Remember Taxes
Every conveyance of property or of an interest in property from one person to another is prompted, or at least influenced, by economic considerations. The parties to the transaction may swap properties, or one party may transfer a property to another in exchange for money[i] or for the services of the other party. In these instances, there has been a conscious or deliberate exchange of value between the parties – each party has determined that the exchange will improve their own position.[ii]
Even where a party transfers property – something of actual or potential value, including an interest in a closely held business – to another party without the expectation of receiving any consideration in exchange, the transferor has decided that the transferee would realize a greater economic benefit from the property than would the transferor,[iii] or the transferor has concluded that the disposition of the property today would result in substantial cost savings for the transferor in the future.[iv]
Immediate Tax Cost – Economics of a Transfer
Speaking of costs, another factor that must be considered by the owner of property in determining whether a transaction makes economic sense is the cost of consummating the transaction.
Among the most immediate and certain of the costs to be incurred, and perhaps the most significant, is taxes.
Given the considerable economic burden that taxes may represent,[v] it will behoove the parties to any transaction, including one that is ostensibly structured as a gift, to understand the tax treatment of the property interests that may be transferred, as well as the tax treatment of the vehicle through which the transfer is effectuated.
While most business owners and many of their beneficiaries are familiar with the income taxation of an equity interest in a business, which is the form of property interest commonly conveyed by a business owner to such beneficiaries, very few are versed in the income tax treatment of what is probably the vehicle most commonly used by a transferor for conveying an economic interest in such property to the transferor’s beneficiaries – the trust.[vi]
It Takes All Kinds
The tax laws recognize several categories of “taxpayer,” some of which are subject to income tax, others which are not, still others that may be taxed in one taxable year but not another, and a few that are disregarded for purposes of the tax.[vii]
In general, the first category, of taxable persons, includes individuals and “C” corporations;[viii] the second category, of non-taxable persons, includes partnerships[ix] and “S” corporations[x]; the third category, of persons the tax status of which may vary year-to-year, includes non-grantor trusts[xi]; the last category, of disregarded persons, includes grantor trusts,[xii] qualified subchapter S subsidiaries,[xiii] and single member LLCs.[xiv]
Passthroughs
A taxpayer included in either the second or fourth categories is often referred to as a “passthrough” entity.
The income and gain realized by a passthrough entity is reported on the income tax returns of its owners, or deemed owners,[xv] whether or not distributed to them,[xvi] and takes the same character in their hands as in the hands of the entity.
Entity Distributions – Taxpayer Beware
Understandably, many taxpayers may conclude, because of a particular entity’s passthrough nature, that a distribution of money or other property from the entity to its owners would not be taxable, either to the entity or its owners; unfortunately for these taxpayers, they’d be only partially correct.
Partnership
In the case of a partnership, for example, a distribution of money by a partnership to a partner is generally not taxable to the partner except to the extent the amount of money distributed exceeds the adjusted basis of such partner’s interest in the partnership immediately before the distribution.[xvii] Because a partner’s basis for their partnership interest is increased by the amount of such partner’s distributive share of the partnership’s taxable income for the taxable year and prior years, the distribution of cash reflecting the amount of such previously included income is “absorbed” by the partner’s adjusted basis.[xviii]
A distribution of property in-kind to a partner is generally not a taxable event.[xix] There are exceptions, however; for example, if a partnership distributes to one of its partners (A) a property that was contributed to the partnership by another partner (B), the contributing partner (B) may be surprised to learn that they must recognize the gain that was inherent in the distributed property as of the time of its contribution, if such distribution occurs within seven years of such contribution.[xx]
A distributee-partner and their fellow partners may also be surprised to learn that a distribution may result in a taxable event for all of them. Assume the partnership holds money and assets the sale or exchange of which would generate capital gain. Assume the partnership also owns assets, the sale or exchange of which would generate ordinary income.[xxi] Say the partnership distributes money or capital gain property to the distributee-partner in liquidation of such partner’s equity interest. In effect, the former partner will have received an amount of money or capital gain property that exceeds their share of such property immediately before the liquidation of their interest in the partnership. Conversely, the remaining partners will end up with a greater share of ordinary income property than they had before the distribution. The Code[xxii] treats the former partner as having exchanged their share of ordinary income property in exchange for a greater share of the partnership’s pre-distribution money and capital gain property. This deemed exchange causes the former partner to recognize some ordinary income and the partnership (i.e., the remaining partners) to recognize some capital gain.[xxiii]
S Corporation
A distribution of money by an S corporation to its shareholders is not taxable to the shareholders to the extent of their adjusted basis for their stock.[xxiv] As in the case of a partnership, such basis is adjusted upward to account for the shareholders’ inclusion in their income of their pro rata share of the S corporation income and gain.[xxv]
If an S corporation distributes to its shareholders property with a fair market value in excess of the corporation’s basis for such property, the corporation will be treated as having sold such property to the shareholders.[xxvi] The gain realized by the corporation from the deemed sale is reported by the shareholders on their own tax returns.[xxvii]
Although a corporation is not treated as having more than one class of stock[xxviii] if its governing provisions[xxix] provide for identical distribution and liquidation rights, any distributions – including actual, constructive, or deemed distributions – that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.[xxx] For example, a disproportionate distribution may be treated as one that was made on a pro rata basis among the shareholders, then followed by a transfer of value between those shareholders who, respectively, received more or less than their pro rata share; depending upon the facts and circumstances, the shareholder who received less than their share may, for example, be treated as having made a gift or having paid compensation or other consideration to the other shareholder.[xxxi]
Grantor Trust
Assuming the grantor’s purpose in creating and transferring property to a trust was to remove such property from their gross estate and provide for their beneficiaries, the grantor will not have retained any rights with respect to the trust or its property that would defeat this purpose. For example, the grantor would not be expecting to receive a distribution from the trust.[xxxii]
However, if the trust’s original governing instrument or applicable law gives the trustee the discretion to reimburse the grantor for that portion of the grantor’s income tax liability attributable to the trust, the existence of that discretion, by itself (whether or not exercised) will not cause the value of the trust’s assets to be includible in the grantor’s gross estate.[xxxiii] In the event the trustee decides to reimburse the grantor, the transfer of money from the trust to the grantor will be disregarded for purposes of the income tax because the trust is a disregarded entity as to the grantor.
Where the grantor of the trust is required to include all the income and gain of the trust on the grantor’s own tax return, any distribution by the trust to its beneficiaries will not be subject to income tax in the hands of such beneficiaries. Indeed, for purposes of the income tax, the transfer – i.e., the trust distribution – is treated as having been made by the grantor. In the absence of any consideration paid by the recipient beneficiary, the deemed transfer from the grantor – by which the grantor’s ownership, for income tax purposes, of the property distributed from the trust is terminated – should be treated as a gift for purposes of the income tax.[xxxiv]
What if the distribution from the grantor trust to the beneficiary consists of property in-kind that is encumbered by a liability subject to which the beneficiary takes the property? In that case, the grantor will be treated as having sold the property for an amount of consideration equal to the amount of the liability,[xxxv] and will be required to report on their tax return the gain from such sale.
Non-Grantor Trust
Which brings us to the subject of today’s post – a distribution resulting in the early termination of a non-grantor trust.
In general, a non-grantor trust is an irrevocable trust that is created by a grantor, either during their lifetime or following their death. The trustees of such a trust – acting as fiduciaries under applicable state law – take title to the property that was conveyed to them by the grantor as a lifetime gift to the beneficiaries of the trust, or by the grantor’s estate as a testamentary transfer to such beneficiaries.
The trustees will hold the property conveyed to them for the benefit of the beneficiaries[xxxvi] designated by the grantor.[xxxvii] The discretion allowed the trustees by the grantor with respect to the management, investment, disposition, and distribution of the trust property and the income arising therefrom may range from very broad to strictly limited.[xxxviii]
Trust Taxation
The Code[xxxix] imposes the federal income tax upon the taxable income of a non-grantor trust. The trustee of the trust is required to make and file the trust’s annual income tax return[xl] and to pay the tax imposed on the taxable income of the trust.
Of course, the gross income of the trust and of its beneficiaries does not include the value of any property conveyed to the trust by gift or bequest.[xli]
Query whether the distribution of such gifted or bequeathed property by the trust to its beneficiaries should, likewise, not be included in their income – after all, if they had received it directly from the grantor or the grantor’s estate such receipt would not have been taxable to the beneficiaries.
In fact, any amount which, under the terms of the trust, is properly paid or credited as a gift or bequest of a specific sum of money or of specific property, and which is paid or credited all at once, or in not more than three installments, is neither included in the income of the recipient-beneficiary – the distribution does not carry out taxable income[xlii] of the trust – nor deducted by the trust for purposes of determining taxable income.[xliii]
That said, the income realized by the trust that arises from any such gifted or bequeathed[xliv] property is not excluded from the gross income of the trust. Likewise, where the interest conveyed to the trust by gift or bequest is the income from a property (as distinguished from the property itself), the amount of such income is also not excluded.[xlv]
In general, the taxable income of a trust is computed in the same manner as in the case of an individual.[xlvi] There are exceptions, however; for example, the Code provides a special deduction for trusts.
The Distribution Deduction
Specifically, in computing its taxable income for a particular year,[xlvii] a non-grantor trust is allowed to claim a deduction for certain distributions made[xlviii] by the trust to its beneficiaries during such year.[xlix] These rules bring us back to the third category of taxpayer mentioned earlier – the taxpayer that may or may not be subject to the income tax for a particular taxable year.
Stated simply,[l] the purpose of this distribution deduction is to ensure that the taxable income of a trust is taxed only once – either to the trust or to its beneficiaries.[li] This outcome is best illustrated with the so-called “simple trust.”
Simple Trust
A simple trust is required to distribute all of its income currently. The income beneficiaries of the trust are required to include in their gross income the income that the trust is required to distribute, whether or not the trust actually makes such distribution.[lii] In turn, the trust is allowed a deduction for the amount of the required income distribution in computing its own taxable income for the taxable year in which the income is required to be distributed currently, but not in excess of the trust’s “distributable net income” for the year.[liii]
Thus, the simple trust is, in some ways, similar to a passthrough – its income is taxed to its beneficiaries whether or not distributed to them. However, the trust is still taxable on its capital gains. If the trust distributes such gains for a taxable year, it will not be treated as a simple trust for such year but, rather, as a complex trust.[liv]
Complex Trust
A trust will also be treated as a complex trust if it is not required to distribute all of its income currently. If such a trust makes no distributions to its beneficiaries for a taxable year,[lv] the trust – not its beneficiaries – will be liable for income tax with respect to its taxable income for that year.
If the trust is required to make current distributions of income for a taxable year,[lvi] or if other amounts are properly distributed or required to be distributed from the trust for such year, the trust will be allowed a deduction in computing its taxable income of an amount equal to the sum of the income required to be distributed currently and any other amounts properly paid or required to be distributed for such year.[lvii] However, the deduction cannot exceed the trust’s distributable net income for the taxable year.
The trust will have taxable income for a taxable year if its distribution deduction for such year does not equal or exceed the trust’s distributable net income.
At the same time, the beneficiaries of the trust will include in their gross income the amount of income required to be currently distributed to them (whether or not distributed), plus all other amounts properly paid or required to be distributed to the beneficiaries for the year.[lviii]
However, the amount included in the gross income of the beneficiaries cannot exceed the trust’s distributable net income. In other words, the amount distributed to the beneficiaries for a taxable year will generally not be taxable to them to the extent it exceeds the trust’s distributable net income for the year.[lix]
If a trust was allowed to deduct with respect to a taxable year the amount of trust income for such year that was required to be distributed by the trust currently, plus any other amount that was required to be distributed for such year, the trust will not be allowed to claim a distribution deduction with respect to the subsequent distribution of such amount in a later taxable year, and the beneficiary-recipients will not be required to include the amount of such distribution in income.[lx]
If a trust reported and paid tax on its taxable income for a taxable year when the trust was not required to, and in fact did not, make any distributions for such year, the subsequent distribution of such income to the beneficiaries of the trust in a later year will not be included in the taxable income of such beneficiaries – having already been taxed to the trust.
Trust Termination
It is likely that, at some point, whether by its own terms or by agreement of the interested parties, a trust will terminate by distributing its property (including any current and accumulated income) to those beneficiaries of the trust that are entitled to succeed to such property upon termination of the trust.[lxi]
This final distribution to the beneficiaries will carry out the trust’s distributable net income for the final year of the trust. But should the distribution otherwise be taxable notwithstanding the amount distributed exceeds the trust’s distributable net income? Should it be taxable where the property that the grantor or the grantor’s estate originally gifted or bequeathed to the trust was not taxable at the time of such gift or bequest?
In general, a trust distribution of property in-kind should not generate taxable gain for the trust or its beneficiaries unless the trust elects to recognize gain – as if the property had been sold to the distributee-beneficiaries at its fair market value[lxii] – or unless the distribution is made in satisfaction of a pecuniary amount owed to the distributee-beneficiary or in place of another specific property that was supposed to have been distributed to such beneficiary.
Gain may also be recognized where (i) the trust instrument provides for pro rata distribution of the properties comprising its corpus on termination of the trust in accordance with its terms (not a commutation), (ii) the trust and local law are silent as to the trustee’s authority to make a non-pro rata distribution of such properties in kind, and (iii) the trustee (at the request of the beneficiaries) makes a non-pro rata distribution such that each beneficiary ends up with 100 percent ownership of the property distributed to such beneficiary.[lxiii] Specifically, the non-pro rata distribution by the trustee is treated as the equivalent of a pro rata distribution by the trustee, followed by an exchange among the beneficiary-distributees of their respective pro rata shares of the trust corpus.
The IRS had also previously ruled[lxiv] that the amount received by the life tenant of a trust in consideration for the transfer of the life tenant’s entire interest in the trust (a term interest) to the holder of the remainder interest was to be treated as an amount realized from the sale or exchange of a capital asset. According to the agency, the right to income for life from a trust estate was a right in the estate itself.
Are there other income tax consequences that may occur as a result of the liquidating distribution? Is there another scenario in which gain may be realized by the trust or by its beneficiaries by reason of a distribution of property in kind?[lxv]
A recent IRS letter ruling[lxvi] illustrated one such scenario. The IRS’s holding (described below) should alert taxpayers and their advisors that there may be other tax risks lurking within a transaction that may otherwise be viewed as fairly innocuous to someone who is unfamiliar with them.
Agreement to Terminate
Settlor created and contributed property to an irrevocable trust, Trust, for the benefit of Grandchild. No other additions were made to the trust.
Under the terms of Trust, the trustees were required to pay an annual annuity to Grandchild.No other distributions were permitted during Grandchild’s lifetime. Upon Grandchild’s death, the annuity was to be paid per stirpes to Grandchild’s lineal issue. At all times relevant to the IRS’s ruling, Grandchild had two living adult children (the Current Remaindermen) and four living grandchildren (the Successor Remaindermen). None of Grandchild’s lineal issue had a predeceased child with living issue.[lxvii]
By its terms, Trust was to terminate upon the last to die of ten individuals, including Grandchild. Upon termination of Trust, all the trust property was required to be distributed per stirpes to the issue of Grandchild, outright and free of trust. The Current Remaindermen and a Corporate Trustee were serving as co-trustees of Trust.
On Date, Grandchild, the Current Remaindermen, and the Corporate Trustee[lxviii] entered into Agreement, which provided for the early termination of Trust.[lxix] Upon such termination, Trust property would be distributed to the beneficiaries in accordance with the actuarial value of each beneficiary’s interest in Trust at that time (the Proposed Distribution), which was to be determined by a qualified appraiser.[lxx]
Agreement further provided that the co-trustees could make non-pro rata distributions of Trust property to satisfy the Proposed Distribution.[lxxi]
Rulings Requested
In connection with implementing Agreement, the co-trustees asked the IRS to consider several issues, including whether: (i) the Proposed Distribution in termination of Trust would be treated as a taxable sale or exchange of Grandchild’s and Successor Remaindermen’s interests in Trust to the Current Remaindermen; and (ii) to the extent the Current Remaindermen exchanged property, including property deemed received from Trust, for Grandchild’s and the Successor Remaindermen’s interests in Trust, such exchange would be taxable to the Current Remaindermen.
IRS’s Analysis
According to the Code, a taxpayer’s gross income includes the gains derived by such taxpayer from dealings in property;[lxxii] it also includes income from the taxpayer’s interest in a trust.[lxxiii]
The gain realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income sustained by the exchanging taxpayer.[lxxiv]
The gain from the sale or other disposition of property is equal to the excess of the amount realized therefrom by the taxpayer over the taxpayer’s adjusted basis[lxxv] for the property.[lxxvi]
The amount realized by a taxpayer from the sale or other disposition of a property is equal to the sum of any money received plus the fair market value of other property received.[lxxvii]
In determining gain from the sale or disposition of a “term interest in property”[lxxviii] – which does not include a remainder interest – that portion of the adjusted basis of the interest which is determined by reference to the settlor’s basis in the property at the time the property was gifted to the trust is disregarded.[lxxix]
Proposed Distribution – Really a Sale
Although the transaction in question took the form of a distribution of Trust’s property in accordance with the actuarial values of the respective interests of Grandchild, the Current Remaindermen, and the Successor Remaindermen, the IRS determined that, in substance, it was a sale of Grandchild’s and the Successor Remaindermen’s interests to the Current Remaindermen, and an exchange by the Current Remaindermen of their interests with the other beneficiaries.
Accordingly, the amounts received by Grandchild as a result of the termination of Trust were amounts received from the sale or exchange of a capital asset to the Current Remaindermen.[lxxx]
Similarly, the amounts received as the Proposed Distribution by the Successor Remaindermen were amounts received from the sale or exchange of a capital asset to the Current Remaindermen. The amount realized would be the fair market value of the Proposed Distribution received by the Successor Remaindermen.
In addition, to the extent that the Current Remaindermen exchanged property, including property deemed received from Trust, for the interests of Grandchild and the Successor Remaindermen, the Current Remaindermen would recognize gain on the property exchanged, based on the fair market value of the property transferred to Grandchild and the Successor Remaindermen as the Proposed Distribution.
Observations
The IRS’s private letter ruling described above should put trustees, trust beneficiaries, and their respective advisers on alert for potentially adverse income tax consequences that may result from the early termination of a trust.
Unfortunately, the ruling is mostly conclusory and short on analysis – in other words, it does not offer much guidance. In fact, it relies on an earlier published ruling[lxxxi] that is factually distinct from the scenario in the letter ruling, but for the fact that it involved an early termination of the trust.
It appears likely that the IRS was also basing its conclusion upon another published ruling[lxxxii] – not cited – in which the non-pro rata nature of the trust-terminating distribution requested by the beneficiaries, but not authorized under the trust agreement or local law, provided the foundation for concluding that the trust initially made a pro rata distribution among the beneficiaries, following which the beneficiaries rearranged the ownership of the properties as they had agreed among themselves.
In the commutation of a trust, the trustee makes terminating distributions to the holders of the beneficial interests in the trust equal to the actuarial value of their interests. Each beneficiary gives up their respective beneficial interest in the trust in exchange for a lump sum payment in money or in-kind. The commutation terminates any relationship between the beneficiaries and the trust, and the trust terminates.
Because the trust terminates, there cannot have been a sale between the trust and the beneficiaries. Does that necessarily mean there must have been a sale among the beneficiaries, at least in the case where neither the trust agreement nor local law authorize non-pro rata distributions.[lxxxiii]
But what if such distributions are authorized, as was the case in the letter ruling?
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] This will not necessarily involve a change in ownership – allowing another the temporary use of one’s property in exchange for consideration is as much an economic decision as the sale or exchange of such property.
[ii] No, this is not going to be a discussion of rational choice theory. (That said, Adam Smith’s birthday is next week.)
[iii] This is why we talk about disposable wealth when we advise clients who are contemplating gifts to others.
[iv] Think along the lines of removing an appreciating asset from one’s estate by gifting it to a family member. The estate tax savings to the grantor’s estate and beneficiaries may far outweigh the loss of a basis step-up that would otherwise have been realized by the same persons upon the grantor’s demise.
[v] For example, the prospect of a 40 percent federal gift tax on the transfer of property to the trust, or the imposition of a 37 percent federal income tax on the income generated by such gifted property in the hands of the trust, will greatly impact the economic costs and therefore, the economic benefits of the transfer.
[vi] We won’t be covering the creditor protection that a properly drafted trust may afford its beneficiaries, but this benefit – one driven by economics – should not be underestimated.
[vii] Though not disregarded for other taxes; for example, employment taxes.
[viii] Electing small business trusts (ESBTs) may also be included here. IRC 641(c); Sec. 1361(e); Reg. Sec. 1.1361-1(m). An ESBT is eligible to own shares of stock in an S corporation. In exchange form this privilege, the ESBT is taxed on its pro rata share of S corporation income and gain at highest applicable tax rate, and it is not permitted to claim a deduction against such income for distributions made to its beneficiaries. More on this shortly.
Assume the corporations in question are not exempt from federal income tax; for example, corporations described in IRC Sec. 501(c).
[ix] For our purposes, please ignore the imputed underpayment rules of the centralized partnership audit regime under the Bipartisan Budget Act of 2015. Of course, a partnership includes an LLC that (i) has not elected to be treated as an association for tax purposes (Reg. Sec. 301.7701-3) and (ii) has at least two members.
[x] Please also ignore the excess net passive income rule of IRC Sec. 1375 and the built-in gain rule of IRC 1374.
[xi] Basically, Subchapter J of Chapter 1 of the Code. These may be “simple” or “complex” trusts.
[xii] IRC Sec. 671 et seq. We assume here that the entire trust is treated as a grantor trust, and that the grantor owns both the trust’s income and corpus. We also assume an “intentionally defective” grantor trust – one that is irrevocable. See IRC Sec. 673, 674, 675, and 677. In the context of estate planning, IRC Sec. 674 and Sec. 675 are likely the most commonly encountered grantor trust the provisions, though IRC 677 may be the only operative provision in the case of a SLAT (where one spouse creates a trust for the benefit of the other spouse and their issue). Where the subject of the gift is shares of S corporation stock, a qualified subchapter S trust, or QSST, the sole beneficiary of the trust is treated as the owner of the stock under the grantor trust rules, with one exception: any gain from the sale of the stock is taxed to the trust, not the beneficiary. IRC Sec. 1361(d); Reg. 1.1361-1(j).
[xiii] IRC Sec. 1361(b)(3).
[xiv] Yet another deliberate simplification – the LLC has not elected to be treated as an “association” for tax purposes. Reg. Sec. 301.7701-3.
[xv] The “grantor” of a grantor trust is generally treated as the “owner” of the trust’s assets and income. IRC Sec. 671; Reg. Sec. 1.671-2.
[xvi] See, for example, Reg. Sec. 1.702-1(a) and Reg. Sec. 1.1366-1(a)(1). The grantor trust to which we refer is an irrevocable trust the assets of which that are intended to be excluded from the grantor’s gross estate. For that reason, the grantor will typically not have retained any right to distributions in respect of such property. IRC Sec. 2036. There are exceptions, however; GRATs, for example, provided the grantor survives the term of their retained interest.
[xvii] IRC Sec. 731(a)(1).
[xviii] IRC Sec. 705(a).
[xix] IRC Sec. 731(a).
[xx] IRC Sec. 704(c)(1)(B). Similarly, if the partnership distributes property (X) in-kind to a partner (A) who, within the preceding seven-year period, had contributed a different property (Y) to the partnership, such contributing partner (A) will recognize gain up to the built-in gain of the contributed property (Y), at the time of its contribution. IRC Sec. 737. See also the disguised rules under IRC Sec. 707, especially IRC Sec. 1.707-3, which may, for example, treat the contribution of a property by a partner (A) to a partnership as a sale of such property by A if the partnership distributes money to the contributing partner (A) within two years of such contribution.
[xxi] This includes “substantially appreciated inventory and “unrealized receivables” – the latter encompasses a range of assets; for example, unrealized receivables and depreciation recapture. IRC Sec. 751(c).
[xxii] Obviously, the “Code” refers to the Internal Revenue Code. There are other, albeit lesser (lower case “c”) codes; bankruptcy, for example. (Sorry, Kris.)
[xxiii] IRC Sec. 751(b).
[xxiv] IRC Sec. 1368(b). We assume the S corporation does not have C corporation earnings and profits. IRC Sec. 1368(c).
[xxv] IRC Sec. 1367 and Sec. 1366.
[xxvi] IRC Sec. 311(b).
[xxvii] IRC Sec. 1366. Depending upon the property and other circumstances, all or some of this gain may be treated as ordinary income. IRC Sec. 1239, Sec. 1245.
[xxviii] In order to qualify as a small business corporation which may elect to be treated as an ‘S’ corporation, a corporation cannot have more than one class of stock. IRC Sec. 1361(b)(1)(D).
[xxix] The articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds. Reg. Sec. 1.1361-1(l)(2).
[xxx] Reg. Sec. 1.1361-1(l)(2).
[xxxi] Alternatively, if one shareholder receives their pro rata distribution much later than another shareholder, the former may be treated as having made a loan to the distributing corporation. Reg. Sec. 1.1361-1(l)(2)(vi), Example 2.
[xxxii] Of course, in the case of a trust that is a SLAT, distributions may be made to the grantor’s spouse without causing inclusion of the trust in the grantor’s estate.
Note: when the grantor of a trust, who is treated as the owner of the trust, pays the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, the grantor is not treated as making a gift of the amount of the tax to the trust beneficiaries. Rev. Rul. 2004-64.
[xxxiii] However, if, pursuant to the trust’s governing instrument, the grantor must be reimbursed by the trust for the income tax payable by the grantor that is attributable to the trust’s income, the full value of the trust’s assets will be includible in the grantor’s gross estate under IRC Sec. 2036.
Note there are PLRs according to which the modification of a trust agreement to add a tax reimbursement clause will constitute a taxable gift by the trust beneficiaries because the addition of a discretionary power to distribute income and principal to the grantor is a relinquishment of a portion of the beneficiaries’ interest in the trust. The valuation of such a gift is another story.
[xxxiv] IRC Sec. 102. We’re assuming the gift was already completed for purposes of the gift tax. Reg. Sec. 25.2511-2.
[xxxv] Reg. Sec. 1001-2(a)(4).
[xxxvi] Or class of beneficiaries.
[xxxvii] Reg. Sec. 301.7701-4(a) provides that:
“the term ‘trust’ as used in the Internal Revenue Code refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts.”
[xxxviii] In any case, the grantor will not have retained any rights with respect to the trust property or its income that would cause the grantor to be treated as the owner thereof for purposes of the income tax.
Significantly, the grantor will also have been careful to avoid the retention of any interest in the trust that would cause the trust’s property to be included in the grantor’s gross estate under their death. See IRC Sec. 2035 to 2038, and Sec. 2042.
[xxxix] IRC Sec. 1(e)(2); Sec. 641(a).
[xl] On IRS Form 1041, U.S. Income Tax Return for Estates and Trusts. IRC Sec. 6012(a), Sec. 6072(a).
[xli] IRC Sec. 102(a).
[xlii] Actually, distributable net income.
[xliii] IRC Sec. 663(a); Reg. Sec. 1.663(a)-1(a).
[xliv] Used broadly to include not only a testamentary transfer of personal property but also a devise of real property.
[xlv] IRC Sec. 102(b).
[xlvi] IRC Sec. 641(b).
[xlvii] Trusts are required to use the calendar year as their taxable year. IRC Sec. 644.
[xlviii] Or deemed to have been made. See the 65-day rule under IRC Sec. 663(b).
[xlix] IRC Sec. 662.
It should be noted that complex trusts are not the only entity that is allowed a distribution deduction under the Code. For example, RICs and REITs are allowed to reduce their taxable income by the so-called dividends-paid deduction, which refers to certain dividend distributions made by such entities to their shareholders. As in the case of the trust, this distribution deduction allows these other entities to be treated as passthroughs, in some respects, for income tax purposes.
[l] Actually, oversimplified, but probably sufficient for our purposes.
[li] Compare this to partnerships and S corporations – their owners (not the entities) are taxed on the entity’s taxable income regardless of whether any distributions are made to the owners.
[lii] IRC Sec. 652.
[liii] IRC Sec. 651. Basically, the taxable income of the trust with respect to a taxable year, with certain modifications. IRC Sec. 641(b); IRC Sec. 643(a); Reg. Sec. 1.643(a)-0. Among the modifications: there is no deduction for distributions; capital gains are excluded to the extent they are allocated to corpus and are not paid, credited, or required to be distributed to any beneficiary during the taxable year. IRC Sec. 643(a)(3). Reg. Sec. 1.643(a)-3.
[liv] In its final taxable year, when it distributes all its assets, a simple trust will be treated as a complex trust.
[lv] As where income, in the discretion of the fiduciary, may be either distributed to the beneficiaries or accumulated. IRC Sec. 641(a).
[lvi] The so-called simple trust is required to distribute all of its income currently. The income beneficiaries of the trust are required to include in their gross income the income that the trust is required to distribute, whether or not the trust actually makes such distribution. IRC Sec. 652. In turn, the trust is allowed a deduction for the amount of the required income distribution in computing its own taxable income for the taxable year in which the income is required to be distributed currently (but not in excess of the trust’s distributable net income for the year). IRC Sec. 651.
Thus, the simple trust is, in some ways, similar to a passthrough. However, the trust is still taxable on its capital gains. Moreover, if the trust distributes such gains, it will not be treated as a simple trust but, rather, as a complex trust. A trust will also be treated as a complex trust if it is not required to distribute all of its income currently.
[lvii] IRC Sec. 661.
[lviii] IRC Sec. 662.
[lix] IRC 662(a)(2).
[lx] IRC Sec. 663(a)(3); Reg. Sec. 1.663(a)-3.
[lxi] Reg. Sec. 1.641(b)-3(b).
At some point, Congress will get its act together and eliminate the federal transfer tax benefits currently associated with the use of dynasty trusts.
[lxii] IRC Sec. 643(e)(3). Indeed, the basis of any property received by a beneficiary in a distribution from a trust will be the adjusted basis of such property in the hands of the trust immediately before the distribution. IRC Sec. 643(e)(1).
[lxiii] Rev. Rul. 69-486.
[lxiv] Rev. Rul. 72-243.
[lxv] We are assuming the trustee will not elect to recognize gain under IRC Sec. 643(e)(3). Reg. Sec. 1.661(a)-2(f).
[lxvi] Private Letter Ruling 202509010, 03/03/2025.
[lxvii] In other words, the per stirpes designation of beneficiaries was of no import.
A “per stirpes” designation directs property that would otherwise have passed to a predeceasing beneficiary to such beneficiary’s issue. For example, if one of the Current Remaindermen in the ruling had predeceased Grandchild, that deceased Current Remainderman’s share would have passed to their issue (a member of the Successor Remaindermen).
[lxviii] There was also a special representative appointed by the Court to represent the minor and unborn Trust beneficiaries.
[lxix] Not all trusts may be terminated early; for example, GRATs and QPRTs. Reg. Sec. 25.2702-3(d)(5); Reg. Sec. 25.2702-5(c)(6).
[lxx] Thus, it is unlikely that gifts were made among the various holders of interests in the trust. To the contrary, see IRC Sec. 2519 which addresses IRC Sec. 2056(b)(7) QTIP marital trusts.
[lxxi] Court approved Agreement.
[lxxii] IRC Sec. 61(a)(3).
[lxxiii] IRC Sec. 61(a)(14).
[lxxiv] Section 1.1001-1(a).
[lxxv] Provided in IRC Sec. 1011.
[lxxvi] IRC Sec. 1001(a).
[lxxvii] IRC Sec. 1001(b).
[lxxviii] A “term interest” in property defined as (a) a life interest in property, (b) an interest in property for a term of years, or (c) an income interest in a trust. IRC Sec. 1001(e)(2).
[lxxix] Pursuant to IRC Sec. 1015, to the extent that the adjusted basis for the interest is a portion of the entire adjusted basis of the property. IRC Sec. 1001(e)(1). However, this rule does not apply to a sale or other disposition which is a part of a transaction in which the entire interest in property is transferred. IRC Sec. 1001(e)(3); Reg. Sec. 1.1001-1(f).
[lxxx] The IRS cited Rev. Rul. 72-243 in support of this conclusion.
[lxxxi] Rev. Rul. 72-243.
[lxxxii] Rev. Rul. 69-486.
A revenue ruling is an official interpretation by the IRS of the Code and regulations. It is the conclusion of the IRS on how the law is applied to a specific set of facts. Revenue rulings are published for the information of and as guidance to taxpayers, IRS personnel and tax professionals.
A private letter ruling (PLR) is issued in response to a written request submitted by a taxpayer and is binding on the IRS if the taxpayer fully and accurately described the proposed transaction in the request and carries out the transaction as described. A PLR may not be relied on as precedent by other taxpayers or IRS personnel.
[lxxxiii] Query whether this is a realistic scenario.
