’s share of the value transferred as determined for gift or estate tax purposes.
The proposal would exclude from recognition any gain on all tangible personal property such as household furnishings and personal effects (excluding collectibles). The $250,000 per-person exclusion under current law for capital gain on a principal residence would apply to all residences and would be portable to the decedent’s surviving spouse, making the exclusion effectively $500,000 per couple. Finally, the exclusion under current law for capital gain on certain small business stock would also apply.
In addition to the above exclusions, the proposal would allow a $5 million per-donor exclusion from recognition of other unrealized capital gains on property transferred by gift during life. This exclusion would apply only to unrealized appreciation on gifts to the extent that the donor’s cumulative total of lifetime gifts exceeds the basic exclusion amount in effect at the time of the gift. In addition, the proposal would allow any remaining portion of the $5 million exclusion that has not been used during life as an exclusion from recognition of other unrealized capital gains on property transferred by reason of death. This exclusion would be portable to the decedent’s surviving spouse under the same rules that apply to portability for estate and gift tax purposes (resulting in a married couple having an aggregate $10 million exclusion) and would be indexed for inflation after 2022. The recipient’s basis in property, whether received by gift or by reason of the decedent’s death, would be the property’s fair market value at the time of the gift or the decedent’s death.
The proposal also includes several deferral elections. Taxpayers could elect not to recognize unrealized appreciation of certain family-owned and operated businesses until the interest in the business is sold or the business ceases to be family-owned and operated. Furthermore, the proposal would allow a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death, other than liquid assets such as publicly traded financial assets and other than businesses for which the deferral election is made. The IRS would be authorized to require security at any time when IRS perceives a reasonable need for security to continue this deferral. That security could be provided from any person, and in any form, deemed acceptable by the IRS.
Additionally, the proposal would include other legislative changes designed to facilitate and implement this proposal, including without limitation: the allowance of a deduction for the full cost of appraisals of appreciated assets; the imposition of liens; the waiver of penalty for underpayment of estimated tax to the extent that underpayment is attributable to unrealized gains at death; the grant of a right of recovery of the tax on unrealized gains; rules to determine who has the right to select the return filed; the achievement of consistency in valuation for transfer and income tax purposes; coordinating changes to reflect that the recipient would have a basis in the property equal to the value on which the capital gains tax is computed; and a broad grant of regulatory authority to provide implementing rules.
To facilitate the transition to taxing gains at gift, death and other events under this proposal, the Secretary and her delegates would be granted authority to issue any regulations or other guidance necessary or appropriate to implement the proposal, including rules and safe harbors for determining the basis of assets in cases where complete records are unavailable, reporting requirements for all transfers of appreciated property including value and basis information, and rules where reporting could be permitted on the decedent’s final income tax return instead.
The proposal would be effective for gains on property transferred by gift, and on property owned at death by decedents dying, after December 31, 2022, and on certain property owned by trusts, partnerships, and other non-corporate entities on January 1, 2023.
As expected, a transfer of appreciated property by gift or at death is treated as a realization event and the income tax payable would be deductible on the estate tax return. This change has been suggested and rejected for more than 50 years, and most recently in 2020. Also, marital deduction and charitable deduction transfers would not be realization events. However, significant changes were made in its operation.
The exemption, both for transfers during life and at death, has been substantially increased to $5 million, or $10 million for spouses, with a carryover of unused exemption to the surviving spouse. This increase in the exclusion, indexed for inflation after 2022, is desirable. Also, exclusions are available for (i) tangible personal property (other than collectibles) and (ii) $250,000, $500,000 with spouses, for the sale of any residences and is also portable between spouses. The exclusions will remove most estates that do not have to pay a federal estate tax from having to pay a tax on unrealized appreciation. The failure to have a “fresh start” for determining the unrealized appreciation is a significant defect and inconsistent with the inflation increase.
The discussion broadens the scope of the proposal; the tax would be recognized by “a trust, partnership or other non-corporate entity” that has not been subject to a taxable event within the prior 90 years (since December 31, 1939). Transfers to and distributions from a trust, other than one that is fully revocable, would result in recognition of gain or loss, even though the trust was created before 2023. The mark-to-market rule (a recognition event) would be covered “if the transfers have the effect of a gift to the transferee.” This expansion would be complex and controversial, particularly because a broad grant of regulatory authority is given to the Treasury. Additional details are needed and the scope of this expansion, if enacted, should be covered in the statute. The relationship between the 90-year rule and the 20 percent minimum tax rule is not explained.
A fundamental problem with taxing unrealized appreciation owned by individuals (or others) is that the constitutionality of such a tax has not been determined by the Supreme Court. Thus, any estimate as to the amount that would be produced also is uncertain. This issue has been discussed in past issues. See Issue 2022-1, p, 5.
As to the operation of the exclusion, it would be available for both gift tax and estate tax purposes, but details are omitted. For example, is its use elective or mandatory for gifts? The sentence in the penultimate paragraph on page 2 that the exclusion “would apply only to unrealized appreciation on gifts to the extent that the donor’s cumulative total of lifetime gifts exceeds the basic exclusion amount in effect at the time of the gifts” is an abomination and says nothing. Does this mean that a gift tax must be incurred for use of the exclusion? How are annual exclusion gifts to be treated?
For gifts, the exclusion should be optional and at death the executor could exercise it in a manner similar to the use of the GST exclusion; where a gift is included in the gross estate, the executor could allocate exclusion to the gift property except that if the death value is less than the gift exclusion, the difference could not be “recovered” for use at death.
The tax could be deferred by an election for “certain family-owned and operated businesses until the interest in the business is sold or the business ceases to be family-owned and operated.” The deferral raises many unanswered questions as to its operation and definitions would be needed for new terms.
The failure to provide a “fresh start” for basis purposes would present serious proof of basis issues. The “unhelpful” statement is made that regulations will include “rules and safe harbors for determining the basis of assets in cases where complete records are unavailable.”
In summary, the proposal is more expansive and complex than the more balanced one proposed by Harry L. Gutman which was published in the January 11, 2021 issue of Tax Notes Federal and was discussed at length in Issue 2021-2.
An article, Parnell, Let’s Fix Biden’s Billionaire’s Tax, Tax Notes Federal, May 9, 2022, suggests an alternative to taxing unrealized capital gains. Excerpts from the article state:
[I]f the real complaint is that billionaires can finance their lifestyles with bank loans secured by unrealized assets, let’s just focus on that.
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[O]btaining loan proceeds that are based on the unrealized appreciated assets of a wealthy person could be characterized as a realization event (that is, a disguised sale). There is precedent in our tax code to impose income tax on loan proceeds.
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In effect, under this suggestion, a loan based on unrealized appreciated assets would be deemed a sale of the unrealized asset (akin to deeming a loan from a CFC to be a taxable dividend under section 956). The tax would be calculated by taking the difference between the loan proceeds and the tax basis in the assets on which the loan is based. Those gains would be taxed under the existing capital tax regime applied to individuals.
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While it’s true that the revenue yield of taxing loans based on appreciated assets would not raise as much revenue as Biden’s proposed 20 percent tax on net worth, it would be simpler for the IRS to administer, and compliance would be easier for taxpayers (and less fraught with valuation understatement temptations inherent in Biden’s billionaire’s tax). Treating loans to covered taxpayers as disguised sales would build on existing tax law and not add as many complexities as the Biden proposal. There would be fewer disputes and the proposal would rely on third-party bank reporting for enforcement. Also, taxing disguised sales under our income tax law would seem to be at less risk of a constitutional challenge under the 16th Amendment compared with Biden’s billionaire’s tax proposal, which is more easily labeled a wealth tax.
The article discusses additional detail of its author’s proposal.
2. IMPOSE A MINIMUM INCOME TAX ON THE WEALTHIEST TAXPAYERS
The proposal would impose a minimum tax of 20 percent on total income, generally inclusive of unrealized capital gains, for all taxpayers with wealth (that is, the difference obtained by subtracting liabilities from assets) of an amount greater than $100 million.
Under this proposal, taxpayers could choose to pay the first year of minimum tax liability in nine equal, annual installments. For subsequent years, taxpayers could choose to pay the minimum tax imposed for those years (not including installment payments due in that year) in five equal, annual installments.
A taxpayer’s minimum tax liability would equal the minimum tax rate (that is, 20 percent) times the sum of taxable income and unrealized gains (including on ordinary assets) of the taxpayer, less the sum of the taxpayer’s unrefunded, uncredited prepayments and regular tax. Payments of the minimum tax would be treated as a prepayment available to be credited against subsequent taxes on realized capital gains to avoid taxing the same amount of gain more than once. The amount of a taxpayer’s “uncredited prepayments” would equal the cumulative minimum tax liability assessed (including installment payments not yet due) for prior years, less any amount credited against realized capital gains in prior years.
Uncredited prepayments would be available to be credited against capital gains taxes due upon realization of gains, to the extent that the amount of uncredited prepayments, reduced by the cumulative amount of unpaid installments of the minimum tax (net uncredited prepayments),exceeds 20 percent of unrealized gains. Refunds would be provided to the extent that net uncredited prepayments exceed the long-term capital gains rate (inclusive of applicable surtaxes) times the taxpayer’s unrealized gains — such as after unrealized loss or charitable gift. However, refunds would first offset any remaining installment payments of minimum tax before being refundable in cash.
Minimum tax liability would be reduced to the extent that the sum of minimum tax liability and uncredited prepayments exceeds two times the minimum tax rate times the amount by which the taxpayer’s wealth exceeds $100 million. As a result, the minimum tax would be fully phased in for all taxpayers with wealth greater than $200 million.
For single decedents, net uncredited prepayments in excess of tax liability from gains at death would be refunded to the decedent’s estate and would be included in the decedent’s gross estate for Federal estate tax purposes. For married decedents, net uncredited prepayments that are unused would be transferred to the spouse or as otherwise provided by the Secretary or her delegates through regulations or other guidance.
Taxpayers with wealth greater than the threshold would be required to report to the IRS on an annual basis, separately by asset class, the total basis and total estimated value (as of December 31 of the taxable year) of their assets in each specified asset class, and the total amount of their liabilities. Tradable assets (for example, publicly traded stock) would be valued using end-of-year market prices. Taxpayers would not have to obtain annual, market valuations of non-tradable assets. Instead, non-tradable assets would be valued using the greater of the original or adjusted cost basis, the last valuation event from investment, borrowing, or financial statements, or other methods approved by the Secretary or her delegates (Secretary). Valuations of non-tradable assets would not be required annually and would instead increase by a conservative floating annual return (the five-year Treasury rate plus two percentage points) in between valuations. The IRS may offer avenues for taxpayers to appeal valuations, such as through appraisal.
This reporting also would be used to determine if the taxpayer is eligible to be treated as “illiquid.” Taxpayers would be treated as illiquid if tradeable assets held directly or indirectly by the taxpayer make up less than 20 percent of the taxpayer’s wealth. Taxpayers who are treated as illiquid may elect to include only unrealized gain in tradeable assets in the calculation of their minimum tax liability. However, taxpayers making this election would be subject to a deferral charge upon, and to the extent of, the realization of gains on any non-tradeable assets. The deferral charge would not exceed ten percent of unrealized gains.
Estimated tax payments would not be required for minimum tax liability. The minimum taxpayment amount would be excluded from the prior year’s tax liability for purposes of computing estimated tax required to be paid to avoid the penalty for the underpayment of estimated taxes.
The proposal would provide the Secretary with the authority to prescribe such regulations or other guidance determined to be necessary or appropriate to carry out the purposes of the proposal, including rules to prevent taxpayers from inappropriately converting tradeable assets to non-tradeable assets.
The proposal would be effective for taxable years beginning after December 31, 2022.
The proposal resembles the billionaires’ income tax of Senator Ron Wyden on October 27, 2021. See Tax Notes Doc. Service, Docs. 2021-40764 and 2021-40768. It is a new tax on taxpayers with $100 million or more in assets whose effective tax rate in any year is less than 20 percent of their income and is in addition to the income tax the taxpayer otherwise pays. The tax would apply to (i) ordinary income and (ii) the unrealized increase in the value of the assets during the year involved after the first year when all previously accrued gains would be recognized. Thus, it is a tax on unrealized capital gains. This is accomplished by treating the tax payments as prepayments to be credited against later taxes on realized gains to avoid a “double tax.” An affected taxpayer would have nine years in which to pay the tax on the increase in asset value from the first day of accumulation. There would be no “fresh start.” In future years, taxpayers would have five years to pay the tax on annual unrealized capital gains. The proposal does not discuss whether losses in future years would be allowed to offset annual gains.
Taxpayers would have a duty to report their assets to the IRS annually. Non-tradeable assets would be assessed at the last valuation event, increased annually at the five-year Treasury rate plus two percent, or by “other methods approved” by the Treasury. As previously mentioned, a significant question is whether a tax on unrealized appreciation is constitutional.
“Illiquid” taxpayers – those whose tradeable assets are less than 20 percent of their wealth – would be able to defer payments until sale and incur an interest charge.
Taxpayers could elect to pay the minimum tax in equal installments for nine years as to the first year of liability and over five years for later years. Taxpayers with “tradeable assets” of less than 20 percent of their net wealth would have an election to include only such assets in determining the minimum tax with a deferral charge “upon, and to the extent of, the realization of gains on any non-tradeable assets” not to exceed ten percent of unrealized gains.
The proposal is fundamentally inconsistent with American values. As a matter of basic fairness, if an income tax prepayment is imposed on accrued capital gains, a deduction should be created for all accrued capital losses. We do not believe this would occur. The proposal, even though limited to a select “wealthy” group of citizens may well be unconstitutional and should be rejected. It would also be an administrative nightmare. The Administration does have a remedy – changing the law to require carryover basis for property included in a decedent’s estate. The constitutional problem is compounded by applying the change in the law to property acquired before the change as well as to property acquired after the change.
3. MODIFY ESTATE AND GIFT TAXATION
MODIFY, INCOME, ESTATE AND GIFT TAX RULES FOR CERTAIN GRANTOR TRUSTS
The proposal would require that the remainder interest in a GRAT at the time the interest is created have a minimum value for gift tax purposes equal to the greater of 25 percent of the value of the assets transferred to the GRAT or $500,000 (but not more than the value of the assets transferred). In addition, the proposal would prohibit any decrease in the annuity during the GRAT term and would prohibit the grantor from acquiring in an exchange an asset held in the trust without recognizing gain or loss for income tax purposes. Finally, the proposal would require that a GRAT have a minimum term of ten years and a maximum term of the life expectancy of the annuitant plus ten years. These provisions would impose some downside risk on the use of GRATs so they are less likely to be used purely for tax avoidance purposes.
For trusts that are not fully revocable by the deemed owner, the proposal would treat the transfer of an asset for consideration between a grantor trust and its deemed owner or any other person as one that is regarded for income tax purposes, which would result in the seller recognizing gain on any appreciation in the transferred asset and the basis of the transferred asset in the hands of the buyer being the value of the asset at the time of the transfer. Such regarded transfers would include sales as well as the satisfaction of an obligation (such as an annuity or unitrust payment) with appreciated property. However, securitization transactions would not be subject to this new provision.
The proposal also would provide that the payment of the income tax on the income of a grantor trust is a gift. That gift occurs on December 31 of the year in which the income tax is paid (or, if earlier, immediately before the owner’s death, or on the owner’s renunciation of any reimbursement right for that year) unless the deemed owner is reimbursed by the trust during that same year. The amount of the gift is the unreimbursed amount of the income tax paid.
The GRAT portion of the proposal would apply to all trusts created on or after the date of enactment. The portion of the proposal characterizing the grantor’s payment of income taxes as a gift also would apply to all trusts created on or after the date of enactment. The gain recognition portion of the proposal would apply to all transactions between a grantor trust and its deemed owner occurring on or after the date of enactment. It is expected that the legislative language providing for such an immediate effective date would appropriately detail the particular types of transactions to which the new rule does not apply.
a. GRATs and IDITs (Intentionally Defective Income Trusts)
The decision to limit the changes in Rev. Rul. 85-13, 1985-1 C.B. 184, to GRATs and IDITs is understandable. The changes in the GRATs requirements mentioned above are reasonable (see page 7). Also, GRATs and IDITs created prior to the effective date should be exempted from being subject to the changes to the extent in kind payments are made after the effective date to the grantor.
The Tax Law Center at NYU Law (NYU Law) has submitted a list of projects for the 2022-2023 Priority Guidance Plan. Tax Analysts Doc. No. 2022-18115. The list includes among its high priority items “Limit efficiency of GRATs for transfer tax avoidance” which states:
Section 2702(a) provides a method for valuing a grantor’s retained interest in a split-interest trust. The regulations thereunder provide the method for determining the gift tax value of the remainder interest passing to the remainder beneficiaries.77 The value of the remainder interest is calculated by subtracting the value of the taxpayer’s retained interest as determined under section 2702(a) from the total value of the assets transferred to the trust.78 Section 2702(a) provides that unless the retained interest is a “qualified interest,” the value of the retained interest is zero. In effect, the entire value of the split-interest trust is subject to gift tax if the retained interest does not meet the requirements for a “qualified interest.”
Treasury and the IRS should propose regulations clarifying that a “qualified interest” has a minimum required annuity term. The current definition of a “qualified interest” as one that pays an annuity “at least annually” does not specify what the minimum or maximum annuity term for a qualified interest may be. Clarifying under the authority provided in section 7805(a) that a “qualified interest” has a minimum and maximum term will eliminate the inappropriate planning opportunities created by very short-term or very long-term GRATs.
Treasury and the IRS could also adopt a rule prohibiting the trustee of a GRAT from converting a substantial portion or all of the GRAT assets into debt obligations through a sale of such assets to trusts created by the annuitant or other related parties. Taxpayers are prevented from allocating their exemption from the generation-skipping transfer (“GST”) tax to assets in a GRAT until the earlier of the grantor’s death or the end of the annuity term.79 However, taxpayers circumvent this restriction by having the GRAT sell assets to an existing GST exempt trust in exchange for a note amortized over the GRAT’s annuity term. This sale transaction is not reported to the IRS and allows appreciation transferred through the GRAT structure to benefit from the existing trust’s GST exempt status. Adopting a rule that prohibits the trustee of a GRAT from converting a substantial portion or all of the GRAT assets into debt obligations through such a sale would complement other additional regulatory requirements that govern qualified interests.80
Additionally, Treasury and the IRS should clarify the prohibition on “additional contributions”81 as it applies to trusts with “qualified interests.” Typically, taxpayers insulate their GRATs from market volatility by swapping appreciated assets out of the GRAT in exchange for promissory notes of equal value. Under the regulations, it is not clear what an additional contribution to a trust is and whether replacing appreciated assets in a GRAT with new assets is considered an additional contribution to the trust. By contrast, the regulations explicitly prohibit the grantor from swapping or selling trust property in a qualified personal residence trust (“QPRT”).82 Like GRATs, QPRTs are split-interest trusts and a creation of the regulations under section 2702. Consistent with the model provided for QPRTs under the authority of section 2702, Treasury and the IRS should consider expanding the prohibition on additional contributions to include asset sales and substitutions.
Finally, in the case of a remainder interest that is not a “qualified remainder interest, ”Treasury and the IRS should clarify that section 2702 does not apply to determine the value of the remainder interest for purposes of determining the value of such an interest on any transfer following its creation.83 While this result follows from a strict reading of the rules in section 2702, a rule or example can be added to make this explicit.
The clear implication from this discussion is that the Treasury and the IRS, taken together, have the authority to do what is recommended by regulations. We believe there is doubt concerning this point and legislation is needed. For example, the proposals suggest that IRC Sec. 7805(a) provides authority to amend the definition of “qualified interest.” We disagree. An amendment of IRC Sec. 2702 would be needed as the Administration recognizes in its Green Book proposals.
b. Grantor Trusts
Many trusts are created where the grantor desires to have the income of the trust taxed to him or her. The purpose is to enable the grantor to pay income taxes on the trust income instead of having the income taxed to one or more beneficiaries of the trust or the trust itself. This is done because the payment of the income taxes by grantor is, in effect, a “tax-free” gift. In 2021, the House Ways and Means Committee proposed changes which would have reversed Rev. Rul. 85-13; the leading authority supporting the result of taxing trust income to the grantor in which the ruling held that the donor of a grantor trust is treated as owning the assets of the trust for all federal income tax purposes. These changes were dropped from the House version before passage of the Build Back Better Act (H.R. 5376) by the House of Representatives. In its Fiscal Year 2023 Budget Revenue Proposals, the Biden Administration proposes to modify the grantor trust rules in a more limited fashion than in H.R. 5376.
Before Rev. Rul. 85-13, contrary authority existed. In W&W Fertilizer v. United States, 527 F.2d 621 (Ct. Cl. 1975), Subchapter S stock was involved. The court held that the sale should be recognized for Subchapter S purposes and stated that ownership under the grantor trust rules were only for attributing income tax items from the trust to the grantor and not otherwise to ignore the trust. Also, in Swanson v. Comm’r, T.C. Memo. 1974-61, aff’d, 518 F.2d 59 (8th Cir. 1975), the court had before it the insurance exclusion for the gross income under IRC Sec. 101. The holding was that the receipt of insurance proceeds by a grantor trust were excludible because they were deemed to be received by the grantor due to his control over the trust. These cases did not deal with a sale between the donor and the grantor trust.
Other cases deserve mention. They are Madorin v. Comm’r, 84 T.C. 667 (1985), Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984) and Textron v. Comm’r, 117 T.C. 67 (2001). In Madorin, a grantor trust terminated when its liabilities exceeded the tax basis of the trust property. The court held that termination caused a disposition for federal income tax purposes and cited Treas. Reg. §1.1001-2(c), Example 5. In Rothstein, the court held that IRC Secs. 671, 674 and 675 do not negate the separate existence of a grantor trust but rather attribute the income tax items of the trust to the grantor. As a result, a sale between the grantor and the grantor trust was recognized for federal income tax purposes as to a capital loss. In Textron, the court held that the words “direct or indirect ownership” do not mean that the grantor of a grantor trust is treated as “directly or indirectly” owning the stock. Instead, the court held that would occur only if constructive attribution of ownership was the test, which was not the case.
Rev. Rul. 85-13 discusses Rothstein as follows:
In Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984), the court considered a transaction that is in substance identical to the facts described in this ruling. The court held that the grantor was the owner of a trust under section 675(3) of the Code because by exchanging an unsecured note for the entire trust corpus, the grantor had indirectly borrowed the trust corpus. The court held further, however, that although the grantor must be treated as the owner of the trust, this means only that the grantor must include items of income, deduction, and credit attributable to the trust in computing the grantor’s taxable income and credits, and that the trust must continue to be viewed as a separate taxpayer. The court held, therefore, that the transfer of trust corpus to the grantor in exchange for an unsecured promissory note was a sale and that the taxpayer acquired a cost basis in the assets.
In Rothstein, as in this case, section 671 of the Code requires that the grantor includes in computing the grantor’s tax liability all items of income, deduction, and credit of the trust as though the trust were not in existence during the period the grantor is treated as the owner. Section 1.671-3(a)(1) of the regulations. It is anomalous to suggest that Congress, in enacting the grantor trust provisions of the Code, intended that the existence of a trust would be ignored for purposes of attribution of income, deduction, and credit, and yet, retain its vitality as a separate entity capable of entering into a sales transaction with the grantor. The reason for attributing items of income, deduction, and credit to the grantor under section 671 is that, by exercising dominion and control over a trust, either by retaining a power over or an interest in the trust, or, as in this case, by dealing with the trust property for the grantor’s benefit, the grantor has treated the trust property as though it were the grantor’s property. The Service position of treating the owner of an entire trust as the owner of the trust’s assets is, therefore, consistent with and supported by the rationale for attributing items of income, deduction, and credit to the grantor.
The court’s decision in Rothstein, insofar as it holds that a trust owned by a grantor must be regarded as a separate taxpayer capable of engaging in sales transactions with the grantor, is not in accord with the views of the Service. Accordingly, the Service will not follow Rothstein.
The above discussion about the consequences of Rev. Rul. 85-13 indicates why the proposed section dealing with grantor trusts was omitted from the House Bill’s version of the Build Back Better Act passing to the Senate. The law relating to the subject is difficult and the consequences of new legislation dealing with grantor trusts needs to be considered in detail including its effect on what appear to be inconsistent results of its application. Clearly, the use of the word “all” in the revenue ruling is inconsistent with decided case law. The general rule of inclusion of grantor trust in the gross estate would have consequences outside of the primary objective of preventing its application to GRATs and IDITs.
As described above on page 7, the Biden Administration does not set forth an overall solution to the above discussion but rather a limited solution intended to cover GRATs and IDITs. This would be accomplished by (i) recognizing gain on sales between a grantor and his or her grantor trust and (ii) the payment of income tax by a deemed owner of a grantor trust deemed treated as a gift by the grantor. Unfortunately, the discussion itself needs clarification. The first quoted paragraph makes no mention of gifts to spouses. We assume that they will be exempt. Another omission is a failure to mention exclusions from gift tax under IRC Sec. 2503(b). Again, we assume that because the gift itself is excluded, any unrealized appreciation on distributions in kind will also be excluded from income tax.
The NYU Law submission includes another high priority item which states:
Require recognition for transactions between a grantor and certain grantor trusts
As a general rule, trusts are separate taxpayers for purposes of the federal income tax.67 However, section 671 provides that if a trust is a “grantor trust,” then the trust’s income will be included in the grantor’s income tax return. Neither the statutory provisions nor the regulations thereunder necessitate that the grantor and their grantor trust be treated as the same or a single taxpayer for all federal income tax purposes. Nevertheless, Rev. Rul. 85-1368 (which declined to follow Rothstein v. US69) provides that a grantor and their grantor trust will not be treated as separate taxpayers for federal income tax purposes and as a result, transactions between a grantor and their grantor trust will not be recognized for federal income tax purposes. This ruling enables taxpayers to take advantage of the grantor trust rules70 and engage in highly leveraged wealth transfer transactions, death-bed basis shifting transactions, and even perpetuities planning71 with no federal income tax consequences. These transactions serve to minimize transfer tax obligations and maximize valuation discounts and tax-free basis step up on death.
Treasury and the IRS should revoke Rev. Rul. 85-13 and propose new regulations in Treas. Reg. §1.671-1, -2, or -3 to generally align the treatment of transactions between grantors and certain grantor trusts with Rothstein.72 The grantor trust rules were intended to confer special treatment on trust arrangements where a taxpayer retains a high degree of control over the trust property.73 Accordingly, the new proposed regulations could further refine the grantor trust rules and provide special treatment for certain trust arrangements where there is a particularly high degree of control over the trust property. For example, the new proposed regulations could provide a special rule for grantor trusts that Treasury and the IRS consider appropriate to remain wholly disregarded for all federal income tax purposes, such as investment trusts, “rabbi trusts,”74 liquidating trusts, environmental remediation trusts, and fully revocable trusts (collectively, “wholly disregarded trusts”). This special rule could consider any person treated as the grantor of any portion of a wholly disregarded trust as directly owning the trust assets attributable to that portion of the wholly disregarded trust for all federal income tax purposes.75
For grantor trusts other than wholly disregarded trusts (if carved out), the revocation of Rev. Rul. 85-13 would cause common estate planning techniques (like sales to grantor trusts, deathbed basis planning, and perpetuities planning with expiring trusts) to be recognized for federal income tax purposes. The existing grantor trust rules would still apply to shift the federal income tax burden with respect to trust assets to the grantor. Finally, this proposal would have the added benefit of limiting the efficiency of grantor retained annuity trusts(“GRATs”), which are typically established as grantor trusts.76
Given the lengthy time Rev. Rul. 85-13 has been in effect and the controversies that have developed concerning its operation, we believe a new statutory framework is desirable rather than a limited regulatory approach.
A new development has occurred. On June 9, 2022, Treasury Secretary Yellen appeared before the House Ways and Means Committee to discuss the Administration’s fiscal year 2023 budget. She was asked about a regulation project providing guidance on grantor trusts. She replied that guidance would be coming out “very, very soon.” Presumably it will deal with the question of whether a stepped-up basis for the trust property occurs at the death of the grantor. Such guidance has been requested by Representative Pascrell, the Chairman of the Ways and Means Committee Oversight Subcommittee who has requested that the guidance clearly provide that no step-up in basis occurs at the grantor’s death. Whether the guidance will deal with any other aspect of grantor trusts is uncertain. See Tax Analyst Doc. No. 2022-18771.
4. REQUIRE CONSISTENT VALUATION OF PROMISSORY NOTES
Generally, an individual who lends money at a below-market rate of interest to another individual is treated as making a gift for gift tax purposes and the lender is imputed a commensurate amount of income for income tax purposes. The Internal Revenue Code requires minimum rates of interest based on the duration of a note or other loan (its term); the IRS issues monthly rates for each term. These rates effectively create a safe harbor: if the interest rate on a loan is at least equal to the minimum rate of interest specified by the IRS for a loan of the same term, the loan avoids being a “below-market loan” (the forgone interest on which is subject to income tax) and the loan is not treated as a gift for gift tax purposes.
Reasons for Change
The rules for below-market loans allow a taxpayer to take inconsistent positions regarding the valuation of a loan and thereby achieve a tax savings. Typically, a taxpayer sells a valuable asset intra-family for a promissory note carrying the minimum interest rate required to ensure that the loan is not taxed as a “below-market loan” for income tax purposes. The taxpayer claims that the minimum interest rate is sufficient to avoid both the treatment of any foregone interest on the loan as imputed income to the lender and the treatment of any part of the transaction as a gift .However, in subsequently valuing that unpaid note for Federal estate tax purposes after the death of the taxpayer, the estate takes the position that the fair market value of the note should be discounted because the interest rate is well below the market rate at the time of the taxpayer’s death. In other words, the taxpayer relies on the statutory rules to assert that the loan is not below market for gift tax purposes at the time of the transaction and relies on the underlying economic characteristics to assert the loan is below market for estate tax purposes later. Because the prescribed minimum interest rates for promissory notes have been so low for at least the past decade, the use of these notes has become a popular tax planning technique to reduce gift and estate taxes.
Alternatively, the term of a promissory note may be very lengthy, and at death, the holder’s estate may claim a significant discount on the value of the unpaid note based on the amount of time before the note will be paid in full.
The proposal would impose a consistency requirement by providing that, if a taxpayer treats any promissory note as having a sufficient rate of interest to avoid the treatment of any foregone interest on the loan as income or any part of the transaction as a gift, that note subsequently must be valued for Federal gift and estate tax purposes by limiting the discount rate to the greater of the actual rate of interest of the note, or the applicable minimum interest rate for the remaining term of the note on the date of death. The Secretary and her delegates (Secretary) would be granted regulatory authority to establish exceptions to account for any difference between the applicable minimum interest rate at the issuance of the note and actual interest rate of the note. In addition, the term of the note would be treated as being short term regardless of the due date, or term loans would be valued as demand loans in which the lender can require immediate payment in full, if there is a reasonable likelihood that the note will be satisfied sooner than the specified payment date and in other situations as determined by the Secretary.
The proposal would apply to valuations as of a valuation date on or after the date of introduction.
The concern as to “consistent” valuation of notes appears primarily directed at intrafamily loans where an elder family member relies upon IRC Sec. 7872 to use the applicable federal rate and avoid a gift tax and then uses a different rate in valuing the note for estate tax purposes. As quoted above under the Administration’s recommendation, regulatory authority would be created to limit the discount rate used for estate tax purposes with “exceptions.”
Treas. Reg. §20.2031-4 provides:
The fair market value of notes, secured or unsecured, is presumed to be the amount of unpaid principal, plus interest accrued to the date of death, unless the executor establishes that the value is lower or that the notes are worthless. However, items of interest shall be separately stated on the estate tax return. If not returned at face value, plus accrued interest, satisfactory evidence must be submitted that the note is worth less than the unpaid amount (because of the interest rate, date of maturity, or other cause), or that the note is uncollectible, either in whole or in part (by reason of the insolvency of the party or parties liable, or for other cause), and that any property pledged or mortgaged as security is insufficient to satisfy the obligation.
The NYU Law submission for a low priority item is “Limit availability of discounts on gift loans at death.” It states:
Under section 7872, if a promissory note bears interest at a rate at least equal to the applicable federal rate (“AFR”), the lender will not be considered to make a gift as result of the loan that gave rise to the promissory note. The AFR is generally well below the prevailing market interest rate for arm’s length loans. Under estate tax regulations, the value of a note includable in a decedent’s estate is the unpaid principal plus accrued interest, unless the evidence shows that the note is worth less (e.g., due to a low interest rate or inability to collect).103 When a decedent dies holding a promissory note bearing interest at the AFR, the executor of the decedent’s estate may take a valuation discount on the value of the note because the note bears a below market interest rate. As a result, while the note bears sufficient interest during the taxpayer’s life to not cause gift tax implications, under estate tax valuation rules, the note can be discounted for bearing interest at a rate well below market norms.
A long-outstanding proposed regulation under section 7872 addresses the valuation of a term loan made with donative intent by providing that it equals the lesser of (i) the unpaid principal and accrued interest; or (ii) the sum of the present value of all payments due under the note using the AFR in effect on the decedent’s death.104 Although this proposed regulation project has not appeared in recent PGPs, Treasury and the IRS should republish the proposed rule and consider broadening its application to demand and term loans regardless of donative intent. These revised rules could resemble the FY2023 Green Book proposal to limit the discount rate on notes for estate tax valuation purposes to the greater of the note’s actual interest rate and the AFR in effect on the date of the decedent’s death.105 Such regulations could be promulgated under the authority of sections 2031, 7872,and 7805(a) as necessary for appropriately determining the FMV mandated for estate tax purposes consistent with the standards for valuation reflected under section 7872.
The NYU Law proposal is substantially the same as what the Administration is proposing and is a regulatory fix.
Any attempt to prescribe an interest rate is troublesome because rates often change. The effect of a rate change can be plus or minus for either the IRS or the taxpayer. The problem is compounded by the fact that for a significant period of time the rates have been low.
We believe it is undesirable to provide that, in the case of an estate, the interest rate should be at anything other than based on the fair market value of the note as of the decedent’s death. To do so may present marital or charitable deduction issues in an estate tax return. The problem is created by the failure of IRC Sec. 7872 to reflect an accurate market rate at the time the note is made. The change which should be made should not undercut Treas. Reg. §20.2031-4 quoted above but rather should reflect current interest rates at the date the note is created. To do so should require either a statutory change or a change in the regulations under IRC Sec. 7872. The preferable solution in our judgment is to amend the statute.
5. REQUIRE REPORTING OF ESTIMATED TAX VALUE OF TRUST ASSETS
The proposal would require certain trusts administered in the United States, whether domestic or foreign (other than a trust subject to the reporting requirements of section 6048(b) of the Code), to report certain information to the IRS on an annual basis to facilitate the appropriate analysis of tax data, the development of appropriate tax policies, and the administration of the tax system. That reporting could be done on the annual income tax return or otherwise, as determined by the Secretary, and would include the name, address, and TIN of each trustee and grantor of the trust, and general information with regard to the nature and estimated total value of the trust’s assets as the Secretary may prescribe. Such reporting on asset information might be satisfied by identifying an applicable range of estimated total value on the trust’s income tax return. This reporting requirement for a taxable year would apply to each trust whose estimated total value on the last day of the taxable year exceeds $300,000 or whose gross income for the taxable year exceeds $10,000.
The proposal would apply for taxable years ending after the date of enactment.
This proposal was made in the Green Book for Fiscal 2022. The description and its title indicate that it is concerned with “values” of trust assets but not with their beneficiaries. This is made clear from the failure to discuss beneficiaries and the emphasis upon “the nature and estimated total value of the trust’s assets.” However, the word “nature” is different from “value” and needs a definition or perhaps this word should be eliminated since it is not referred to in the title.
The proposal has a minimum value for reporting as $300,000 or gross income for a taxable year in excess of $10,000. The $300,000 figure should be increased to $500,000 and the reference to a gross income figure should be eliminated.
Care should be taken as to what information is requested and it should be specified. The increase in the use of trust advisors should be recognized. In general, these advisors deal with investments and distributions. In some cases, the role of a corporate trustee is merely administrative.
6. LIMIT DURATION OF GENERATION-SKIPPING TRANSFER TAX EXEMPTION
The proposal would provide that the GST exemption would apply only to: (a) direct skips and taxable distributions to beneficiaries no more than two generations below the transferor, and to younger generation beneficiaries who were alive at the creation of the trust; and (b) taxable terminations occurring while any person occurring while any person described in (a) is a beneficiary of the trust. However, section 2653 of the Internal Revenue Code (Code) would not apply for these purposes. In addition, solely for purposes of determining the duration of the exemption, a pre-enactment trust would be deemed to have been created on the date of enactment. The result of these proposals is that the benefit of the GST exemption that shields property from the GST tax would not last as long as the trust. Instead, it would shield the trust assets from GST tax only as long as the life of any trust beneficiary who either is no younger than the transferor’s grandchild or is a member of a younger generation but who was alive at the creation of the trust.
Specifically, this limit on the duration of the GST exemption would be achieved at the appropriate time by increasing the inclusion ratio of the trust to one, thereby rendering no part of the trust exempt from GST tax. Because contributions to a trust from different grantors are deemed to be held in separate trusts under section 2654(b) of the Code, each such separate trust would be subject to the same rule for the duration of the exemption, measured from the date of the first contribution by the grantor of that separate trust. The special rule for pour-over trusts undersection 2653(b)(2) would continue to apply to pour-over trusts and to trusts created under a decanting authority, and for purposes of this rule, such trusts would be deemed to have the same date of creation as the initial trust. The other rules of section 2653 would continue to apply and would be relevant in determining when a taxable distribution or taxable termination occurs. An express grant of regulatory authority to the Secretary and her delegates would be included to facilitate the implementation and administration of this provision.
The proposal would apply on and after the date of enactment to all trusts subject to the generation-skipping transfer tax, regardless of the trust’s inclusion ratio on the date of enactment.
In recent years, several states have changed their rule against perpetuities from the old common law rule of lives in being plus 21 years to much longer periods. The result means that trusts can be created for longer periods of time. This is the reason why the Administration proposes a tax rule “limiting” the period of time that trusts can remain protected from the generation-skipping transfer tax. The new rule would also attack the problem by the new tax on unrealized appreciation which is discussed above.
The approach described above is reasonable. Trusts would continue to be exempt but only for the life of a first or second-generation beneficiary or any younger generation beneficiary who is alive at creation of the trust. The provision would apply retroactively to existing trusts except that for purposes of determining the duration of the GST exemption, “a pre-enactment trust would be deemed to have been created on the date of enactment”
Point of Interest
As many of our readers know, the IRS has received new funds which will enable it to employ additional personnel to audit income tax returns of high-income taxpayers. A recent article in Tax Notes discusses what has occurred with new examiners. It is based upon discussions with a member of a large accounting firm. Curry, IRS’s New High-Income Examiners Off to Rocky Start, Tax Pros Say, Tax Analysts Doc. No. 2022-18916. A paragraph in the article states:
“When you have [chief counsel] assisting these examiners, you’re kind of collapsing the [audit] process,” Paul continued. He said he’s seeing more arguments at the IRS exam level that are claiming that a taxpayer crossed the line of substance over form, such as by creating a grantor-retained annuity trust that’s fully compliant with the code but was “too successful,” and therefore for public policy reasons should be disallowed.
What this paragraph says is scary.
* * *
67See section 641(b).
681985-1 C.B. 1984.
69735 F.2d 704 (2d Cir. 1984).
70See sections 671-679.
71Trust assets held in trusts subject to a perpetuities period are subject to some transfer tax following the trust’s termination. Tax planners avoid this outcome by utilizing the grantor trust rules to transfer assets out of an expiring trust and into a dynasty trust. For example, an expiring trust can be granted a section 678 power over a dynasty trust, and the trust assets can be sold to the dynasty trust at a substantial discount. Because the expiring trust is the grantor of the dynasty trust, the transaction is not recognized for federal income tax purposes. Further, this transaction is not reported on any returns and can be repeated as necessary to substantially shrink the value of a trust subject to a nearing perpetuities date.
72See Daniel J. Hemel, How Treasury and the IRS Have Allowed High-Net-Worth Taxpayers to Exploit Stepped-Up Basis on Intergenerational Wealth Transfers, and How They Can Stop It: Answers to Question for the Record (January 17, 2022) (“Ideally, after rescission of Revenue Ruling 85-13,Treasury and the IRS would promulgate regulations via notice-and-comment rulemaking that adopt Judge Friendly’s position in Rothstein.”); see generally Jonathan Curry, How Industry Pushback Sank the Grantor Trust Changes — For Now, Tax Notes Federal (January 31, 2022).
73For a comprehensive discussion of the history of the grantor trust rules and a detailed legislative proposal, see Mark L. Ascher, The Grantor Trust Rules Should be Repealed, 96 Iowa L. Rev. 885 (2011).
74This arrangement, where an employer funds a grantor trust with assets intended to satisfy its deferred compensation obligations to its employees, is so identified because it was first publicly used to secure benefits for a rabbi. See PLR 8113107 (December 31, 1980) and Rev. Proc. 92-64, 1992-2 C.B. 422 (providing model trust provisions for a “rabbi trust”).
75This suggestion is a narrow version of Prop. Treas. Reg. §1.671-2(f). The special rule for wholly disregarded trusts would present limited wealth transfer planning opportunities because of the applicable restrictions and tax attributes of wholly disregarded trusts. The assets of wholly disregarded trusts or the interests therein are generally subject to the creditors of the settlors or interest holders and estate tax on the interest holder’s death. These features of wholly disregarded trusts are distinct from those of intentionally defective grantor trusts and indicative of a greater degree of dominion over the trust property, consistent with the intended purposes of the grantor trust rules.
76See “Limit efficiency of GRATs for transfer tax avoidance,” infra at pg. 14.
103 See Treas. Reg. §20.2031-4.
104 See Prop. Treas. Reg. §20.7872-1 in Below-Market Loans, LR-165-84, 50 Fed. Reg. 33,553 (August 20, 1985).
105 See FY2023 Green Book, at 43.
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