Traditional estate planning for large estates focuses on reducing estate tax by a grantor transferring property to an irrevocable trust with few retained powers so that the property and future appreciation are excluded from the grantor’s gross estate at death.
The transfer, however, will not lead to favorable income tax results because the property’s basis is not adjusted when transferred to the trust or at the grantor’s death.
This is the unfortunate result under I.R.C. § 1014 and I.R.C. § 1015. Years after funding the trust, the grantor may desire step-up basis for appreciated property held by the trust to reduce future income tax.
This article presents three approaches focused on reducing income tax by the grantor reacquiring appreciated property of the trust for step-up basis at death.
As discussed in the above article, the Code contains an income tax discrepancy between testamentary and lifetime transfers. For testamentary transfers, I.R.C. § 1014 generally provides that the basis of property acquired from a decedent is the fair market value of the property at the decedent’s death, without recognition of gain under I.R.C. § 102. For lifetime transfers, I.R.C. § 1015 generally provides that the basis of property acquired by gift is the same as it would be in the hands of the donor, without recognition of gain under I.R.C. § 102. Thus, a testamentary transfer of appreciated property results in step-up basis, but a gift does not.
This discrepancy is not favorable to the grantor who transfers property to an irrevocable trust during life. The grantor may later wish to reacquire appreciated property of the trust so that the property will receive a step-up basis at the grantor’s death under I.R.C. § 1014 and, thus, cure the discrepancy between I.R.C. § 1014 and I.R.C. § 1015. The above article addresses the tax implications of three approaches to accomplish this goal, including exercise of a grantor’s substitution power.
A trust agreement that provides the grantor a substitution power is one way to create a grantor trust. I.R.C. § 675(4)(C) provides that the grantor shall be treated as the owner of any portion of a trust in respect of which a power of administration is exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity, and “power of administration” means a power to reacquire trust corpus by substituting other property of an equivalent value. The substitution power is a popular grantor trust power because the Service has ruled that a substitution power results in grantor trust treatment without gross estate inclusion.
Although drafting a substitution power appears simple, complex questions will arise when the grantor exercises the power.
How should the substitution be structured?
What are the applicable values for substitution?
How should objections by the trustee or the Service be addressed?
This article examines these issues and other drafting and reporting considerations for the exercise of a grantor's substitution power.