Grantor Trust Reform: What You Should Know
How proposed IRC Sections 2901 and 1062 could dramatically affect your clients, if enacted
Given the sheer volume of information out there, along with political infighting, tax practitioners have been conditioned to never take tax proposals seriously.
I count myself among this group of skeptics, and the most recent House Ways and Means proposal from September 13 is no exception. While this proposal (and Chairman Neal’s markup) create opportunities for discussion, it is difficult to fathom a situation where these proposals pass unscathed through the House and Senate.
However, there is one set of proposals which made my spidey senses tingle. This set of proposals will change the way grantor trusts are taxed in the future. For more information, I have published a 15-minute video summarizing these changes, which woudl be codified in Code Sections 2901 and 1062 if enacted:
I am bearish on the chances of IRC 2901 and 1062 being enacted in their current form. But, there are two things that bother me strategically:
For my firm, and I imagine many other estate planning law firms, the enactment of these Code provisions would require us to analyze a vast number of trusts, and communicate a game plan to grantors of these trusts.
The effective date would be the date of enactment (if any) of IRC Sections 2901 and 1062, which creates a very small window of time to avoid or defer the effect of these new Code provisions.
With that being said, this article serves as a supplement to the video above. I believe that an ounce of prevention is worth a pound of cure, and simple actions right now can buy time for you and your clients.
To narrow the focus, I have drafted a brief client update here, which you can markup, use, and deliver to save time:
SAMPLE CLIENT UPDATE
One of the proposed tax reforms will affect the tax treatment of certain irrevocable trusts, which are taxed as “grantor trusts.” While we do not yet know whether this reform will be part of a new tax law, it may affect transfers to irrevocable grantor trusts occurring after the law is passed. Therefore, it is important to take action.
If you have created an irrevocable trust to which you plan to make future gifts or payments, we should discuss a plan for how these ongoing transfers may be affected. These payments include, for example, insurance premium payments to an irrevocable life insurance trust, or annual transfers which are designed to use your gift tax annual exclusion. At the very least, you may wish to consider making those transfers now instead of waiting until year-end, or the next premium due date.
In addition, the grantor of a grantor trust is treated as the income tax owner of all trust assets. Under current law, this allows a grantor to sell or exchange assets with a trust without incurring income tax. However, the proposal would close this loophole. Just in case this proposal is enacted, you may wish to consider exchanging assets with an irrevocable grantor trust, or having the trust pay off or forgive any promissory note payable to the grantor (in full or in part).
While changes to irrevocable trusts are limited or restricted, it may be possible to convert these trusts so that they are no longer treated as grantor trusts. Such a conversion (if possible) could prevent the application of the proposed grantor trust reforms to any future transfers to the trust.
If you would like to discuss how these proposals may affect your estate plan, please reach out. There is a limited window to take action, but simple steps can limit or defer the effect of this proposed change to the tax treatment of grantor trusts.
Once that is edited, published, and delivered, the question is how to respond to those clients who do choose to call you regarding their existing irrevocable grantor trusts.
The objectives from a gift tax perspective are simple, and two-fold:
Identify any transfers to grantor trusts which could occur on or after the date IRC Sections 2901 and 1062, which could happen in a matter of weeks if they survive congressional scrutiny,
Either make those transfers now (in full or in part), or convert trusts to non-grantor trusts.
The lowest hanging fruit, or minumum effective dose, is to go ahead and make any planned transfers to grantor trusts ahead of time. These could include things like:
premium payments to ILITs;
annual exclusion gifts as part of a gifting plan; or
capital contributions to a family entity which could be credited as a gift to a grantor trust which holds an interest in the entity.
If these transfers are made soon, they could be grandfathered in under the new law, along with prior transfers to grantor trusts.
More problematic, however, is the income tax treatment of grantor trusts. Generally, grantor trusts will continue to be disregarded for income tax purposes, but they will no longer be disregarded with respect to sales or exchanges between the grantor and the trust. So, just in case IRC Sections 2901 and 1062 are enacted, these immediate action items should be considered:
Forgiving any note payable from an intentionally defective grantor trust to a grantor. This is a taxable gift, but is not currently taxed as forgiveness of indebtedness. However, IRC Section 1062 could cause this note forgiveness to be taxable income to the trust in the future, and it is unclear whether this would be treated as a completed gift to the trust under IRC 2901.
Exercising any substitution power between the grantor and the trust. If such a power exists (which is common for trusts which are intentionally established as grantor trusts), the grantor can exchange individually-owned assets for trust-owned assets so long as these amounts are equal. Such an exchange is not an income tax event under current law, since the grantor trust is disregarded. However, IRC 1062 could treat this exchange as a gain recognition event, and would also treat the grantor and the trust as related parties for purposes of loss deductibility.
These are actions which would be good to consider anyway, especially if the lifetime gift tax exclusion is reduced by one-half on January 1, 2022 (which is also in the most recent package of proposals).
Once this work is complete, you can at least buy some time to determine whether or not it makes sense to convert (if possible) your clients’ existing grantor trusts to non-grantor trusts. But, this is a subject for another time, and it may be too complex and reactive given the short time frame for tax reform.
But, with that being said, be on the lookout for additional information from me in the coming weeks.