National Association of Estate Planners and Councils

September, 2007 Newsletter
Provided by Leimberg Information Services

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Transaction of Interest – Toggling Grantor Trust

LISI wanted you to be aware of something that may have a huge impact on the sales to grantor trusts. 

Our thanks to Larry Brody of Brian Cave for bringing this to our attention:

EXECUTIVE SUMMARY:

The IRS and the Treasury announced that they are aware of a type of transaction, that uses a grantor trust, and the purported termination and subsequent re-creation of the trust's grantor trust status, for the purpose of allowing the grantor to claim a tax loss greater than any actual economic loss sustained by the taxpayer or to avoid inappropriately the recognition of gain. 

The two organizations have stated that

"this transaction has the potential for tax avoidance or evasion, but lack sufficient information to determine whether the transaction should be identified specifically as a tax avoidance transaction." 

Notice 2007-73 identifies this transaction, and substantially similar transactions, as transactions of interest for purposes of Code Sections 1.6011-4(b)(6) , 6111 and 6112. 

It also alerts persons involved with these transactions to certain responsibilities that may arise from their involvement with these transactions. 

MORE ON NOTICE 2007-73 TO FOLLOW.  BUT FIRST, EDITOR ANDY DeMAIO ISSUES A LAWTHREADS ALERT!

RUDKIN TRUST ISSUE: SHOULD WE CARE?

At first glance, the issues to be addressed by the U.S. Supreme Court in the Rudkin Trust case seem to involve relatively small amounts of money.

However, participants in a recent online discussion point out that the amounts in controversy may well exceed 2% of the estate's adjusted gross income.

To read this and other recent LawThreads reports, log in to LISI at http://www.leimbergservices.com

Once you have logged in, click the blue LawThreads button under Recent Entries.

NOW BACK TO NOTICE 2007-73!

FACTS:

VARIATION 1:

  • Grantor purchases four options. 
  • The value of each one of the options is expected to move inversely in relation to at least one of the other options over a relevant range of values so that, before expiration of any one of the options, there will be a gain in two options (gain options) and a substantially offsetting loss in the other two options (loss options). 
  • Grantor creates Trust and funds Trust with the options and a small amount of cash. 
  • Grantor gives a short-term unitrust interest in Trust to the Beneficiary and retains a noncontingent remainder interest in Trust. 
  • The remainder interest is structured to have a value as determined under § 7520 that equals the fair market value of the options. 
  • Grantor takes the position that Grantor's remainder interest is a qualified interest under Code Section 2702. 
  • Because of the retained remainder interest, the Grantor treats the Trust as a trust Grantor Trust (one owned by Grantor under the so-called grantor trust Code Sections 671 and following). 
  • The trust agreement also provides that Grantor will have the power, exercisable in a nonfiduciary capacity, to reacquire Trust corpus by substituting other property of an equivalent value (the substitution power) and that this substitution power will become effective on a specified date in the future.  (Code Section 675(4)).
  • After establishing and funding Trust, Grantor sells the remainder interest in Trust to an unrelated person (Buyer) for an amount equal to the fair market value of the remainder interest (which is equal to the fair market value of the options). 
  • Grantor claims that the basis in the remainder interest is determined by allocating to the remainder interest a portion of the basis in all of the Trust assets (based on the respective fair market values of the remainder and unitrust interests at the time of the sale).  Therefore, Grantor claims there is no gain recognized on the sale of the remainder interest because Grantor's basis in the remainder interest is the same as the amount realized (prearranged to be equivalent to the fair market value of the options). 
  • Buyer gives Grantor an installment obligation (Note), cash, or other consideration for the remainder interest. 
  • Grantor claims that the sale of the remainder interest has terminated (toggled off) the grantor trust status of Trust so that, during the period after the sale and before the effective date of the substitution power, Trust is no longer a grantor trust under Code Section 671.
  • Grantor claims that, once the substitution power becomes effective, Trust's grantor trust status is restarted (toggled on). 
  • The loss options are then closed out.  
  • The amount Grantor paid for those options (the original basis of those options) is greater than the amount Trust receives when the loss options are closed out.  Grantor claims that Trust's status as a grantor trust causes Grantor to recognize the loss on the two loss options.  Grantor calculates the loss based on the difference between the amount realized and the original basis in the loss options, even though Grantor previously used a portion of the basis in the Trust assets (equivalent to the basis in all of the options) to eliminate Grantor's gain on the sale of the remainder interest.  Trust's remaining assets then consist of the two gain options, the contributed cash, and amounts received, if any, upon the termination of the loss options.
  • Buyer then purchases the unitrust interest in Trust from Beneficiary for an amount equal to the actuarial value of that interest (which equals or approximates the amount of cash Grantor contributed to Trust), making Buyer the owner of both the remainder interest and the unitrust interest. 
  • Trust then terminates (by operation of law or Buyer's action), and Trust's assets are distributed to Buyer. 
  • Buyer claims a basis in the assets (the gain options and the cash) from Trust equal to the amount paid by Buyer for the two separate interests in Trust. 
  • Grantor does not treat the termination of Trust as a taxable disposition by Grantor of the assets of Trust.
  • The gain options are exercised or sold, or otherwise terminate, and Buyer claims to recognize gain on the gain options only to the extent that the amount realized exceeds the basis Buyer allocates to the gain options.  The transaction has been structured so that any gain recognized would be minimal. 
  • If Buyer purchased the remainder interest from Grantor with a Note, Buyer uses the proceeds from the options to pay the Note.  If Grantor borrowed to purchase the options, Grantor repays the loan from the Note proceeds. 

VARIATION 2:

In another variation of the transaction, the facts are the same as described above except for the following. 

  • Grantor contributes to Trust liquid assets such as cash or marketable securities, rather than options.  Grantor's basis in the contributed assets equals or is approximately equal to the fair market value of the assets at the time of contribution. 
  • Before the specified date on which Grantor's substitution power becomes effective, Grantor sells the remainder interest in Trust to Buyer for an amount equal to the fair market value of the remainder interest and claims to recognize no gain or a minimal gain or loss for the same reason as described above. 
  • As in the prior variation, Grantor claims that the sale terminates (toggles off) Trust's grantor trust status. 
  • After the substitution power becomes effective, Grantor substitutes appreciated property for Trust's liquid assets.  The fair market value of the substituted property is equivalent to the fair market value of the liquid assets.  Grantor claims that, once the substitution power becomes effective (prior to the exchange), Trust's grantor trust status is restarted (toggled on), and, therefore, the substitution will not cause Grantor to recognize gain.
  • As described above, Buyer purchases the unitrust interest in Trust from Beneficiary, terminates Trust, and receives Trust's assets on distribution.  For tax purposes, Grantor does not treat the termination of Trust as a disposition by Grantor of the appreciated assets in Trust.  Buyer claims a basis in the assets of Trust (the appreciated property and cash) equal to the amount paid by Buyer for the interests in Trust.
  • One of the purported tax consequences of the first variation of the transaction is that Grantor sells the remainder interest and receives an amount substantially equal to the fair market value of the (non-cash) assets contributed to Trust but nevertheless claims a tax loss attributable to those assets even though Grantor has not suffered an equivalent economic loss. 
  • One of the purported tax consequences of the second variation of the transaction is that Grantor avoids the recognition of gain on the disposition of the appreciated assets substituted for the original assets contributed to Trust. 
  • These transactions usually occur within a short period of time during the taxable year (typically within 30 days), and, in each case, Grantor claims that the termination and subsequent reestablishment of grantor trust status, combined with the series of events regarding Trust's assets, result in tax consequences that could not be achieved without both the toggling off and on of grantor trust status. 

The transactions in this notice, as described above, do not include the situation where a trust's grantor trust status is terminated, unless there is also a subsequent toggling back to the trust's original status for income tax purposes.

TRANSACTION OF INTEREST

Effective Date:

Transactions that are the same as, or substantially similar to, the transactions described in this notice are identified as transactions of interest effective August 14, 2007, the date this notice was released to the public.  

Persons entering into these transactions on or after November 2, 2006, must disclose the transaction as described in § 1.6011‑4. 

Material advisors who make a tax statement on or after November 2, 2006, with respect to transactions entered into on or after November 2, 2006, have disclosure and list maintenance obligations under §§ 6111 and 6112.  See § 1.6011-4(h) and §§ 301.6111-3(i) and 301.6112-1(g) of the Procedure and Administration Regulations. 

Independent of their classification as transactions of interest, transactions that are the same as, or substantially similar to, the transaction described in this notice may already be subject to the requirements of §§ 6011, 6111, or 6112, or the regulations thereunder. 

When the IRS and Treasury Department have gathered enough information to make an informed decision as to whether this transaction is a tax avoidance type of transaction, the IRS and Treasury Department may take one or more actions, including removing the transaction from the transactions of interest category in published guidance, designating the transaction as a listed transaction, or providing a new category of reportable transaction.

Participation

 Under Code Section 1.6011-4(c)(3)(i)(E), Grantor, Buyer, and Beneficiary are participants in this transaction for each year in which their respective tax returns reflect tax consequences or a tax strategy described in this notice. 

Time for Disclosure

See Code Sections 1.6011-4(e) and  301.6111-3(e).

Material Advisor Threshold Amount 

The threshold amounts are the same as those for listed transactions.  See Code Section 301.6111-3(b)(3)(i)(B).  

Penalties

Persons required to disclose these transactions who fail to do so may be subject to the Section 6707A penalty or the 6707(a) penalty. 

Persons required to maintain lists of advisees under Code Section 6112 who fail to do so (or who fail to provide such lists when requested by the Service) may be subject to the penalty under Code Section 6708(a). 

In addition, the Service may impose other penalties on parties involved in these transactions or substantially similar transactions, including the accuracy-related penalty under § 6662 or § 6662A.

COMMENT:

Where is this all going and what impact will it have on routine sales to grantor trusts?  It's too soon to know  but Notice 2007-73 is sure to be one of the more significant warnings from the IRS this year.  LISI's Commentator Team will keep you informed.

Meanwhile, "Be Careful Out There!"

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Steve Leimberg

CITE AS:

Steve Leimberg's Estate Planning Newsletter # 1161  (August 14, 2007) at http://www.leimbergservices.com 

Copyright 2007 Leimberg Information Services, Inc. (LISI).  Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Authorization.

CITES:

Notice 2007-73 - Transaction of Interest – Toggling Grantor Trust

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