In PLR 201245006, the IRS addressed a question that has been puzzling tax advisors for years. A person who was not a citizen or resident of the United States created a foreign grantor trust and funded the trust with shares of non-U.S. corporations. Upon his death, the trust provided that its assets were to be distributed to or held in trust for the grantor’s children, some of whom were apparently U.S. taxpayers. Because the grantor was neither a citizen nor a resident of the United States and the trust’s assets did not have a U.S. situs, the trust property was not subject to U.S. estate tax upon the grantor’s death.
In addressing the income tax basis of the trust’s assets following the death of the grantor, the IRS determined that these assets would receive a fair market value income tax basis under IRC Section 1014(b)(1), which accords a basis step-up to property “acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent.” The IRS concluded that this description included the assets from the grantor trust that would go to the decedent’s children upon the decedent’s death.
Would the IRS issue this same ruling with respect to a wholly domestic grantor trust? A very common estate planning technique to transfer future asset appreciation to younger generation family members is the sale to a so-called defective” grantor trust – a trust that is a grantor trust for income tax purposes so the grantor will still be treated as the owner of the assets in the trust for income tax purposes and pay all income taxes due on the trust’s income. At the same time, the trust does not contain any provisions that would cause the property it holds to be subjected to estate tax when the grantor dies. During the grantor’s lifetime, he does not recognize any tax gain on the sale and the trust does not get a stepped-up tax basis.
Whether the property will receive a basis step-up upon the death of the grantor has been uncertain, and advisors have expressed different opinions. Many believe that because the trust property is not subject to estate tax at the grantor’s death, it likely does not receive a basis step-up. Others argue that, because for income tax purposes, the transfer to the trust is deemed to occur at the grantor’s death, Section 1014(b)(1) should apply. The trust in PLR 201245006 would have been included in the grantor’s estate if he was a United States taxpayer, where the usual defective grantor trust is drafted so that it will not be included in the grantor’s estate. The IRS is not likely to agree that property held by such a trust receives a basis increase when the grantor dies.