Gift Tax with Grantor Trust?

[Snaggletooth]

Have a client whose mother established a grantor trust for him, granting shares of S corp. Mother receives K-1 to include these shares just as if the trust had never been created. I am told this is because the grantor trust is a non-recognized entity. The "grantor" trust and the non-entity implies that the "gift" is not complete. (At least to my feeble brain)

However, I've also found out that mother filed a gift tax return for the value of these shares.

Can this happen? Should this be?

[Roland Slugg]

First of all, the trust is NOT a non-recognized entity. It is a disregarded entity ... for income tax purposes.

When M gave her S Corp shares to her S, that constituted a gift, triggering the requirement to file a gift tax return ... if the shares' value, along with all other gifts given in the same year, exceeded the filing threshold.

If her K-1 includes the income allocable to the gifted shares, for the portion of the year after they were gifted to her S, then that K-1 is incorrect. The S should receive a K-1 reporting that income or (loss).

M should be sure and tell S what her basis is in the shares given to him.

[Snaggletooth]

Thanks Sluggo

Yeah, something about this one seemed incongruent.

Thanks for lending your usual expertise to this situation. Snag

[Gary2]

If her K-1 includes the income allocable to the gifted shares, for the portion of the year after they were gifted to her S, then that K-1 is incorrect. The S should receive a K-1 reporting that income or (loss).

That doesn't seem right. A grantor trust is normally taxed to the grantor, not the beneficiary. Am I missing something?

[Burke]

Yes, I agree. It seems the Mom did not gift the shares to her son at this time, she merely put them into a trust, in which she still retains all incidents of ownership and therefore treats the income as if she still receives it -- since the grantor trust is a disregarded entity. The son would be a future beneficiary, it seems. Now this is contingent on the terms of this trust. If it is an irrevocable trust, then it would be treated differently. The trust would own the shares. Get the trust document.

[Roland Slugg]

The above posts by Gary2 and Burke made me realize that the OP can be interpreted two ways. Did mom: (1) create the grantor trust for herself, naming son as successor trustee or a future bene? Or (2) did she pay an attorney to create a grantor trust for her son, as if the son himself had done it, then transfer shares into the trust as a gift to her son? If it's the former, then you can ignore the whole thing. If it's the latter, my comments above should apply.

[Snaggletooth]

Trust Election

Mom was the hammer behind the nail. She gave a substantial amount of ownership shares, but only ONE voting share. The effect of this was to retain the auspices of control, so the arrangement would be considered an incomplete gift, and the trust would be a disregarded entity.

However, the same accountant who set up the grantor trusts also filed the gift tax return for the ownership shares. This is the inconsistency that's driving me nuts.

[Gary2]

Mom was the hammer behind the nail. She gave a substantial amount of ownership shares, but only ONE voting share. The effect of this was to retain the auspices of control, so the arrangement would be considered an incomplete gift, and the trust would be a disregarded entity.

However, the same accountant who set up the grantor trusts also filed the gift tax return for the ownership shares. This is the inconsistency that's driving me nuts.

While I can understand an accountant being involved, wouldn't it require a lawyer to set up the trusts?

I wonder if this was set up to be an Intentionally Defective Grantor Trust, for which the estate/gift tax treatment is different from the income tax treatment. Thus it's disregarded for income tax purposes - the grantor or other controlling party still pays the income tax. But it's not disregarded for estate tax purposes, so that the gift tax must be filed. Plus, because the ownership shares don't include voting control, their value is steeply discounted.

I suggest reading up on IDGTs. A quick search hasn't turned up anything that says keeping voting control of the company triggers the grantor rules (i.e. the rules that push the income tax obligation back onto the grantor), but it seems plausible. It's also possible that there's some other aspect forcing grantor treatment.

So, in answer to your original question, I believe it's yes, you can have a grantor trust that required a gift tax return. I suggest that you don't think of it as being disregarded - a grantor trust might still file a 1041 (e.g. if it receives income under its own EIN). Instead, think of it as a trust for which the rules say that the grantor, and not the trust are liable for the income taxes.

It doesn't sound like this would have any current impact to your client, unless either the trust is only partially a grantor trust, or your client is a part grantor/owner.

[Roland Slugg]

I really don't think this one is difficult at all. Just find out who the trust's grantor is. If it's mom, there was no gift and the son gets no K-1 from the S Corp (unless he already owned some shares). If it's the son (and mom just set it up for him), then there was a gift and son's new grantor trust is the owner of those shares and should receive a K-1 from the S Corp.

S Corps can have both voting and nonvoting common stock, as long as the shares are identical in all other respects. (Code §1361(c)(4))

[Snaggletooth]

Thanks to All

I want to take a minute and thank all who responded. Roland and Gary2 have shed considerable light on the subject. The only possibility that a disregarded entity and gift tax could co-exist is under this "Intentionally Defective Grantor Trust." I never knew there was such an animal, and this even appears to be in violation of IRC §2036.

By its own definition, this IDGT admits that it runs afoul of the IRC, hence its name. I wonder how it could even be legal.

[Gary2]

I want to take a minute and thank all who responded. Roland and Gary2 have shed considerable light on the subject. The only possibility that a disregarded entity and gift tax could co-exist is under this "Intentionally Defective Grantor Trust." I never knew there was such an animal, and this even appears to be in violation of IRC §2036.

By its own definition, this IDGT admits that it runs afoul of the IRC, hence its name. I wonder how it could even be legal.

One thing I didn't make clear was that while IDGTs are a real thing, and various approaches are used to make sure the trust is treated as a grantor trust, using voting control of stock is not one of the approaches I've seen described. That doesn't mean it's right or wrong, just that there could be something else going on here. Indeed, one of the possibilities is that the individual who did the gift tax return was wrong.

Another possibility is that the gift tax and estate taxes are also using different rules. In this case, it may be that 2036 only means that the stock will still be included in the mother's gross estate, but that the gift tax return is due on transfer. Thus it will wind up being included on line 1 of the 706 instead of line 4. (The estate tax is calculated on both the estate and previous gifts - which I hadn't realized till now.) Also, it's possible that the special rules for family owned businesses will come into play.

Setting up a trust or other life estate can't possibly be in violation of 2036. Either the transfer is subject to it or it isn't, but that doesn't make the transfer illegal. What would be illegal is failure to include the item in the estate, at the time the estate tax is calculated, if 2036 applies - but that hasn't happened yet.