In PLR 201730018, the IRS addressed the question whether income tax resulted from the conversion of a non-grantor trust to a grantor trust. The trust in question was a non-grantor charitable lead trust. Such a trust provides for an annual distribution to a charity for a number of years and thereafter holds any property remaining in the trust for non-charitable beneficiaries. The trust was amended to add a power that would cause the trust to become a grantor trust for income tax purposes.
The IRS ruled that such conversion was not treated as a transfer of property from the trust to the grantor, nor did it otherwise give rise to any taxable event. The IRS also held that the conversion did not constitute a prohibited act of self-dealing under Section 4941 of the Code. Finally, the IRS held that the conversion of the trust to a grantor trust did not give rise to any charitable contribution deduction for the grantor.
This ruling presents the flip side of a more common scenario. Taxpayers often create a trust that is treated as a grantor trust for income tax purposes; however, the trust does not contain any provisions that would cause the assets of such trust to be included in the taxpayer’s gross estate for estate tax purposes at his death. Trusts of this nature allow the children and grandchildren of the taxpayer to benefit from any appreciation in the value of the property owned by the trust.
Since the trust is a grantor trust for income tax purposes, the taxpayer who created the trust is required to pay income tax on any income generated by the property held in the trust. This increases the benefits to the children or grandchildren because the payment of tax by the taxpayer depletes his taxable estate and the trust assets will grow at a pretax rate.
Sometimes the taxpayer who created the trust reaches a point where he wants to stop paying the income tax on the income generated by the property held by the trust. Trusts of this nature often contain a provision that allows a disinterested third party to remove the power from the trust that caused it to be a grantor trust. Following the removal of such power, the trust itself becomes a taxpayer and either it pays income tax on the income generated by the property of the trust or, if such income is distributed to the beneficiaries of the trust, the beneficiaries pay the income tax. The IRS has issued several rulings where it concluded that such a conversion in the nature of the trust did not give rise to a taxable event, provided that the property of the trust was not encumbered by liabilities that were in excess of the tax basis of such property.