IRS Is Taking a Closer Look at Trusts: What It Means for Estate Planning
A high-profile tax case is shining a light on how the IRS might view certain estate-planning strategies.
Trusts are a common estate-planning tool, and with trillions of dollars expected to change hands as wealth moves from one generation to the next now and in the coming years, various trust types and the tax rules surrounding them are getting more attention.
But that might not be a good thing if the IRS is taking a second look.
In a current high-profile case, the tax agency is challenging how one family used an irrevocable trust strategy to pass wealth to their children.
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Although the dispute involves a specialized trust arrangement, its potential broader lesson is worth watching for anyone using high-value trusts in their estate plan. Here's more to know.
IRS challenges irrevocable trust tax strategy
The current case involves Nashville residents, the Elcans. The IRS is seeking more than $736 million (roughly $614 million in gift taxes and $122 million in penalties), arguing that the couple's use of three irrevocable trusts didn't qualify for the intended tax treatment.
A little background according to court filings:
- In 2018, Mrs. Elcan set up three grantor-retained annuity trusts (GRATs) to pass wealth to the couple's three children. The two-year irrevocable trusts were funded with marketable securities and closely held business and partnership interests.
- As is typical with GRATs, the trusts made fixed annual payments back to the grantor, while investment growth above a set benchmark passed to the children tax-free.
- The strategy yielded roughly $200 million tax-free for their heirs across two of the trusts.
The trust agreements also contained a "substitution power" that allowed the grantor to swap personal property into the trusts to retrieve original trust assets of equal value. The grantor reportedly used that power to pull investments out of the trusts and replace them with promissory notes — essentially IOUs promising to pay the trusts back with interest.
The trusts used the promissory notes to satisfy the required annual payments, effectively canceling amounts the grantor owed the GRATs.
After auditing the arrangement, the IRS issued a notice of deficiency demanding more than $730 million in gift taxes and penalties.
According to court filings, the agency argues that using the personal promissory notes to satisfy the GRAT’s required annuity payments didn't comply with the rules governing qualified annuity interests.
- Specifically, the IRS contends that the arrangement violates Section 2702 of the Internal Revenue Code and Treasury regulations that prohibit GRATs from issuing notes to satisfy annuity payments.
- The agency argues that swapping personal IOUs into the trust, then returning them to cover the required payment was essentially an indirect step transaction designed to bypass the rule.
If that position prevails, the IRS could treat the entire $687.5 million initially transferred to the GRATs as a taxable gift.
Note: The federal gift tax generally applies when someone gives wealth to another person without receiving equal value in return. Certain estate-planning strategies can help limit how much of a wealth transfer is treated as a taxable gift when a trust is created.
However, the taxpayers maintain they followed the letter of the law because the trust didn't issue new debt to pay the annuities. Rather, they argue, the existing notes were already trust assets that were legally returned to satisfy the payment obligations.
*The case is Elcan v. Commissioner (Tax Court Docket No. 3405-25). The Tax Court hasn't yet ruled on the taxpayer's motion for summary judgment.
What is a grantor retained annuity trust, and how does it work?
A grantor retained annuity trust is an irrevocable trust designed to transfer future investment growth to beneficiaries while allowing the grantor to receive annual payments from the trust for a set period.
The strategy generally works like this:
- A grantor transfers assets to a GRAT and reserves the right to receive annuity payments during the trust term.
- The IRS uses a monthly interest rate (the Section 7520 rate or "hurdle rate") to calculate the present value of the grantor's retained annuity payments.
- If the trust's assets grow faster than the hurdle rate, the excess appreciation can generally pass to the trust beneficiaries at the end of the trust term tax-free, depending on how the GRAT is structured.
But … if the assets don't appreciate as expected, there might be little or nothing left to pass to beneficiaries after the required payments are made, and the grantor receives their principal back through the annuity payments.
In this case, if the U.S. Tax Court agrees with the IRS, the tax treatment of the original transfers could change, potentially making the full value transferred to the GRATs subject to federal gift tax.
A ruling for the IRS could also clarify how similar GRAT arrangements are treated going forward and potentially affect other taxpayers who have used similar strategies.
Trusts and estate planning: Bottom line
The Elcan case (still pending), is a reminder that details matter when using a trust or other potentially high-value estate planning strategies. How trust assets are moved, exchanged, or substituted over time can attract IRS attention.
In this instance, the Tax Court's eventual ruling could provide more guidance on grantor trusts and substitution transactions.
Regardless, always review estate plans periodically and have an estate-planning attorney and tax professional review significant transactions in advance.
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