The Internal Revenue Service (“IRS”) recently issued a Private Letter Ruling[1] (“PLR” or “Letter Ruling”) providing non-recognition treatment to the transfer of an LLC interest from a subtrust to a separate trust in exchange for cash and a promissory note. The Letter Ruling is significant in that it applies the reasoning of Revenue Ruling 85-13[2] (“Rev. Rul. 85-13”) to a transfer of assets from a trust deemed owned by its beneficiary under Section 678(a) of the Internal Revenue Code[3] and, like Rev. Rul. 85-13, it takes into account the overall effect of the transaction to support its conclusion.

More specifically, the Letter Ruling determined that the transaction at issue was not a sale because the separate trust and the subtrust were wholly owned by the same individual, but such was true only after the transaction. The separate trust was wholly owned by the individual before and after the transaction, but the subtrust was not deemed wholly owned by the individual until after the transaction triggered Section 678(a)(1). Thus, the Letter Ruling suggests that the reasoning behind Rev. Rul. 85-13 likewise applies when deemed-ownership of trust assets is caused by the application of Section 678, and also reaffirms the IRS’s tendency to consider the overall effect of the transaction at issue when determining whether a transfer of assets will be deemed a sale for federal income tax purposes.

Background — Revenue Ruling 85-13

Rev. Rul. 85-13 sets forth the long-standing proposition that a transaction involving the transfer of assets between a grantor trust and its grantor is in essence a non-event that is not recognized as a sale for federal income tax purposes. In Rev. Rul. 85-13, an individual created an irrevocable trust, named his wife as trustee, and funded the trust with 100 shares of stock in Corporation Z (“Z shares”). When created, neither the grantor nor any other person had a power over or an interest in the trust that would cause the grantor to be treated as the owner of the trust under the grantor trust provisions of the Code. The following year, the trustee transferred the entire trust corpus (the Z shares) to the grantor in exchange for an unsecured promissory note bearing adequate annual interest and having a face value equal to the fair market value of the Z shares at that time. The Z shares appreciated in value, and grantor sold the Z shares to an unrelated party a few years later.

The issues addressed in Rev. Rul. 85-13 were (1) whether the grantor’s receipt of the Z shares in exchange for the promissory note constituted an indirect borrowing of the trust corpus triggering Section 675(3) (which, if triggered, would treat grantor as the owner of the entire trust corpus), and (2) if yes, whether the trust was a separate taxpayer capable of entering into a sales transaction with the grantor.

The Revenue Ruling viewed the substance of the transaction as being economically equivalent to borrowing the entire trust corpus and thus treated the grantor as the owner of the entire corpus under Section 675(3). As such, the grantor was both the maker and the owner of the promissory note held by the trust. Consequently, the transfer of the Z shares to the grantor was not recognized as a sale for federal income tax purposes because the same person (here, the grantor) was treated as owning the purported consideration (the note) both before and after the transaction.

Without sale treatment, the grantor’s adjusted basis in the Z shares for purposes of calculating gain on the later sale to an unrelated party was the basis of those shares when originally contributed to the trust. In other words, the grantor did not receive a cost basis equal to the value of the shares when acquired from the trust in exchange for the promissory note.

PLR 202022002

Now, more than 30 years after issuing Rev. Rul. 85-13, the IRS uses the same reasoning to deny sale treatment in a transaction where the same person is treated as the owner of the purported consideration both before and after the transaction. This is true despite the fact that, like in Rev. Rul. 85-13, the person was not also deemed the owner of the transferred assets both before and after the transaction.

PLR 202022002 involved a trust (“Trust 1”) which owned an interest in an LLC (“LLC interest”) classified as a partnership for federal tax purposes. Trust 1 transferred a portion of the LLC interest to a subtrust (“Subtrust”). The sole beneficiary (“Beneficiary”) of Subtrust had the authority to withdraw all of its assets except for the LLC interest, and she withdrew the allowable assets pursuant to her withdrawal right. Presumably to circumvent the trust provisions prohibiting Beneficiary from withdrawing the LLC interest held by Subtrust, the trustees agreed to sell the LLC interest to a separate trust (“Trust 2”) in exchange for cash and a promissory note, with Trust 2 being an irrevocable grantor trust with respect to Beneficiary. Although Beneficiary could not withdraw the LLC interest from the Subtrust, she could permissibly withdraw the sale proceeds (the cash and promissory note) from Subtrust. The issue addressed in the Letter Ruling was whether the transaction would be treated as a sale of the LLC interest from Subtrust to Trust 2, thus triggering gain on the sale.

The Letter Ruling relies almost exclusively on Rev. Rul. 85-13 and concludes that the transfer would not be recognized as a sale because Beneficiary would be treated as wholly owning the assets of both trusts. With respect to Subtrust, Beneficiary would be treated as the owner after the transaction pursuant to Section 678(a)(1) because of her power to withdraw the Subtrust’s assets — the cash and promissory note — received from Trust 2 in exchange for the LLC interest.

Like Rev. Rul. 85-13, the same person (here, Beneficiary) would be treated as owning the purported consideration both before and after the transaction. Unlike Rev. Rul. 85-13 where post-transaction ownership of the consideration was caused by Section 675(3), the post-transaction ownership of the consideration used in the Letter Ruling was due to Section 678(a)(1).

Implications of PLR 202022002

In sum, PLR 202022002 demonstrates that the IRS will likely apply the same reasoning set forth in Rev. Rul. 85-13 to a transaction between a person and a trust when the assets of the trust are deemed to be owned by that person pursuant to Section 678. To date, no case and no other Ruling squarely addresses the application of Rev. Rul. 85-13 to a transaction involving a Section 678 trust.

While the Letter Ruling may have limited implications for estate planning, it serves as a reminder of a “trap for the unwary” – the grantor trust rules may be triggered in situations where they are not expected to apply, either shifting the liability for the tax to an unsuspecting taxpayer, or, as here, disregarding a sale as a “no sale” transaction between the deemed owner and the grantor trust.

If you have any questions or comments about the foregoing summary of the Letter Ruling, please contact Bobby Streisel, Blake Betheil, Maurice Holloway, or Wells Hall, who contributed to the preparation of this Tax Report.