The Toggling Grantor Trust (IRS Notice 2007-73)
The IRS and the Treasury Department are aware of a type of transaction that uses a grantor trust, the purported termination and subsequent re-creation of the trust’s grantor status, for the purposes of allowing the grantor to claim a tax loss greater than the actual economic loss sustained (or avoid inappropriately, the recognition of any gain). The IRS and the Treasury Department believe that this transaction has the potential for tax avoidance or evasion, but lack sufficient information to determine whether the transaction should be “listed” (i.e., as a tax avoidance transaction).
Two variations are typically employed, but the critical feature of both is that there is both a toggling off and back on, of grantor trust status, using, e.g., the effective date of the substitution power put in the trust agreement.
Variation #1: Using “Loss” and “Gain” Options, With Springing Substitution Power
One of the variations the IRS is looking at involves a situation in which the Grantor of a trust purchases 4 options, 2 being “gain options” and 2 being “loss options.” A special kind of trust is then established, in which a short-term unitrust interest is given to a beneficiary, but the Grantor retains a qualifying Section 2702 interest in the remainder. Because of this “retained” remainder interest, Grantor treats the Trust as one that is owned by Grantor for Federal income tax purposes (Subchapter J).
The trust agreement also provides the Grantor with powers, exercisable in a nonfiduciary capacity, to reacquire Trust corpus by substitution (of other property of equivalent value) and this substitution power will become effective on a specified date in the future.
The Grantor then looks to sell the remainder interest in Trust to an unrelated party (Buyer) for an amount equal to the FMV of the remainder interest (which is equal to the FMV of the options). Grantor claims that the basis in the remainder interest is determined by allocating to the remainder interest a portion of the basis in all of the Trust assets (based on the respective FMV of the remainder and unitrust interests at the time of the sale). By this, Grantor is able to claim that there is no gain recognized on the sale of the remainder interest because Grantor’s basis in the remainder interest is the same as the amount realized (prearranged to be equivalent to the FMV of the options). Buyer gives Grantor an installment obligation (note), cash or other consideration for the remainder interest. Grantor claims that the sale of the remainder interest has terminated the grantor trust status so that, during the period after the sale and before the effective date of the substitution power, Trust is no longer a grantor trust under Subchapter J.
Then, when the substitution power becomes effective, Trust’s grantor trust status is toggled back on, and then, the “loss options” are closed out. Since the amount Grantor paid for those options (i.e., the original basis) is greater than the amount Trust receives when the loss options are closed out, and Grantor then claims that Grantor is entitled to recognized the loss. The concern is that even though Grantor previously used a portion of the basis in the Trust assets (equivalent to the basis in all of the options), to eliminate Grantor’s gain on the sale of the remainder interest, Grantor calculates the loss based on the difference between the amount realized and the original basis in the loss options.
The Trust then consists of the two gain options, the contributed cash, and amounts received, if any, on the termination of the two loss options. Buyer then purchases the unitrust interest from Beneficiary for an amount equal to the actuarial value of that interest, making the Buyer the owner of both the remainder interest and the unitrust interest. This effectively merges title, and the Trust terminates, with Trust’s assets distributed to Buyer. Buyer claims a basis in the gain options equal to the amount paid by Buyer for the two separate interests, but Grantor does not treat the termination of the Trust as a taxable disposition by Grantor of the assets of the Trust. Any gain then realized on the gain options by the Buyer are minimal. If Buyer purchased the remainder interest from Grantor using a “note,” Buyer uses the proceeds from the options to pay the note. If Grantor borrowed to purchase the options, Grantor repays the loan from the note proceeds.
Essentially, Grantor uses this variation to claim a “tax” loss attributable to those assets, even though Grantor sold the remainder interest and receives an amount substantially equal to the FMV of the non-cash assets contributed to the Trust.
Variation #2: Using Marketable Securities or Cash, with Springing Substitution Power
In the second variation, the Grantor contributes cash or marketable securities (with basis approximately equal to the FMV of the assets at the time of contribution). Again, before the specified date in which the substitution power kicks in, the Grantor sells the remainder interest and claims to recognize no gain (or minimal gain or loss). With the sale of the remainder interest, the Grantor claims that the grantor trust status is turned off, only to have it kick back on, when the substitution power becomes effective. At that time, Grantor substitutes appreciated property for Trust’s more liquid assets, with the FMV of the substituted property equivalent to the FMV of the liquid assets. With grantor trust status back on, it is claimed that the actual act of substitution will not cause Grantor to recognize any gain. Buyer then purchases the unitrust interest from Beneficiary, terminates the Trust, and receives its assets. Yet, for tax purposes, the Grantor does not treat the termination of the Trust as a disposition by the Grantor of the appreciated assets. The Buyer claims a basis in the assets equal to the amount paid by Buyer for the interests in the Trust.
Essentially, Grantor uses this variation to avoid recognition of gain on the disposition of the appreciated assets that were substituted for the original assets contributed to Trust.
If you believe that you may have engaged in a transaction that is the same or substantially similar to either of the two variations of the transaction described above, Federal law may require you to disclose your and other parties’ participation in this “transaction of interest” on IRS Form 8886. For more information about Federal law requirements, please contact us.
