2.1.1 Trust Income is Taxable to the Grantor
188.8.131.52 The income generated by the funded revocable trust is taxable to the grantor due to the operation of the grantor trust rules. I.R.C. Secs. 671-677.
184.108.40.206.1 “Where it is specified in this subpart that the grantor or another person shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust” deemed owned by the grantor or such other person. I.R.C. Sec. 671.
220.127.116.11.1.1 The power to revoke causes the grantor to be taxed on trust income. The grantor is deemed the owner “where at any time the power to revest in the grantor title to such portion is exercisable by the grantor or a non-adverse party, or both.” I.R.C. Sec. 676. Presumably, this attribute is always present in revocable trust.
18.104.22.168.1.2 “Treating the grantor as owner of such a trust is appropriate, because the power to revoke represents absolute and complete control over the trust property.” Lane & Zaritsky, Federal Income Taxation of Estates and Trusts, ¶ 9.02, 9-3 (Warren, Gorham & Lamont, 2004).
22.214.171.124.1.3 Although revocation is the primary cause for a revocable trust to be taxed to the grantor, other grantor trust rules may likewise cause such treatment even if the trust is irrevocable:
126.96.36.199.1.3.1 Income retained for the benefit of the Grantor causes the grantor to be taxed on trust income. I.R.C. Sec. 677. Thus, if the trust pays the grantor’s (or his or her spouse’s) living expenses or discharges a legal obligation of the grantor, it will be taxed as a grantor trust. Treas. Reg. Sec. 1.677(a)-1(d).
188.8.131.52.1.3.2 Retaining the power to control beneficial enjoyment of corpus or income causes the grantor to be taxable on trust income. I.R.C. Sec. 674.
184.108.40.206.1.3.3 Retaining certain administrative powers will also cause the grantor to be taxed on trust income. I.R.C. Sec. 675. Thus, the power to borrow trust assets without adequate interest or security will cause the grantor to be taxed. I.R.C. Sec. 675(2); Rev. Rul. 85-13, 1985-1 CB 184; Rev. Rul. 86-82, 1986-1 CB 253; Benson v. Comm., 76 T.C. 1040 (1981).
220.127.116.11 The general rule is that the transfer of property to a revocable trust has no federal tax impact. For example, certain tax benefits available to individuals have been specifically held to continue after a transfer into the trust.
18.104.22.168.1 The holding period of any asset transferred to the trust is tacked to the grantor’s holding period. GCM 19347, 1938-1 CB 218, declared obsolete on other grounds. Rev. Rul. 73-209, 1973-1 CB 614. If death makes the revocable trust irrevocable, the beneficiaries are deemed to receive a long-term gain holding period. I.R.C. Sec. 1223 (11) and (12) and Notice 97-59 (10/27/97) (I.R.B. 1997-45); Sec. 5001(a) of the Tax Reform Act of 1998. The long-term gain holding period applies to persons receiving property from a decedent.
22.214.171.124.2 Because the grantor is treated as the taxpayer, grantor trusts are permitted shareholders of S corporation stock. I.R.C. Sec. 1361(c)(2)(A).
126.96.36.199.3 The grantor will be treated as the owner of a personal residence for purposes of the exclusion of gain provisions under I.R.C. Sec. 121 as amended by the Taxpayer Relief Act of 1997 (excluding $250,000 of gain for single taxpayers and $500,000 of gain for married taxpayers). See PLR 200104005 which holds that the surviving spouse’s interest in a residence held by a revocable trust qualifies for § 121 treatment but that portion of the joint trust that becomes irrevocable due to the other spouse’s death does not qualify for § 121 treatment except to the extent of the 5+5 power held by the surviving spouse. The Service rejected the argument that a right to live in the residence by the surviving spouse should qualify the other half. The now repealed roll-over under I.R.C. Sec. 1034 (and the old “roll-out” under prior I.R.C. Sec. 121) of gain on the sale of the principal residence likewise held that favorable treatment was not affected by placing the house in a revocable trust. PLR 9912026; PLR 9026036, Rev. Rul. 66-159, 1966-1 CB 162. Also see, Frank MacBoyle Lewis Trust B v. Comm., 83 T.C. 246 (1984), where a testamentary trust and the widow were co-owners of the residence. The trust was to distribute all income to the widow during her life but corpus distributions were at the discretion of an independent trustee. The Tax Court held that the widow could “roll-over” her one-half share but the trust could not have a “principal residence” and therefore no roll-over for the otherwise one-half. The widow’s residential attributes were not deemed to qualify the part held by the trust.
188.8.131.52.4 The transfer of an installment obligation to a revocable trust does not accelerate gain. Rev. Rul. 74-613, 1974-2 CB 153.
184.108.40.206.5 The IRS holds that because the grantor and the trust are one, no sale can occur between the two and no bona fide debt obligation can be created between them. Rev. Rul. 85-13, 1985-1 CB 184. See, however, Rothstein v. U.S., 735 F.2d 704 (2d Cir. 1984) which upheld a sale of stock to a grantor trust for an installment note resulting in an increase in the stock basis. This is a doubtful result. See Huffaker & Kessel, “How the Disconnect Between the Income and Estate Tax Rules Created Planning for Grantor Trusts,” J. Tax (WG&L) (April 2004).
220.127.116.11 Although the grantor trust rules generally shift the trust income to the grantor, some commentators speculate that the creation of a revocable trust may have certain adverse income tax results.
18.104.22.168.1 Incentive stock options transferred to a revocable trust raise questions. Generally, the ISO must be exercisable by the individual grantee only during lifetime or by the laws of descent and distribution at death. I.R.C. Sec. 422. “Revocable Inter Vivos Trusts,” 468-20 Tax Management Estates, Gifts and Trust Portfolios at A-35.
22.214.171.124.2 Additionally, there is a concern that a transfer of small business stock to a grantor trust may violate the § 1244 stock rules which provide that an “individual” may treat his or her loss under certain circumstances as ordinary rather than capital at the end of a sour venture. Under the statute, “individual” does not include a “trust.” I.R.C. Sec. 1244(d)(4); Miller and Rainey, “Dying with the ‘Living’ (or ‘Revocable’) Trust; Federal Tax Consequences of Testamentary Dispositions Compared,” 37 Vanderbilt Law Review 811, 816 (1984).