Common in estate and trust planning is the gift or sale of assets to an irrevocable grantor trust[1] structured to be outside of the grantor’s taxable estate.[2] Often, such gifts or sales are made of interests in family entities such as LLC’s.[3] These entities can provide significant non-tax benefits including consolidation of assets, centralized management, asset protection, and restrictions on transfers. An LLC which has only one owner generally is disregarded for federal income tax purposes unless it has made an election to be taxed as a corporation (S or C).[4] Therefore, when interests in a single-member LLC are transferred to a grantor trust, the entity will remain a disregarded entity for federal income tax purposes.[5] What happens, however, when the grantor (or other deemed owner of trust assets) dies?[6]
Relevant Tax Authorities
The IRS has issued Rev. Rul. 99-5 which addresses conversions of an LLC from a disregarded entity to partnership. There are two scenarios addressed in that revenue ruling as follows:
- In Scenario 1, a new member purchases a 50% interest in an LLC from the single member. The result is that the single member is deemed to have sold a 50% interest in each asset, then the parties are deemed to have made a tax free contribution of those assets to a newly formed partnership.[7] The selling member recognizes gain or loss from this sale.[8] Each member receives an outside basis in their partnership interest equal to the basis of the deemed contributed assets (selling member taking historic cost basis and purchasing member taking cost basis equal to consideration paid for the LLC interests).[9] The partnership takes a cost basis in 50% of the assets equal to the consideration paid by the purchasing member and a cost basis in the remaining 50% equal to the historic cost basis of the selling member.[10] The holding period of partnership assets is equal to the holding period of the purchasing and selling members.[11]
- In Scenario 2, a new member makes a contribution to the LLC in exchange for LLC interests. The new member is deemed to have contributed assets to a newly formed partnership and the historic member is deemed to have contributed the LLC assets to the same new partnership. The tax consequences of this deemed partnership formation is consistent with the outcome in Scenario 1 with respect to basis and holding period.
These scenarios, while not directly addressing conversions at death, should be instructive. While the most useful guidance likely is Rev. Rul. 99-5, there are other authorities which also aid in analyzing the tax consequences of the death of the grantor. The IRS has previously ruled that conversion of a grantor trust to a non-grantor trust is treated as a transfer of partnership interests from the grantor to the trust.[12] Similarly, the Tax Court, has ruled consistent with these authorities.[13] There also is regulatory guidance suggesting a similar result.[14] With respect to such deemed transfers during lifetime, deemed debt relief is treated as an amount realized in exchange for the transfer.[15] The result is that gain can be recognized to the extent the amount of such debt relief is in excess of the basis of assets transferred.
Consequences at Death
Death is not typically considered to be a recognition event.[16] The situations where debt would exceed basis in an estate should be limited due to the adjustment to cost basis of assets held at death to equal fair market value.[17] Although there may be situations where debt could exceed the fair market value (and, thus, basis) of assets transferred at death, the general concept of not causing death to be a tax recognition event should prevail.[18]
Working from the assumption that death should not be treated as a recognition event for tax purposes, it seems logical based on the relevant authorities that the following would be deemed to occur:
- The decedent is treated as transferring LLC assets (and liabilities) to the now non-grantor trust at a percentage equal to the percentage of LLC interests held by the trust.
- The remaining percentage of assets (and liabilities) of the LLC, being the percentage of the LLC held by the decedent, pass to the decedent’s estate or other successor-in-interest.
- Assets deemed transferred by the decedent to the non-grantor trust will not receive a cost basis adjustment at death.[19] Assets passing to the decedent’s estate receive a fair market value cost basis.
- Both sets of assets, those held by the trust and those held by the decedent’s estate or successor-in-interest, are deemed to be contributed to a new partnership.
- Prior to considering the effect of liabilities, the trust’s outside basis in its partnership interests will equal the trust’s historic cost basis in the contributed assets. The decedent’s estate or other successor-in-interest should receive an outside basis in their partnership interest equal to fair market value of the contributed assets.
- Liabilities should be deemed assumed by the partnership and allocated among the partners.[20]
- The partnership will take a basis in the contributed assets equal to the aggregate basis of the contributing partners.
- The partnership’s holding period in the contributed assets should be split with the assets contributed by the decedent’s estate or successor-in-interest being treated as being held for more than a year and the assets being contributed from the trust taking a holding period equal to the grantor trust’s holding period prior to the decedent’s death.[21]
Conclusion
Transfers of LLC interests to grantor trusts are fairly standard estate planning, with potential tax and non-tax benefits. Often, those LLC’s are held only between a trust and the trust’s grantor. When that is the case, a partnership is typically formed up on the death of the grantor. The tax consequences of the grantor’s death is an important consideration, somewhat recently brought more to light after the IRS recently ruled in Rev. Rul. 2023-2 that assets of a grantor trust do not receive a basis adjustment at the death of the grantor.
While there are legal authorities dealing with analogous situations, guidance specifically addressing conversion to a non-grantor trust, and thus formation of a partnership, at the death of a grantor, is sparse. I believe the consequences described here are consistent with relevant authorities and general tax principles. However, at least some of the items described here may ultimately be different than I expect, such as the possibility of gain being triggered. In any event, in addition to other planning considerations, it is important to consider the resulting partnership formation that is likely to occur upon the death of the grantor.
[1] A grantor trust is a trust, the assets and liabilities of which are treated under Subchapter J of the Internal Revenue Code as owned by a separate taxpayer (usually the trust’s grantor). See IRC § 671.
[2] There may be irrevocable grantor trusts structured to be included in the grantor’s taxable estate, sometimes expressly to obtain an IRC § 1014 basis adjustment at death. Examples include many asset protection trusts, and Medicaid planning trusts. However, this writing will focus only on trusts designed to remain outside of the grantor’s taxable estate.
[3] Other entities are frequently used for these purposes, especially limited partnerships. However, for consistency, this writing will refer only to LLC’s.
[4] If the LLC has multiple members and has not elected to be taxed as a corporation, it will be taxed as a partnership. Treas. Reg. §§ 1.7701-2(a), -2(c), and -3.
[5] Note that the LLC is not disregarded for gift tax purposes. See Pierre v. Commissioner, 133 T.C. 24 (2009).
[6] I note that there are similar issues, although potentially with certain different consequences, on the conversion of a grantor trust to a non-grantor trust during the lifetime of the grantor. However, this writing is limited to discussing consequences of the grantor’s death. See, e.g., Rev. Rul. 77-402. Likewise, this writing assumes the relevant LLC interests do not all pass to the irrevocable trust at death such that the LLC remains disregarded for income tax purposes.
[7] IRC § 721.
[8] IRC § 1001.
[9] IRC § 722.
[10] IRC § 723 which would require application of IRC § 704(c) with respect to any gain or loss property deemed contributed by the selling member.
[11] IRC § 1223.
[12] Rev. Rul. 77-402.
[13] Mandorin v. Commissioner, 84 T.C. 667 (1985).
[14] Treas. Reg. § 1.1001-2(c), Ex. 5.
[15] This is also consistent with Crane v. Commissioner, 331 U.S. 1 (1947).
[16] See Rev. Rul. 73-183 and CCA 200923024.
[17] IRC § 1014.
[18] See, Manning, Elliott and Hesch, Jerome M., Deferred Payment Sales to Grantor Trusts, GRATs and Net Gifts: Income and Transfer Tax Elements, March 31, 1999. Available at SSRN: https://ssrn.com/abstract=158489 or http://dx.doi.org/10.2139/ssrn.158489. However, some commentators believe this may not necessarily be the result. Id.
[19] Rev. Rul. 2023-2. As indicated above, this writing is limited to those irrevocable grantor trusts structured to be outside of the taxable estate of the grantor.
[20] This debt allocation should be made pursuant to IRC § 752. Net debt relief (i.e. the amount of debt assumed by the partnership with respect to a partner exceeds the amount of debt reallocated back to that partner) is treated as a distribution of cash from the partnership to the partner. IRC § 752(b). As stated above, while death should not be treated as a recognition event, to the extent such deemed cash distribution exceeds basis, then gain may be recognized. IRC § 731(a).
[21] IRC § 1223(2) (substituted basis assets receiving a tacked holding period) and IRC § 1223(9) (property passing from a decedent pursuant to IRC § 1014(b) will be deemed to have been held for more than one year). In Rev. Rul. 2023-2, the IRS ruled that assets held in a grantor trust at death do not pass from the decent under IRC § 1014(b).
