By: Randall A. Denha, J.D., LL.M.
Irrevocable trusts have been structured for many years as “grantor” trusts for income tax purposes while still maintaining tax-free status for estate tax purposes.
A number of favorable Internal Revenue Service rulings over the years have solidified the irrevocable grantor trust “power of substitution” concept under Internal Revenue Code Section 675(4)(C). This concept allows a grantor to substitute assets of equal value for assets already in the trust without causing any of the asset value to be included in the gross estate for estate tax purposes.
How can this string of positive rulings from the IRS be used from a practical estate planning point of view to improve wealthy estate owners’ plans? Keep in mind that the trustee of an irrevocable trust has a fiduciary obligation to ensure that any “substituted” assets are of equal value to the assets already in the trust.
Before diving into the technique, the following is a short history of the important IRS rulings which permit the “power of substitution” and “grantor trusts”:
• Rev. Rul. 85-13 was the first ruling which stated that a grantor of an irrevocable trust would be treated as owner of the trust assets only for income tax purposes but NOT for estate tax purposes.
• In Rev. Rul. 2004-64, IRS ruled that a grantor’s payment of income taxes on investment income of assets held in an irrevocable trust was NOT a taxable gift to the trust.
• In Rev. Rul. 2007-13, IRS ruled that a transfer of a life insurance policy from one irrevocable grantor trust to another irrevocable grantor trust would NOT violate the transfer for value rule (thereby causing them to be subject to ordinary income tax.) The death proceeds retained their income tax free character under IRC Section 101.
• Rev. Rul. 2008-22 was the first ruling to outline how a grantor trust with a Section 675(4)(C) “power of substitution” clause could be used so that a grantor could substitute assets of equal value for assets already held by the grantor’s irrevocable trust. The ruling stated that the trust assets would NOT be included in the grantor’s gross estate as a retained life interest under IRC Section 2036 and NOT be included as a power to alter, amend, or revoke under IRC Section 2038.
• Finally, Rev. Rul. 2011-28 ruled that the Section 675(4)(C) “power of substitution” would NOT cause life insurance owned by a “grantor” irrevocable life insurance trust to be included in the gross estate as an “incident of ownership” under IRC Section 2042.
How can this string of positive rulings from IRS be used from a practical estate planning point of view to improve the estate plans of wealthy estate owners? Keep in mind that the trustee of an irrevocable trust has a fiduciary obligation to insure that any “substituted” assets must be of equal value to the assets already in the trust.
For example, if an individual were to purchase a piece of real estate for $100,000 and sell it prior to death when it is valued at $1 million, $900,000 would be subject to capital gains taxes, resulting in $180,000 in tax ($900,000 * 20% capital gains tax rate). If depreciation was taken, even more of the sales price would be subject to capital gains taxes. State and local taxes may increase the taxes due even further. However, if the property was held until death, IRC 1014(a) of the Internal Revenue Code would permit the asset a stepped-up basis to the fair market value of $1 million. Thus, if the property was sold after death, no capital gains taxes would be due and the full $1 million would be available for distribution to heirs.
In order to avoid estate taxes, property can be gifted to an irrevocable trust to remove the value of the asset from the grantor’s gross estate. However, if this property is left within the trust, it will not be entitled to a step-up in basis at death. However, irrevocable trusts can be specially drafted to grant an individual the power to swap the assets of the trust with assets the grantor still holds individually. If done properly, the assets can be swapped, or substituted, prior to death so that the assets held in the trust with a low basis can be substituted for assets held by the grantor with high basis. After substitution, the assets with a low basis (i.e. a high amount of accumulated gain) are back in the grantor’s hands and will be eligible for the IRC 1014(a) step-up in basis on the grantor’s death. The high basis assets will no longer be in the grantor’s gross estate and the exchange of assets is not a taxable event.
Alternatively, if the grantor owns a loss asset (basis greater than the fair market value), he or she should consider taking back the low-basis assets held by the trust by substituting the loss asset. This way, the loss is preserved in the trust.
To illustrate the benefits of substitution, assume that real estate purchased for $100,000 (basis) and valued at $1,000,000 was transferred into an irrevocable trust in an effort to remove the $1,000,000 value from the value of the grantor’s gross estate for estate tax purposes. While this will allow for significant estate tax savings, if the asset is left in the trust and sold after the grantor’s death, $900,000 of the sales price will be subject to capital gains taxes. However, using the power of substitution prior to the grantor’s death, he or she can substitute $1,000,000 in cash, or other property with no inherent gain, for the real estate. When the grantor dies, his estate will be able to sell the real estate for the date of death value, with no capital gains taxes being due.
The substitution power held by the grantor or anyone in a non-fiduciary capacity should not cause inclusion of the trust assets in the grantor’s gross estate because the right to swap assets does not allow the grantor to make additional wealth transfers or to diminish the value of the trust’s assets. For example, in order for the grantor to remove the piece of real estate valued at $1 million from the trust, the grantor would need to transfer $1 million in assets to the trust in exchange.
Assume the following set of facts:
• A gross estate well in excess of the estate tax exemption ($5.34 million single and $10.68 million married) so that the excess is subject to a 40% estate tax rate plus state death taxes in many states.
• Over the years, the estate owner has made significant gifts of capital assets in a gain position to a “grantor” irrevocable trust to remove future appreciation from the gross estate. The “grantor” irrevocable trust contained a Section 675(4)(C) “power of substitution” clause. The gifts were lifetime gift tax exemption gifts (currently $5.34 million single and $10.68 married). Form 709 U.S. Gift Tax returns were filed to document the gifts and their value.
• These gifted capital assets were real estate, publicly traded securities, and shares in privately owned S Corps or LLCs. Under IRC Section 1015, the adjusted cost basis of these lifetime gifts “carries-over” and remains the cost basis for any future sale of those capital assets by the trust. This contrasts with capital assets included in the gross estate at death which would get a “stepped-up” basis to date of death value.
• The estate owner kept a part of his investment portfolios liquid in the form of significant money market account or bank holdings in an uncertain economic environment.
The grantor and his/her trustee could consider transferring money market cash to the trust as a substitute for a portion of the capital assets currently held by the trust. This cash would have to equal the appraised fair market value of the capital assets now held by the trust. The capital assets would be returned to the grantor estate owner and would ultimately be included in the gross estate at “stepped-up” basis value for capital gains purposes for the heirs of the estate owner.
The substituted cash could then be used by the trustee to buy a single pay or annual pay no-lapse guaranteed UL or SUL policy owned by the trust. The leveraged death benefit of this policy would be income tax free, estate tax free, and provide an excellent guaranteed Internal Rate of Return (IRR) at life expectancy.
While asset swaps can provide significant income taxes savings, if not done properly, adverse tax consequences can result. Many times, written agreements between the grantor and the trustee can be entered into, providing that if the finally-determined values are not equal, cash or other assets would be transferred to the under-compensated party to equalize the transfers.