Kerry Ryan

“It is not a matter of the cure being worse than the disease.  It is rather, that the cure has become the disease.”¹  This line, written by Leo Schmolka, is quoted in Mark Ascher’s recently published article calling for repeal of (most of) the grantor trust rules.  I quote Schmolka here too because he so pithily captures “the irony of using anti-abuse rules to abuse the tax system.”  The tax avoidance vehicle of choice is known as an “intentionally defective grantor trust” or “IDGT” (sardonically pronounced “I dig it”).  As noted by Ascher, “even their name seethes with irony.”

Ascher’s article makes three main points:  1) the grantor trust rules are obsolete; 2) their continued existence leads to significant erosion of our income and transfer tax bases; and 3) as a result the grantor trust rules (or at least most of them) should be repealed.  To be sure, most of these points are not new, and indeed, two other recent articles cover similar ground.²  However, Ascher’s is by far the most comprehensive and, in my opinion, persuasive of the three.

Trust income is normally taxable either to the trust or its beneficiaries, unless the settlor (aka “grantor”) retains too much “dominion and control” over the trust — in which case items of trust income, deductions and credits are attributed to the settlor and reportable on his or her own tax return.  The statutory grantor trust rules (aka “subpart E”) identify which interests or powers retained by or on behalf of a trust’s settlor will cause a trust to be ignored for income tax purposes.  The reader of Part I of Mark Ascher’s article will understand that the statutory grantor trust rules were a codification of Treasury regulations designed to supplant the vague and ultimately unworkable “dominion and control” standard articulated by the Supreme Court in the Clifford case.

Part I of Ascher’s article also describes the original purpose of the grantor rules (“to prevent high-income taxpayers from avoiding the impact of the progressive nature of the federal income tax by creating certain types of inter vivos trusts with which to splinter income”) and then persuasively argues that these rules are no longer needed for this purpose.  Why?  According to Ascher, the tax world is significantly different now than it was in 1954 when the bulk of subpart E was enacted.  Ascher cites compression of the tax brackets applicable to trusts as the single most important change making subpart E obsolete.  Since 1986, trusts hit the maximum marginal tax rate at extremely low levels of income, as compared to individual taxpayers.  Thus, there is little to no tax benefit in shifting income to an inter vivos trust when that income would be taxed at the trust level.

Part II of Ascher’s article discusses how taxpayers are taking advantage of the grantor trust rules to achieve spectacular tax savings.  The game, so to speak, is to create an inter vivos trust (IDGT) that is ignored for income tax purposes, but respected for transfer tax purposes.  Taxpayers can achieve this incongruous tax result by exploiting the difference between the transfer and income tax definitions of “dominion and control.”  The transfer tax benefits include those associated with most estate freeze techniques.  For little to no gift tax cost, a settlor can remove the transferred property and all subsequent appreciation from the gross estate.  The IDGT kicker, however, is that for as long as the trust remains a grantor trust, the settlor is able to make an additional annual tax-free gift to the trust beneficiaries in the amount of the income tax paid.

Ascher’s discussion of the ostensible income tax benefits of using an IDGT is particularly insightful.  He first observes that the income tax regime applied to any inter vivos trust is implicitly elective.  The problem for Ascher is not electivity per se, but that the grantor trust rules “regularly produce diametrically different results based on truly trivial differences.”  Next, Ascher highlights how subpart E fails to deal with all of the collateral tax consequences of grantor trust status.  In particular, it is virtually silent on how to account for transactions between the settlor and his or her grantor trust.

Out of this statutory void grew a popular estate planning technique wherein a settlor sells appreciated property to his or her grantor trust in return for an installment note.  While the astonishing transfer tax savings garner most of the press, Ascher distinguishes himself by engaging in a thoughtful and thorough discussion of the transaction’s uncertain income tax consequences.  As he points out, for income tax purposes, the most important question may be what is the trust’s basis in the “purchased” assets?  As long as we get that answer right, any untaxed gain will eventually be accounted for.  However, by Ascher’s account, some practitioners are taking the questionable (although not entirely unsupportable) position that under certain circumstances nobody has to “pay the piper.”

After requesting more administrative guidance (and expressing doubt that it will be forthcoming), Ascher calls for repeal of most of the grantor trust rules.  Under his proposal, revocable trusts would be the only domestic trusts subject to the grantor trust regime.  All other domestic irrevocable trusts would be treated as separate taxpayers.  He argues that revocable and irrevocable trusts are sufficiently different to justify different tax treatment.  I prefer Ascher’s proposal to those calling for wholesale repeal of subpart E because it preserves the statutory overrule of the Clifford case.  Ascher’s case is so persuasive and the number of calls for reform so numerous, one wonders in this fiscal environment how much longer policymakers can continue to ignore such low-hanging revenue fruit?

1. Leo L. Schmolka, FLPs and GRATs:  What to Do?, 86 Tax Notes 1490 (March 13, 2000).
2. Daniel L. Ricks, I Dig It, But Congress Shouldn’t Let Me: Closing the IDGT Loophole, 36 ACTEC L.J.  641 (2010),  Laura E. Cunningham & Noël B. Cunningham, Tax Reform Paul McDaniel Style:  The Repeal of the Grantor Trust Rules, available at SSRN.