Rev. Rul. 79-51: No Gift Tax for Renouncing Grantor Powers

Revenue Ruling 79-51 from the Internal Revenue Service clarifies the tax consequences when a grantor, the creator of a trust, gives up powers they held over it. The ruling resolves uncertainty about whether relinquishing control triggers additional tax liabilities, offering a clear answer for grantors and their advisors.

The Foundation of Grantor Trusts

A grantor trust is a trust where the individual who created it retains significant control. Under Internal Revenue Code sections 671 through 679, if a grantor holds certain powers, the trust is disregarded as a separate tax entity. Consequently, all income, deductions, and credits generated by the trust’s assets are reported directly on the grantor’s personal income tax return, such as Form 1040, as if the grantor owned the assets themselves.

The powers that trigger this tax treatment are varied. A common example is the power to revoke the trust, which allows the grantor to take back the trust property at any time. Another is the power to control the beneficial enjoyment of the trust’s income or principal. Certain administrative powers, like the ability to substitute trust assets with others of equivalent value, can also classify a trust as a grantor trust.

The Ruling on Renouncing Grantor Powers

Revenue Ruling 79-51 addresses the gift tax consequences when a grantor renounces the powers that caused the trust to be a grantor trust. The ruling establishes that this act is not a taxable gift. This is because when the grantor initially funded the trust, that action constituted the completed gift for gift tax purposes.

The IRS’s reasoning is that the subsequent renunciation of powers does not transfer any additional property to the beneficiaries that they were not already entitled to under the original trust agreement. The beneficiaries’ interests were fixed when the trust was created. The only change resulting from the renunciation is the shift in who bears the future income tax burden. The act merely perfects the earlier gift by altering its income tax attributes, not by making a new transfer of wealth.

The release of these retained powers is viewed as a modification of the trust’s administrative and tax status rather than a new gratuitous transfer. Changing from a grantor trust to a non-grantor trust by giving up control does not create a second taxable event for the grantor from a gift tax perspective.

Tax Status After Renunciation

When the grantor relinquishes the powers that defined the trust as a grantor trust, its tax status changes. The trust transforms into a non-grantor trust, which is recognized as a separate taxable entity by the IRS. This new entity is required to obtain its own Taxpayer Identification Number (TIN) and file its own annual income tax return, Form 1041.

As a separate taxpayer, a non-grantor trust pays taxes on any income it earns and does not distribute to beneficiaries. These trusts are subject to highly compressed tax brackets, meaning they can reach the highest marginal tax rate at a much lower income level than an individual taxpayer. If the trust distributes income to its beneficiaries, the trust can take a deduction for the distributed amount. The beneficiaries then report that income on their own tax returns, and it is taxed at their individual rates.

This shift means the income tax liability is now shouldered by either the trust itself or its beneficiaries, depending on whether income is accumulated or distributed. The grantor is no longer responsible for paying taxes on the trust’s earnings.