Rev. Rul. 85-13
1985-1 C.B. 184, 1985-7 I.R.B. 28.
Internal Revenue Service
Revenue Ruling
GRANTOR OWNED TRUSTS
Published: February 19, 1985
Section 675.-Administrative Powers, 26 CFR 1.675-1: Administrative powers.
(Also Section 671; 1.671-3.)
Grantor owned trusts. A grantor who acquires the corpus of a trust in
exchange for the grantor's unsecured promissory note will be considered to
have indirectly borrowed the trust corpus. As a result, the grantor will be
treated as the owner of the trust and the grantor's acquisition of the
trust corpus will not be viewed as a sale for federal income tax purpose.
The Service will not follow the Rothstein decision.
ISSUES
(1) Whether a grantor's receipt of the entire corpus of an irrevocable
trust in exchange for an unsecured promissory note given to the trustee,
the grantor's spouse, constituted an indirect borrowing of the trust corpus
which caused the grantor to be the owner of the entire trust under section
675(3) of the Internal Revenue Code.
(2) To the extent that a grantor is treated as the owner of a trust,
whether the trust will be recognized as a separate taxpayer capable of
entering into a sales transaction with the grantor.
FACTS
In 1980, A, an individual, created an irrevocable trust, T. W, A's
spouse, is the trustee of T. The trust instrument of T provides that all
income of T is to be paid semiannually to C, A's child, for a term of 15
years. Upon expiration of the trust term, or if C dies before the trust
term expires, the corpus of T will be distributed to C's child or to the
estate of C's child. Neither A nor any other person has a power over or an
interest in T that would cause A to be treated as the owner of T under the
grantor trust provisions of the Code, section 671 and following.
A funded T with a contribution of 100 shares of stock in Corporation Z.
The 100 shares represented all of the outstanding stock of Corporation Z.
When A funded T, A's basis in the shares was $20x.
On December 27, 1981, when the fair market value of the Corporation Z
shares was $40x, W, as trustee, transferred the 100 shares to A. In
exchange, A gave W A's unsecured promissory note with a face amount of
$40x, bearing an adequate annual rate of interest, payable semiannually,
beginning six months following the date on which the shares were
transferred to A. Principal payments on the note were scheduled to be paid
in 10 equal annual installments, the first installment being due 3 years
following the date on which the 100 shares were transferred to A, December
27, 1984.
On January 20, 1984, A sold the 100 shares to an unrelated party for
$50x. Corporation Z did not make any distributions with respect to the 100
shares at any time before the sale of those shares to the unrelated party.
LAW AND ANALYSIS
Under section 675(3) of the Code, a grantor will be treated as the owner
of any portion of a trust in respect of which the grantor has directly or
indirectly borrowed the trust corpus or income and has not completely
repaid the loan, including any interest, before the beginning of the
taxable year, unless the loan (1) provides for adequate interest, (2) is
adequately secured, and (3) is not made by the grantor or by a related or
subordinate trustee who is subservient to the grantor.
Section 1.675-1 of the Income Tax Regulations explains that, in effect,
section 675 of the Code treats the grantor as the owner of a trust if under
the terms of the trust instrument, or the circumstances attendant to its
operation, administrative control is exercisable primarily for the benefit
of the grantor rather than the beneficiaries of the trust. Section 675(3)
differs from the other provisions of section 675 which provide rules for
determining grantor ownership of a trust, because it requires an
affirmative act (borrowing) rather than a retained power, before it
applies. Nevertheless, the same theme underlies section 675(3) as underlies
the other provisions of section 675 which treat the grantor as owning the
trust. In all of these cases the justification for treating the grantor as
owner is evidence of substantial grantor dominion and control over the
trust.
Section 1.671-3(a)(1) of the regulations states that if a grantor is
treated as the owner of an entire trust, the grantor takes into account in
computing the grantor's income tax liability all items of income,
deduction, and credit to which the grantor would have been entitled had the
trust not been in existence during the period the grantor is treated as the
owner. If the grantor is treated as the owner of a portion of a trust and
that portion consists of specific trust property and its income, section
1.671-3(a)(2) provides that all items directly related to that property are
to be taken into account in computing the grantor's income tax liability.
In this case, A has acquired control over and use of the entire trust
corpus, the 100 shares of Corporation Z stock, in exchange for A's
unsecured note. If A, instead of giving W a note in exchange for the 100
shares, had made a cash payment of $40x to W and subsequently borrowed that
cash, giving W the unsecured note to evidence the borrowing, section 675(3)
of the Code would be applicable and A would be the owner of T. Although A
did not engage in this kind of direct borrowing, A's acquisition of the
entire corpus of T in exchange for an unsecured note was, in substance, the
economic equivalent of borrowing trust corpus. Accordingly, under section
675(3), A is treated as the owner of the portion of T represented by A's
promissory note. Further, because the promissory note is T's only asset, A
is treated as the owner of the entire trust.
Because A is treated as the owner of the entire trust, A is considered to
be the owner of the trust assets for federal income tax purposes. See
Ringwalt v. United States, 549 F.2d 89 (8th Cir. 1977), cert. denied, 432
U.S. 906 (1977); Estate of O'Connor v. Commissioner, 69 T.C. 165 (1977);
Example 5, section 1.1001-2(c) of the regulations; Rev. Rul. 81-98, 1981-1
C.B. 40; Rev. Rul. 78- 175, 1978-1 C.B. 144; Rev. Rul. 77-402, 1977-2 C.B.
222; Rev. Rul. 74-613, 1974-2 C.B. 153; Rev. Rul. 72-471, 1972-2 C.B. 201;
Rev. Rul. 70-376, 1970-2 C.B. 164; Rev. Rul. 66-159, 1966-1 C.B. 162; but
cf. Rev. Rul. 74-243, 1974-1 C.B. 106. In this case, A is considered to be
the owner of the promissory note held by the trust. Therefore, the transfer
of the Corporation Z shares by T to A is not recognized as a sale for
federal income tax purposes because A is both the maker and the owner of
the promissory note. A transaction cannot be recognized as a sale for
federal income tax purposes if the same person is treated as owning the
purported consideration both before and after the transaction. See Dobson
v. Commissioner, 1 B.T.A. 1082 (1925).
A's basis in the shares received from T will be equal to A's basis in the
shares at the time he funded T because the basis of the shares was not
adjusted during the period that T held them. See Rev. Rul. 72-406, 1972-2
C.B. 462, a ruling involving the determination of a grantor's basis in
property upon reversion of that property to the grantor at the expiration
of a trust's term.
In Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984), the court
considered a transaction that is in substance identical to the facts
described in this ruling. The court held that the grantor was the owner of
a trust under section 675(3) of the Code because by exchanging an unsecured
note for the entire trust corpus, the grantor had indirectly borrowed the
trust corpus. The court held further, however, that although the grantor
must be treated as the owner of the trust, this means only that the grantor
must include items of income, deduction, and credit attributable to the
trust in computing the grantor's taxable income and credits, and that the
trust must continue to be viewed as a separate taxpayer. The court held,
therefore, that the transfer of trust corpus to the grantor in exchange for
an unsecured promissory note was a sale and that the taxpayer acquired a
cost basis in the assets.
In Rothstein, as in this case, section 671 of the Code requires that the
grantor includes in computing the grantor's tax liability all items of
income, deduction, and credit of the trust as though the trust were not in
existence during the period the grantor is treated as the owner. Section
1.671-3(a)(1) of the regulations. It is anomalous to suggest that Congress,
in enacting the grantor trust provisions of the Code, intended that the
existence of a trust would be ignored for purposes of attribution of
income, deduction, and credit, and yet, retain its vitality as a separate
entity capable of entering into a sales transaction with the grantor. The
reason for attributing items of income, deduction, and credit to the
grantor under section 671 is that, by exercising dominion and control over
a trust, either by retaining a power over or an interest in the trust, or,
as in this case, by dealing with the trust property for the grantor's
benefit, the grantor has treated the trust property as though it were the
grantor's property. The Service position of treating the owner of an entire
trust as the owner of the trust's assets is, therefore, consistent with and
supported by the rationale for attributing items of income, deduction, and
credit to the grantor.
The court's decision in Rothstein, insofar as it holds that a trust owned
by a grantor must be regarded as a separate taxpayer capable of engaging in
sales transactions with the grantor, is not in accord with the views of the
Service. Accordingly, the Service will not follow Rothstein.
HOLDINGS
(1) A's receipt of the entire corpus of the trust in exchange for A's
unsecured promissory note constituted an indirect borrowing of the trust
corpus which caused A to be the owner of the entire trust under section
675(3) of the Code.
(2) At the time A became the owner of the trust, A became the owner of
the trust property. As a result, the transfer of trust assets to A was not
a sale for federal income tax purposes and A did not acquire a cost basis
in those assets. Accordingly, when A sold the shares of Corporation Z stock
on January 20, 1984, A recognized gain of $30x (amount realized of $50x
less adjusted basis of $20x). Further, this holding would apply even if the
trust held other assets in addition to A's promissory note if A, under any
of the grantor trust provisions, was treated as the owner of the portion of
the trust represented by the promissory note because A would be treated as
the owner of the purported consideration (the promissory note) both before
and after the transaction. See section 1.671-3(a)(2) of the regulations.
Rev. Rul. 85-13, 1985-1 C.B. 184, 1985-7 I.R.B. 28.
