When I first got into tax, I learned one simple rule to always follow: if you think of some clever way to avoid or reduce tax that hasn’t been done before, you haven’t found the reason why it won’t work.
There are a lot of very smart tax attorneys out there who are trying to figure out something new, and yet there’s very little innovation. Almost all techniques that we use are incremental variations of an older technique that’s been tried and tested.
Whenever a new concept or idea comes our way, the good tax attorney will spend a good amount of time researching it and trying to understand it, preferably with a critical mind that’s looking for reasons it won’t work. Every once and a while a new technique comes out that established tax specialists look at in disbelief. Unfortunately, there are plenty of advisors who are not as suspicious or rigorous, who take the optimistic approach, and perhaps lead their clients astray.
This year, three dubious techniques that some less cautious advisors have promoted are now coming to an end.
Step-Up in Basis versus the Estate Tax
Wealthy individuals who plan ahead are faced with a choice for their heirs: pay the capital gains tax or pay the estate tax.
Assets that are in your estate when you pass away receive a step-up in basis, meaning that your heirs don’t need to pay capital gains tax when the assets are sold. Those assets are subject to the estate tax. There are ways to remove assets out of your estate, reducing the estate tax liability, but forfeiting the step-up in basis.
Conceptually, the reason is straightforward – (1) to get the step-up in basis, the asset must transfer due to your death and (2) if an asset transfers due to your death, it’s subject to the estate tax. Specifically, IRC 1014 grants a step-up in basis to the person “acquiring the property from a decedent or to whom the property passed from a decedent” while IRC 2031 calculates an estate tax on the gross estate.
In recent times several tax and estate planning attorneys have published about techniques, and promoted structures, that would allow the client to have it both ways – to remove an asset from the estate while also providing a step-up in basis. The argument notes a difference between IRC 1014(b)(1) which grants a step-up to “property acquired by bequest, devise, or inheritance, or by the decedent’s estate” and IRC 1014(b)(9) which grants the step-up to “property acquired from the decedent by reason of death, form of ownership, or other conditions… if by reason thereof the property is required to be included in… the decedent’s gross estate. The argument is that 1014(b)(9) requires inclusion in the gross estate, and 1014(b)(1) does not, and therefore assets that are acquired by bequest, devise, or inheritance that are not included in the gross estate get a step-up.
Only a minority of estate tax attorneys promoted this, as most attorneys will acknowledge that it is not a good argument. “bequest, devise, or inheritance” are each asset transfers from a decedent. A bequest is personal property given in a Will, a devise is real property given in a Will, and an inheritance is received through intestacy. All three refer to assets owned by the decedent up to the moment of death, and therefore part of the decedent’s taxable estate.
The attorneys who claim it is possible to have it both was look to the discrepancy between Subpart E (IRC 671-679), which determines whether an individual is treated as the owner of property for income tax purposes, and IRC 2031-2045, which determines whether the assets are part of the taxable estate. Tax planning often hinges on these differences, allowing assets to be placed In a trust that is removed from the estate while still being taxed to the individual. However, the key issue is the very title of Subpart E is titled “Grantors and Others Treated as Substantial Owners” – it does not say the grantor is the owner, but that the grantor is treated as the owner. Likewise, IRC 678 allows someone other than the grantor to be treated as the owner. One proponent said that “you own those assets up until the moment you die for income tax purposes…. You, the individual, at your death have for the first time transferred those assets”, which is disingenuous, considering that at the same time the tax attorney is claiming that the assets are not owned by the person for estate tax purposes, and at the time a gift tax return had been filed with the IRS stating those assets were transferred.
Luckily, at least one of those proponents stated that the attorney would also be “advising the client that the IRS will fight the issue”, because the IRS recently issued Revenue Ruling 2023-2, stating definitely that the IRS’s position is that assets that are not included in the gross estate will not receive a step-up in basis.
Monetized Installment Sales / Deferred Sales Trusts
Another questionable technique revolves not around values, but timing. When someone sells a highly appreciated asset, tax is due on the sale of the asset. For example, if you buy an asset for a million dollars and later sell it for five million, you have to pay tax on the $4 million profit. For a single person, assuming no other income, and classification as long-term capital gains, the tax would be over $1 million. On the other hand, if the payments are spread over 10 years, the capital gains would be under $70,000 per year, or about $700,000 in total – not to mention the time-value of money, which is a whole different discussion.
There is a technique that purportedly converts a one-time payment into a long-term income stream. While there are several variations, the general concept is that instead of selling the asset to the buyer, instead the asset is sold to an intermediary (a Trust or an LLC), in exchange for a long-term note. The intermediary then sells the asset to the actual buyer. So, in the above example, you would sell the building for a $5 million Note, that pays out over ten years. The intermediary then sells the asset to the actual buyer for $5 million. The intermediary does not recognize any profit, it buys an asset for $5 million and sells it for $5 million. The proponents of the technique refer to IRC 453, which states that for an installment sale, income is only recognized as the payments are received.
The IRS, and most credible attorneys, take the position that the intermediary is not a bona fide purchaser, and IRS regulation 15a.453-1(b)(3) has stated for decades that receiving a Note from someone other than the actual buyer is equivalent to receiving a lump-sum payment.
This is based on two separate well-established tax doctrines. The “step transaction” doctrine – that a series of formally separate steps can and should be treated as a single integrated event – and the “economic substance” doctrine – tax benefits of a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. Plainly speaking, the intermediary is disregarded, the seller sold the asset to the buyer for a single lump-sum payment and should be taxed as a lump-sum payment.
Every year the IRS lists its “dirty dozen” tax scams, and for several years the IRS has been warning about this. That hasn’t stopped a small circle of advisors from promoting the technique anyway.
On August 04, the IRS proposed a new rule, 88 FR 51756, for which public hearings will be held in October, requiring advisors and participants to file disclosures about all installment sales, which will make it easier for the IRS to challenge these fraudulent transactions.
Section 643 Nongrantor Complex Trust
This structure claims to defer all income tax until funds are distributed from the Trust. The promoters of this structure take a part of a statute out of context and misrepresent what it means or how it’s applied. Part of IRC 643(a)(3) states “gains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus” – taken in a vacuum this sounds like allocating gains to corpus excludes the gain from tax.
Before explaining why this is incorrect, it’s important to understand “Distributable Net Income”. As most people are aware, any income earned is taxed – either by the individual who receives the income, or the entity that receives the income. If income is earned by a Trust or an Estate, the income is taxed to the Trust or Estate – unless the income is distributed to the beneficiary, who is then taxed instead. If a Trust earns $100 but distributes $40 to a Beneficiary, the Trust is taxed on $60 of income, and the Beneficiary is taxed on the $40 he or she receives. In tax terms, that’s the Distributable Net Income.
IRC 643(a) defines and explains the rules for Distributable Net Income. IRC 643(a)(3) does not state that gains allocated to corpus are excluded from income tax, but from the Distributable Net Income. In the example above, the Trust earns $100, but for income tax it gets to deduct Distributable Net Income – the amount that’s distributed and taxed to the beneficiary – which is the amount of income allocated and distributed to the beneficiary. The income that’s allocated to the beneficiary but not distributed is excluded from DNI, and therefore the Trust does not get a deduction for income it retains.
The statute is what’s in linguistics called a double negative – the amount added to corpus is not not taxed to the Trust. The two negatives cancel each other out to mean that the amount added to corpus is taxed to the Trust. Any structure that claims 643 allows you to defer income tax is misreading the two nots that cancel each other out as just one.
On August 09, 2023, the IRS issued a memorandum explaining in detail why the promoted structure doesn’t work the way it’s being promoted.
The moral of the story is to not let your clients be the test case. There are very smart tax attorneys trying to come up with the next great solution, but true innovation in tax is incremental, not revolutionary. If an innovative technique sounds too good to be true, and there are no court cases that support the proposed transaction or structure, be cautious.
Arthur H. Geffen
Attorney & Counselor at Law
17330 Preston Rd., Suite 200D-260
Dallas. TX 75252