Here I will discuss the tax aspects of contributions to trust. There are three types of taxes we consider in this context: (i) income; (ii) gift; and (iii) estate. Gift and estate taxes are referred to as “transfer taxes” since they apply to asset transfers (i) by gift to trust or a (ii) to your estate because of your death.
If you transfer property while alive, you pay either an income or a gift tax. You pay income taxes if you sell property to a third party. You pay gift taxes if you transfer property without adequate consideration to a third party such as a trust. If you die owning property and you did not transfer the property during your life, either through sale or by gift, you pay an estate tax. The upshot is that you will pay one of these three taxes on the transfer of property: (i) income tax on the sale of your property to a third party; (ii) gift tax on contribution to trust; or (iii) estate tax at your death. Your goal should be to minimize the ultimate tax you pay.
In considering income and transfer taxes as they apply to a contribution to trust, you begin by breaking the analysis down to two different trusts: (i) revocable and (ii) irrevocable.
These are easy. You, as the “grantor” establishing the trust, reserve the right to “revoke” or cancel the trust. This results in an “incomplete gift” and a “grantor trust.” This retained power to revoke under IRC §676 will result in your being treated as the owner of the contribution for income tax purposes and under IRC §2038 will result in your being treated as the owner of the contribution at death for estate tax purposes.
When you contribute property to a revocable trust, you have made a transfer to yourself and, consequently: (i) no income tax results; (ii) the trust takes the asset onto its books at the same income tax basis as you have; (iii) your beneficiaries will receive a tax-free step up in income tax basis for the property on your death under IRC §1014; (iv) no gift tax results; and (v) estate taxes will be assessed at your death on the value of your estate.
The revocable trust on your contribution of property results in no income or transfer taxes and the trust takes the assets at your income tax basis. At your death, a step-up in basis in that asset to fair market value occurs and your estate recognizes estate taxes. The current unified exemption makes gift and estate taxes irrelevant for most everyone.
The second alternative is more interesting since the estate planning opportunities are almost incalculable. In this, I am assuming your contribution will be a “complete” gift for transfer tax purposes and that your irrevocable trust is a “non-grantor trust.” I am also assuming that you are establishing a Wyoming domestic asset protection trust (“DAPT”) and will a beneficiary under a discretionary distribution provision.
A gift is generally defined by the IRS as: Any transfer by an individual, either directly or indirectly, where full consideration (measured in money or money’s worth) is not received in return.
You contribute property to a DAPT and receive a beneficial interest in the DAPT. This is a transfer to a third party without consideration since you received no consideration in return; particularly in the context of a DAPT where you receive a beneficial interest subject to a discretionary distribution provision that is not a property right under state law. W.S. §4-10-504(g).
This results in no income tax because the contribution and receipt fall outside the definition of “gross income” in IRC §61(a)(3) since no consideration was exchanged.
This does result in a “taxable gift” under IRC §2503(a) because you transferred an item of value (your property) to a third-party (the non-grantor trust) without compensation. You will receive a credit against this gift (adjusted yearly for inflation) under IRC §2010 of $11.8M in 2022 if you are single and twice that if you are married. This “unified credit” may be used against gift taxes, estate taxes, or both, hence the exemption is a unified credit.
The contribution does not result in an estate tax because the gift tax applies, and you did not die. On your death, no estate tax results because you no longer own the property, i.e., the gift was “complete” at contribution.
The gift requires an assessment of the transferred property’s fair market value under IRC §2512 (“FMV”) and reporting the FMV as a gift to the IRS. You then apply your available unified credit. The resulting tax is generally zero.
Benefits and Detriments. Your contribution to a non-grantor trust has two major benefits. First, you generally have no gift tax since the unified credit equals or exceeds your gift for most of us. Second, you freeze the value of the property at contribution out of your estate so that at your death there is no estate tax assessment on any increase in value on the property from the date of contribution to your date of death. In other words, transfer taxes after contribution are no longer an issue because you assessed yourself with a transfer tax on contribution and you no longer own the asset, therefore, there are no estate taxes to pay at your death since the trust owned the property, and the trust did not die.
Escaping transfer taxes on this appreciation has a downside in that your trust and subsequently your beneficiary under the trust after your death receives a “carryover basis” from you in the property under IRC §1015. On sale of the property, the trust will pay income tax on the difference between the sales price and your original basis. There will be no step-up in basis under IRC §1014; thus, your beneficiary will end up paying income tax on the appreciation that “escaped” transfer taxation.
Contributions to an irrevocable trust result in no income or estate tax assessments but do result in gift tax assessments at the date of contribution equal to the FMV of the property less your available unified credit, an amount generally being zero. This freezes the value of the asset out of the transfer tax regime and, consequently, there will be no estate tax assessment at your death. The trust, however, takes the contributed assets at your income tax basis, a carry-over basis; consequently, at your death there is no step-up in basis in that asset to FMV.
No contribution to Trust
If you keep the property without a transfer to trust, the FMV of the property will be determined at your death and the result will be taxed under IRC §2031 after applying any remaining unified credit; thus, the transfer tax regime will capture all appreciation in the property; however, your beneficiary will take a stepped-up basis under IRC § 1014 and when selling the property will not have income tax on any appreciation that accrued prior to the your death.
Intentionally Defective Grantor Trust (“IDGT”). This is a misnomer as there is no defect, but rather, a planned utilization of a mismatch between income and transfer tax rules. Let’s talk about income tax basis first.
Income Tax Basis
The concept of basis applies solely to income taxes, which are assessments on wealth equal to your tax rate on the sales price less basis. Transfer taxes are excise on the value of property by transferred by gift or death and do not consider basis.
The taxpayer, as discussed above, generally must make one of two choices in anticipation of the significant appreciation of an asset: (i) transfer the property today and save estate taxes on the appreciation while losing the IRC §1014 increase in basis at death, or (2) transfer the property at death incurring estate taxes on the appreciated value and saving income taxes on the appreciation due to the applicability of IRC §1014.
Mismatch between IRC Income Tax and Estate Tax. There is a mismatch between income and transfer taxes. IRC rules define a transfer to trust as an “incomplete” or “defective” gift if you retain one of the delineated powers over your contribution; thus, you are treated as still owning the property contributed for income tax purposes and must pay tax on the income produced by the contributed property while that power is in place.
Neither IRC §§1014 nor 1015 comes into play until the transfer is complete. Because you, as the grantor, are still treated as owning the property for income tax purposes, your contribution retains its income tax basis under IRC §1012 until there has been (i) a completed gift or (ii) you die.
In structuring an IDGT, the typical grantor power retained is the power to swap property in and out of the trust. By swapping property, you can effectively elect whether that property's basis will be determined under IRC §§ 1014 or 1015 in the trust.
This brings the mismatch between IRC §§1014 and 1015 into play. In the context of a trust contribution: (i) IRC §1014 provides an increase in carry-over basis on your death to FMV because your estate is liable for estate taxes on your contribution to a grantor trust; and (ii) IRC §1015 precludes an increase in carry-over basis on your death to FMV because there are no estate taxes since there was a gift tax at contribution and the trust, as a non-grantor trust, is not liable for estate taxes, i.e., the freeze-out discussed above.
IRC §1015, in the context of trust contributions, is meant to preclude the Treasury from being whipsawed by taxpayers who transfer property to trust in anticipation of excluding future appreciation in the property from transfer taxation and then avoiding income taxes under IRC §1014 on the appreciation. Simply put, the transfer tax regime is mostly harmonious with the income tax regime.
Gaps between Income and Transfer Taxes
There are a few narrow gaps between the income and estate tax regimes, i.e., some grantor retained powers that result in grantor trust status do not trigger estate tax inclusion. The most widely exploited is a power to reacquire trust property by substituting property of an “equivalent value” (“swap power”).
IRC §675 provides that this power causes grantor trust status and results in you recognizing the income tax from the trust; however, there is no corresponding transfer tax provision including the contribution in your estate at death. In other words, you are liable for the income tax, receive a step-up in basis and the property is excluded from your personal estate at your death.
Here’s an example of how this could work for you. Gift and Estate Tax. You contribute property to trust and solely retain a swap power. You file a gift tax return recognizing the gift and reporting the tax. This “freezes” the value of the property contributed for transfer tax purposes, i.e., the property will be valued under IRC §2512 as of the date of the gift because the swap power does not trigger estate tax inclusion under IRC §§2036 or 2038, i.e., the contributed property belongs to the trust and will not be included in your estate at death. The gift is complete for transfer tax purposes. The property then appreciates in value.
Since you retained a swap power, you are treated for income tax purposes as owning the contributed asset under IRC §675. Consequently, the trust is disregarded for income tax purposes, and you are taxed on the trust income. Thus, when you exercise the swap power and reacquire property from the trust in exchange for property of equivalent value, the transaction has no income tax consequences because you are considered to have in effect taken property from one pocket and put it into the other. Rev. Rul. 85-13. The property would then, however, be included in your estate tax.
This is where it gets interesting because, generally, the carryover basis rule of IRC §1015 would ensure that the appreciation was taxed under the income tax regime; however, by exercising the swap power, the grantor can swap high-basis property into the trust in exchange for the appreciated (low-basis) property, which will pass through the grantor's estate and receive a stepped-up basis under § 1014.
This is the beauty of the IDGT, swapping high basis for low basis assets when the trust has been in place for a significant period of time resulting in your having the best of both income and transfer tax universes.