The Transfer Tax Landmine - Code §2511(c) - Partially Defused

By Steven B. Gorin, Esq., Thompson Coburn, St. Louis, MO

Thompson Coburn LLP, St. Louis, MO

Is it an escape hatch that allows billionaires to circumvent the transfer tax system?

Is it a landmine that threatens sales to irrevocable grantor trusts, grantor retained annuity trusts (GRATs), and life insurance?

Does it inhibit certain innocuous charitable giving techniques?

Or does it merely prevent wealthy residents of high-tax states from avoiding state capital gain tax?

As readers know, Congress allowed the 2010 changes to the transfer tax system take effect, which surprised the overwhelming majority of estate planners. When estate planners started focusing on these changes, we dissected §2511(c) of the Internal Revenue Code of 1986, which provides: Treatment of certain transfers in trust. Notwithstanding any other provision of this section and except as provided in regulations, a transfer in trust shall be treated as a transfer of property by gift, 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 of chapter 1. 

Let's focus on the simple interpretation of this language, "Absent regulations, a transfer in trust is a gift unless the donor or donor's spouse is treated as owning the entire trust for income tax purposes." Doesn't that mean that a transfer to a properly structured irrevocable grantor trust escapes the gift tax and estate tax system altogether? Would Treasury really let donors achieve that? Perhaps Treasury might say, "OK, but when it's no longer inside a grantor trust, either because of a distribution or cessation of grantor trust status, then the gift is deemed to be made." Wouldn't that undermine life insurance trusts (which generally are grantor trusts under §677(a)(3)), GRATs, and sales to irrevocable grantor trusts, all of which are based on leveraging the initial gifts into larger transfers to beneficiaries? What in the world was Congress thinking when it enacted this statute?1

Although the 2001 legislative history does not address this issue directly, Joint Committee on Taxation Report [JCX-12-02], when describing a change made in the Job Creation and Worker Assistance Act of 2002, P.L. 107-147, summarized the provision as follows:Transfers in trust. The provision clarifies that the effect of section 511(e) of the Act (effective for gifts made after 2009) is to treat certain transfers in trust as transfers of property by gift. The result of the clarification is that the gift tax annual exclusion and the marital and charitable deductions may apply to such transfers. Under 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. For example, if in 2010 an individual transfers property in trust to pay the income to one person for life, remainder to such persons and in such portions as the settlor may decide, then the entire value of the property will be treated as being transferred by gift under the provision, even though the transfer of the remainder interest in the trust would not be treated as a completed gift under current Treas. Reg. sec. 25.2511-2(c).  Similarly, if in 2010 an individual transfers property in trust to pay the income to one person for life, and makes no transfer of a remainder interest, the entire value of the property will be treated as being transferred by gift under the provision.

So, with this as a backdrop, the IRS issued Notice 2010-19, which it titled, "Guidance for Persons Making Transfers in Trust After December 31, 2009." The Notice provides:Some taxpayers may have inaccurately interpreted section 2511(c) as excluding from the gift tax transfers to a trust treated as wholly owned by the donor or the donor's spouse under subpart E of part I of subchapter J of chapter 1, even though those transfers would otherwise be taxable under Chapter 12. The provisions of Chapter 12 regarding the substantive law applicable to the gift tax were not amended by EGTRRA, and those provisions continue to apply to all transfers made by donors during 2010. Section 2511(c) is an addition to those substantive law provisions and is applicable to transfers made in 2010. Section 2511(c) broadens the types of transfers subject to the transfer tax under Chapter 12 to include certain transfers to trusts that, before 2010, would have been considered incomplete and, thus, not subject to the gift tax. Accordingly, each transfer made in 2010 to a trust that is not treated as wholly owned by the donor or the donor's spouse under subpart E of part I of subchapter J of chapter 1 is considered to be a transfer by gift of the entire interest in the property under section 2511(c). The provisions of Chapter 12 as in effect on December 31, 2009, continue to apply (both before and during 2010) to all transfers made to any other trust to determine whether the transfer is subject to gift tax. 

The Notice applies to all transfers made after December 31, 2009, and Treasury announced that it would issue regulations consistent with the Notice. In one fell swoop, the Treasury answered the first two questions posed in this article: the rules that existed before 2010 determine whether a transfer to a wholly owned grantor trust will constitute a completed gift.

Some argue that the Notice improperly interprets the statute's plain language. When Congress enacted §2511(c), it assumed that the one-year repeal of the estate tax would be extended, and the only reason for a gift tax was to backstop the income tax.  Because no income shifting is possible when a donor continues to be taxed on the trust's income and Congress was not concerned with backstopping the estate tax, treating the gift to the irrevocable trust as a non-event makes all the sense in the world. This author leaves it to the reader to determine which position to take on that issue.

Shortly before the IRS issued the Notice, the charitable estate planning community had an unpleasant revelation.  A common practice is for the donor to retain a unitrust interest in a charitable remainder trust and provide that one or more individuals receive this unitrust interest upon the donor's death. The donor also retains the right to revoke these beneficiaries' interest in the donor's will, so that any interest not belonging to the donor or the charitable remainderman constitutes an incomplete gift, thereby avoiding immediate gift tax, even though future estate tax might be generated. Section 2511(c) would make this gift a completed gift, because a charitable remainder trust cannot be a grantor trust. Because no income shifting occurs that is not expressly contemplated by §664, no income tax abuse is possible, and §2511(c) should not apply.  Accordingly, on February 5, 2010, Conrad Teitell, as counsel to the American Council on Gift Annuities, an organization of 1200 charities, asked that the IRS issued another notice—this time protecting charitable remainder trusts.

What other landmines does §2511(c) constitute? Only time will tell, as estate planners continue to struggle with these issues. Those who do frequently invoke the Chinese curse, "May you live in interesting times." This author hopes instead that readers will instead answer the door when opportunity knocks.

 For more information, in the Tax Management Portfolios, see Streng, 800 T.M., Estate Planning,  and in Tax Practice Series, see ¶6350, Estate Planning.

 1 On Dec. 20, 2009, this author asked Treasury to address these issues in an IRS notice.