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Is the IRS Turning Gift Planning on Its Head?

Given the Service’s interpretation of IRC Section 2511, the answer seems to be ‘”yes”

When is a completed gift to a trust not a taxable gift? If you read Section 2511(c) of the Internal Revenue Code of 1986, as amended, the answer is “when it is a gift to a wholly-owned grantor trust made during 2010.”

When is an otherwise incomplete gift a taxable gift? If you read Notice 2010-19, the answer is “when it is a gift to a trust that is not a wholly-owned grantor trust.”

The language of IRC Section 2511(c) is clear. It’s the interpretation of the statute that has muddied the waters. With Notice 2010-19, the Internal Revenue Service has told us that if it walks like a duck and talks like a duck, then it isn’t a duck.

What it Says

IRC Section 2511(c), which was enacted in 2001 under the Economic Growth and Tax Relief Reconciliation Act (P.L. 107-16) (EGTRRA), provides:

Treatment of Certain Transfers in Trust: Notwithstanding any other provision of this section and except as provided in regulations, a transfer in trust is treated as a transfer of property by gift unless the trust is treated as wholly owned by the grantor or the grantor’s spouse under subpart E of part I of subchapter J of chapter 1 [the “grantor trust rules”].

This provision is effective for transfers made after Dec. 31, 2009 and before Jan. 1, 2011.

Simply interpreted, IRC Section 2511(c) provides that a transfer to a grantor trust is not a gift.

Notice 2010-19

Despite the plain language, the IRS disagrees with this interpretation of the statute.

In Notice 2010-19, the Service stated that the substantive provisions of Chapter 12 were not amended by EGTRRA and continue to apply to all transfers made by donors during 2010. In its view, IRC Section 2511(c) doesn’t mean what it says and, despite the plain language of the statute, transfers to grantor trusts are taxable gifts.

The Service then went one step further and stated that IRC Section 2511(c) “broadens” the types of transfers subject to gift tax so as to include certain transfers to trusts that, prior to 2010, would have been treated as incomplete gifts. Accordingly, under IRC Section 2511(c), as interpreted by Notice 2010-19, incomplete gifts are taxable gifts.

This turns gift planning in 2010 on its head.

The Service’s interpretation of IRC Section 2511(c) conflicts with the plain meaning of this statute which is obvious–transfers to trust are gifts unless they are taxable to the grantor or the grantor’s spouse. That means that transfers to trusts are not gifts if the trust is wholly owned by the grantor or the grantor’s spouse.

Notice 2010-19 is the Service’s attempt to have taxpayers ignore the plain meaning of IRC Section 2511(c) in spite of the straightforward language of the statute. For argument’s sake, interpreting the statute according to its plain meaning would allow taxpayers to “drive a bus through” the transfer tax system. We believe that is exactly what was intended for the following reason:

The gift tax is merely a backstop to the estate tax—if we did not have a gift tax, taxpayers could gift away their assets before death and avoid transfer tax at death. During the year 2010, there is no estate tax; therefore, there is no need to backstop the estate tax with a gift tax.

Why therefore do we have a gift tax in 2010? As a backstop to the income tax by preventing income shifting.

As one commentator noted very late in the drafting of EGTRRA, if the gift tax were repealed, taxpayers could shift income tax responsibility from higher income taxpayers to lower income taxpayers. Therefore, the gift tax was retained to avoid income shifting in that manner. However, there would still be the ability to shift income if the taxpayer created a trust that was not a grantor trust. So IRC Section 2511(c) was enacted to provide that if taxpayers attempt to create a trust that shifts the income, the attempt will be treated as a gift. Otherwise, the gift tax will not apply; nor should the gift tax apply during a year with no estate tax.

Note that IRC Section 2511(c), as initially enacted, read as follows: “Notwithstanding any other provision of this section and except as provided in regulations, a transfer in trust shall be treated as a taxable gift under section 2503, unless the trust is treated as wholly owned by the donor or the donor’s spouse under subpart E of part I of subchapter J or chapter 1.” Section 411(g) of the Job Creation and Worker Assistance Act of 2002 (Pub. L. 107-147) (the 2002 Act) deleted the words “a taxable gift under section 2503” and substituted the phrase “transfer of property by gift.”

Why was this edit made? The Technical Explanation to the 2002 Act notes that the amendment was made so as to clarify the fact that the gift might not be a taxable gift by reason of the annual exclusion or the marital or charitable gift tax deduction. That makes sense. A gift to a trust, such as a qualified terminable income property (QTIP) trust, is not a taxable gift if the appropriate election is made. Likewise, a gift to a charitable remainder trust (CRT) will qualify for the gift tax charitable deduction if the trust is a qualified charitable remainder annuity trust or charitable remainder unitrust as defined in IRC Section 664.

The Technical Explanation goes on to say that “[u]nder the provision, as clarified, certain amounts transferred in trust will be treated as transfers of property by gift, despite the fact that such transfers would be regarded as incomplete gifts or would not be treated as transferred under the law applicable to gifts made prior to 2010.” Assuming that Congress intended the term “transfer of property by gift” as used in this sentence to mean gifts that were not necessarily taxable gifts (as used in the prior sentence), this provision also makes sense.

What doesn’t make sense is the Service’s current position that the statute does not mean what it says. Furthermore, under its interpretation of the statute, it’s now impossible to make an incomplete gift to a non-grantor trust. Not only has the IRS unilaterally ignored the plain meaning of IRC Section 2511(c), but also in doing so, Notice 2010-19 has undermined the use of CRTs.

Simply put, CRTs are not “grantor” trusts and do not shift income – therefore, there is no reason for IRC Section 2511(c) to apply to such vehicles. However, under Notice 2010-19, a gift of property to a CRT under which the donor is the sole beneficiary of the unitrust or annuity interest would be deemed a taxable gift of the entire interest.

In other words, unless the Service clarifies its position with specific reference to CRTs, the donor will be deemed to either have made (1) a taxable gift of the entire interest to himself, or (2) a taxable gift (eligible for the gift tax charitable deduction) of the entire interest to the charitable remainderman.

In addition, many gifts to two-lifetime CRTs anticipate an incomplete gift of the successor interest. However, under Notice 2010-19, if a donor creates a CRT for his own benefit and, following his death, the benefit of a successor beneficiary, the donor would be deemed to have made a taxable gift to the successor beneficiary at the time the trust was established, even if the donor retained the right to revoke the successor beneficiary’s interest. By putting forth the proposition in that notice that a gift to a non-grantor trust would be a gift of the “entire interest” to the trust, practitioners are no longer confident that the normal gift tax rules governing CRTs are still applicable, since the entire interest—including the charitable interest—is now considered a gift.

CRTs are not the only planning vehicles impacted by the Service’s interpretation of the statute. Rather, the overall effect of Notice 2010-19 is to prevent taxpayers from taking advantage of the repeal during the year 2010.

For example, an individual might make a gift to a QTIP trust for the benefit of his spouse. The trust instrument could provide that the grantor retains the right to reacquire trust corpus by substituting property of an equivalent value (a “grantor trust” power under IRC Section 675(4)(c)). The trust would thus be disregarded for income tax purposes and all income earned by the trust would be taxable to the grantor. For gift tax purposes, the grantor would have the option to (1) take the position that the gift was not a taxable gift under a literal interpretation of IRC Section 2511(c), or (2) elect to qualify the trust for the QTIP marital deduction.

Certainly the first option presents the more exciting planning opportunity to exclude the value of the transferred property from both the grantor’s and the grantor’s spouse’s gross estates. However, if the Service holds fast to its interpretation of IRC Section 2511(c) under Notice 2010-19, the grantor could have until Oct. 15, 2011 (assuming the gift is made on Dec. 31, 2010 and returns are put on extension) to make the decision to QTIP the trust or not.

Where We Are….

We expect that practitioners will protest the Service’s interpretation of the statute. However, we also expect that the answer will be resolved long after IRC Section 2511(c) has disappeared with the sunset.

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