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Conversion of Non-Grantor Trust to Grantor Trust Not Taxable

Conversion of Non-Grantor Trust to Grantor Trust Not Taxable

The Internal Revenue Service, in a private letter ruling, has ruled on several aspects of the conversion of a non-grantor trust to a grantor trust. The taxpayer was seeking rulings on whether the proposed conversion (1) is not a taxable transfer of property to the grantor trust, (2) is not an act of self-dealing that would result in a tax under IRC Sec. 4941, and (3) would result in a charitable deduction for the grantor under IRC Sec. 170.
Based on the information submitted by the taxpayer, the IRS ruled that the conversion of a non-grantor trust to a grantor trust is not a taxable transfer of property, is not an act of self-dealing, and will not result in a charitable deduction to the grantor.

Grantor Trusts

Code Sec. 671 provides that where the grantor is treated as the owner of any portion of a trust, then included in computing the taxable income and credits of the grantor are those items of income, deductions and credits of the trust, to the extent that such items would be reportable in computing taxable income or credits of an individual.

Regulations provide that the grantor is treated as the owner of any portion of a trust over which there is a power of administration, exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity.  The term “power of administration” includes a power to reacquire the trust corpus by substituting other property of equivalent value.

Transfers of property involving grantor trusts

When the grantor of a trust which holds a partnership interest, renounces all grantor trust powers over that trust during life, the grantor is treated as having transferred the partnership interest and will recognize a gain or loss. The ruling states that the result would also be the same if the trust were treated as a grantor trust because of powers exercisable by a party other than the grantor and ceased to be a grantor trust upon the release or renunciation of those powers or upon the expiration or lapse of such powers.

Rev Rule 85-13, 1985-1 CB 184 , holds that a grantor who acquired the corpus of a trust in exchange for an unsecured promissory note is considered to have indirectly borrowed the trust corpus, resulting in grantor trust treatment. Thus, the transfer of trust assets to the grantor is not a sale for federal income tax purposes. The IRS ruling concluded that the grantor became the owner of the trust corpus which he had indirectly borrowed and thus was taxed on the trust’s income and, as the deemed owner of the trust assets, could not engage in a transaction with the trust for income tax purposes.

Treatment of split-interest trusts as private foundations

A trust which is not exempt from tax under Code Sec. 501(a) and which has amounts in trust for which a deduction was allowed under Code Sec. 170 (or other charitable deduction provision) then  Code Sec. 4941 applies as if such trust were a private foundation.

As a private foundation an excise tax is imposed and paid by the disqualified person, on each act of self-dealing between a private foundation and a disqualified person for each year in the taxable period.  An act of self-dealing includes any direct or indirect transfer to, or for the use by or for the benefit of, a disqualified person of the income or assets of a private foundation.  The exercising of a power to substitute trust assets may also result in an act of self-dealing

The term “disqualified person” includes a substantial contributor to the foundation, a foundation manager, or a family member, such as the individual’s spouse, children, grandchildren, great-grandchildren, and the spouses of children, grandchildren, and great-grandchildren.

Trust charitable deductions

No charitable deduction is allowed for the value of any interest in property (other than a remainder interest) transferred in trust unless the interest is in the form of a guaranteed annuity or the trust instrument specifies that the interest is a fixed percentage distributed yearly of the fair market value of the trust property and the grantor is treated as the owner of such interest.

The donor to a grantor charitable lead annuity trust may claim a federal income tax charitable deduction in the year that assets are irrevocably transferred to the trust.

Facts

Grantor, as settlor and initial trustee, created Trust pursuant to Agreement. Agreement provides that until the X anniversary of the initial contribution date, an amount equal to the annuity amount will be distributed to Charity. Trust is seeking to amend Agreement. The amended article permits the substitutor to have the power, exercisable at any time without the approval or consent of any person in a fiduciary capacity, to acquire or reacquire Trust principal by substituting other property of equivalent value.  Substitutor is not a trustee of Trust.  Substitutor and Grantor are siblings.

Issues

Whether assuming the amendment is enacted:

  1. There was a conversion from a non-grantor to a grantor trust;
  2. The conversion from a non-grantor trust to a grantor trust is a taxable transfer of property held by Trust to Grantor as settlor;
  3. The conversion from a non-grantor trust to a grantor trust is an act of self-dealing that would result in a tax; and
  4. The conversion from a non-grantor trust to a grantor trust would result in an income tax charitable deduction for Grantor in the year of conversion.

Ruling

The trust became a grantor trust. Under Code Sec. 675(4) , the power given to substitutor makes the trust a grantor trust.

No transfer of property. IRS concluded that there was no transfer of property when the trust was converted to a grantor trust.  It was noted that the lapse of grantor trust status during the grantor’s life may have income tax consequences but does not impose such consequences on a non-grantor trust that converts to a grantor trust.  Given the lack of authority imposing such consequences, the conversion of Trust from a non-grantor trust to a grantor trust will not be a transfer of property to Grantor from Trust under any income tax provision.

No self-dealing. IRS concluded that the conversion of the trust will not be an act of self-dealing since there is no disqualified person involved.  In order for an act of self-dealing to occur, the act needs to occur between a disqualified person and a private foundation. The substitutor is not considered a disqualified person because he is a sibling of Grantor.

Trust/Grantor get no charitable deduction. IRS held that upon the conversion of Trust from a non-grantor trust to a grantor trust, the owner of the grantor trust can claim a federal income tax charitable deduction only if the property has been transferred to the grantor trust from the non-grantor trust. Because Trust was converted from a non-grantor trust to a grantor trust it is not a transfer of property for income tax purposes, so no charitable deduction.

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