Revenue Ruling 85-13: Grantor Trust Tax Implications
Understand the tax implications of treating a grantor and trust as a single taxpayer, from non-taxable asset sales to gain recognition when the status ends.
Revenue Ruling 85-13 is an Internal Revenue Service (IRS) pronouncement addressing the income tax consequences of transactions between a grantor and their grantor trust. The ruling’s conclusion is that for federal income tax purposes, the grantor and the trust are treated as a single entity. Therefore, any transaction between the two is disregarded and not considered a taxable event, as the grantor is effectively dealing with themselves.
The Ruling’s Core Principle
Revenue Ruling 85-13 arose from a specific case where an individual created a trust, funded it with stock, and later “purchased” that stock back from the trust using a promissory note. The IRS analyzed this transaction through the lens of the grantor trust rules. Since the grantor retained certain powers over the trust, they were treated as the owner of its assets for income tax purposes.
The IRS concluded that a transaction cannot be a “sale” for federal income tax purposes if the same person is both the buyer and the seller. The transfer of stock from the trust to the grantor in exchange for the note was therefore disregarded. As a result, the grantor did not recognize any gain or loss on the transaction, and their cost basis in the assets remained unchanged.
Understanding the Grantor Trust Rules
The foundation of Revenue Ruling 85-13 lies in the grantor trust rules, found in Internal Revenue Code sections 671 through 679. These rules define when a trust, though a separate legal entity, is ignored for income tax purposes. A trust is classified as a “grantor trust” if the grantor retains certain powers, such as the power to revoke the trust, control its beneficial enjoyment, or substitute assets of equivalent value.
If any of these powers exist, the trust is disregarded as a separate taxpayer. All items of income, deduction, and credit from the trust are reported directly on the grantor’s personal income tax return, Form 1040, as if the grantor owned the assets directly. The original purpose of these rules was to prevent taxpayers from shifting income to lower tax brackets using trusts. For income tax purposes, the trust is transparent, and the grantor is treated as the owner of the assets and is responsible for any tax liability.
Tax Treatment of Transactions During Grantor Trust Status
The principles of Revenue Ruling 85-13 are applied in tax planning while a grantor trust is active. One strategy is an installment sale to an Intentionally Defective Grantor Trust (IDGT). A grantor sells an appreciating asset to the trust for a promissory note. The sale is disregarded for income tax purposes, so no immediate capital gains tax is triggered, and interest paid on the note is not taxable income.
This technique allows future appreciation of the asset to occur within the trust, outside of the grantor’s taxable estate. The grantor continues to pay the income taxes on the trust’s earnings, which further reduces their estate without being considered a taxable gift. This “tax burn” enhances the growth of the trust’s assets, as the trust does not use its funds to pay income taxes.
Another application involves asset substitutions. Many grantor trusts allow the grantor to reacquire trust property by substituting other property of equivalent value. This exchange is not a taxable event. This power can be used to pull low-basis assets out of the trust in exchange for high-basis assets like cash. The low-basis assets, now in the grantor’s ownership, would then be eligible for a step-up in basis upon the grantor’s death, which can eliminate capital gains for heirs.
Tax Consequences When Grantor Trust Status Ends
The tax treatment under Revenue Ruling 85-13 depends on the trust maintaining its grantor status. The termination of this status is a taxable event that requires careful planning. Termination occurs when the grantor dies or when they release the power that originally triggered grantor trust status, such as the power of substitution.
When the status ends, the grantor and the trust are no longer a single entity. Any prior transactions that were disregarded are re-evaluated as if they just occurred between two separate parties. For example, if an installment sale to an IDGT occurred and the note is still outstanding, termination is treated as a disposition of that note. This triggers the immediate recognition of any deferred capital gain from the original sale.
The IRS’s position is that the once-disregarded transaction becomes a taxable event upon termination. While some court cases have offered a different view, the IRS continues to enforce its stance. Planners must account for this potential tax liability, as the termination can create a substantial and immediate income tax bill for the grantor or their estate.