Thursday, January 21, 2010

New Gift Tax Provision for Transfers to Irrevocable Trusts

Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16), as amended in part by the Jobs Creation and Worker Assistance Act of 2002 (P.L. 107-147), collectively referred to as the Bush tax cuts, a new provision was added to the federal gift tax law, requiring that any transfer of money or other property to a trust after 12/31/2009 be deemed a taxable gift, subjecting the transferor to gift tax ramifications, unless the trust qualifies as a grantor trust of the transferor for income tax purposes (i.e., unless the trust is considered as wholly owned by the transferor or the transferor's spouse under the grantor trust rules of the income tax law).

This newly effective gift tax provision, codified as subsection (c) of Internal Revenue Code section 2511, was enacted by Congress with the intent of preventing higher-bracket taxpayers from shifting the income tax bite on their passive investment income to an irrevocable nongrantor trust created for the benefit of their children or other lower-bracket family members, while avoiding gift tax on the transfer. Legislators were concerned that the gift tax law could be circumvented simply by having the transfer made to a nongrantor trust with respect to which the transferor would retain sufficient control over the beneficial interests as to make the transfer "incomplete" (and thus nontaxable), for gift tax purposes.  

IRC §2511(c), though seemingly straightforward, has in fact caused a tremendous amount of confusion and consternation among tax practitioners across the nation. Whereas the statute, on its face, provides that any post-12/31/2009 transfer to a nongrantor trust is automatically to be treated as a completed gift, thereby triggering gift tax consequences, the statutory language may be interpreted conversely to mean that any post-12/31/2009 transfer to a grantor trust is necessarily to be treated as an incomplete gift, thereby precluding gift taxation of such a transfer under any circumstances. If that interpretation were to be held valid by a federal court, then such commonly used estate planning strategies as the Grantor Retained Annuity Trust (GRAT) and the installment sale to an Intentionally Defective Irrevocable Trust (IDIT) may no longer be viable tax reduction techniques, as both require the underlying gift transfers to be deemed "completed" for gift tax purposes. Indeed, a literal reading of the statute raises the question of whether a post-12/31/2009 transfer to an irrevocable grantor trust can ever be subject to gift tax, even where the grantor trust is drafted for the specific purpose of excluding the gifted assets from the transferor's taxable estate upon death. In other words, under §2511(c), a transfer to a grantor trust which has been drafted so as to exclude the trust corpus from the transferor's taxable estate upon death may avoid gift taxes at the time of transfer, and then, upon the death of the transferor, avoid estate taxes as well!  Clearly, this result does not appear to have been the intent of Congress in enacting the statute. It is yet one more classic example of the law of unintended consequences which often arises when politicians try to remedy a specific tax problem without considering the larger picture.

IRC §2511(c) also fails to address the tax ramifications of a gift transfer to a grantor trust which later becomes a nongrantor trust during the transferor's lifetime. It would seem that a taxable gift should occur as of the date on which the trust changes its status from "grantor" to "nongrantor," the amount of the gift being determined by the gifted asset's fair market value as of the date of change.  But what if the trust no longer holds that particular asset at the time the change of status occurs? Determining the value of the gift under such circumstances may become extremely burdensome, if not impossible.

IRS, for its part, has publicly stated that it is well aware of the confusion surrounding section 2511(c), and that it will attempt to issue guidance and clarification on the statute as soon as possible.  Moreover, antiticpated new legislation by Congress this year to address estate tax reform may also impact the treatment of gifts to irrevocable trusts.

For further information contact the writer, Keith Codron, toll-free, at (800) 497-0864, or online at keith@octrustlawyer.com.