Grantor Trust Ownership Again
June 5, 2020
by Monte A. Jackel
The IRS very recently expressed its view that changes in the ownership percentages of investors in a multiple owner grantor trust were sales and purchases for federal tax purposes. In Rev. Proc. 2020-34 https://www.irs.gov/pub/irs-drop/rp-20-34.pdf, the IRS provided safe harbors for an entity titled a statutory trust under Delaware law from being treated as having the power to vary investment due to new money coming in and other changes to the debt and lease arrangements of a trust described in Rev. Rul. 2004-86. https://www.irs.gov/irb/2004-33_IRB#RR-2004-86. The key issue in the revenue ruling was whether the entity had the power to vary investment. If so, the state law trust would have been a business entity under the check-the-box regulations and would have defaulted into federal partnership tax treatment.
In discussing at the end of the revenue procedure the effect of new money coming into the trust from either new or existing owners due to the coronavirus pandemic, the IRS states: “A cash contribution from one or more new trust interest holders to acquire a trust interest or a non-pro rata cash contribution from one or more current trust interest holders must be treated as a purchase and sale under § 1001 of the Code of a portion of each non-contributing (or lesser contributing) trust interest.
This position flows logically from Rev. Rul. 85-13 where the IRS stated that ownership of a grantor trust is ownership of the underlying property of the trust for federal tax purposes. I have recently published an article in Tax Notes dealing with that very issue. https://www.taxnotes.com/tax-notes-today-federal/entity-characterization/grantor-trust-ownership-what-does-it-mean/2020/04/13/2cc1t?highlight=Jackel. The article summarized the state of the law as a conflict between the owners of the grantor trust disregarding the trust as a separate tax entity or as merely an income attribution vehicle. The clear trend of the guidance is to disregard the trust’s separate federal tax existence.
Now, consider a state law trust similar to that in the revenue ruling except that there is a sufficient variation in the facts so that there is a power to vary by the trustee and, thus, the state law trust becomes a federal tax business entity and defaults to a federal tax partnership. Now assume that the non-pro rata contributions to the partnership by either or both of new or current investors occur. Is there also a sale and purchase among the partners on those facts?
For example, consider Rev. Rul. 95-69. That revenue ruling involved a stock exchange by a partnership in a purported reorganization where the partnership promptly distributes the stock received to its partners. The IRS ruled that the partners had indirect ownership of the stock by virtue of being partners and that continuity of proprietary interest under section 368 was satisfied in that case.
In a follow-up article on the subject of indirect ownership years ago in Tax Notes, https://www.taxnotes.com/tax-notes-today-international/partnership-taxation-incl-llcs/indirect-ownership-through-partnership-what-does-it-mean/1996/01/05/1d1y5?highlight=%22rev.%20rul.%2095-69%22, I asked the question whether, if the partners of a partnership have indirect ownership by virtue of being partners, is there a sale or exchange under section 1001 if the partners’ interests change over time because there was indirect ownership at least for purposes of continuity of interest? The answer to that question should be a resounding no as partnership tax practitioners, as well as the IRS, believe that no sale of exchange occurs when partnership allocation percentages change unless there is a capital shift that occurs in the transaction.
And, even in the case of a capital shift, the IRS has gone out of its way to say, whether through a deemed circular cash flow or otherwise, that the partners have no gain by shifting their respective shares of partnership appreciated assets among the partners inter se. I frankly see no substantive difference between the state law trust being treated as a grantor trust or being a tax partnership for purposes of section 1001. All it takes is a power to vary investment to raise the issue.
The tax law currently treats the conversion of a grantor trust into a regular trust as a disposition for section 1001 purposes. In the reverse case where a regular trust becomes a grantor trust, that event should be treated as a trust distribution and recontribution which, depending on the facts, could also be a disposition under section 1001 for federal tax purposes. The guidance up until the subject revenue procedure was released under the grantor trust rules mostly related to ownership for tax purposes by the owners of the grantor trust. Ownership for purposes of section 1001 was not among those pre-existing authorities.
Ownership of property for purposes of section 1001 is an important issue. Looking through the fog, the issue at play seems to be a timing of income recognition issue. That is to say, if there was no section 1001 event when disproportionate contributions to the grantor trust are made, there would be a true- up when the grantor trust is finally liquidated and the proceeds distributed. This is how the tax system currently deals with the situation when the state law trust is a tax partnership. There is a misallocation of income, gain, deduction or loss that is tolerated in the tax partnership area for bona fide business or investment reasons but the same misallocations of income and loss are apparently not tolerated by the IRS for the owners of multiple-owner grantor trusts.
I think that grantor trust ownership for purposes of section 1001 is not a mere restatement of existing law and, as such, a revenue procedure was not appropriate to announce this new rule. Rather, either a regulation or, at worst, a revenue ruling on the subject would be more appropriate. What do others think?