Why is this Topic Important to Wealth Managers? The IRS recently released proposed regulations relating to the exclusion from gross income of discharge of indebtedness income of a grantor trust or an entity that is disregarded as an entity separate from its owner. Further, the proposed regulations provide rules regarding the term “taxpayer” for purposes of applying the existing law to discharge of indebtedness income of a grantor trust or a disregarded entity. The proposed regulations thus generally affect wealth managers who have clients/”taxpayers”” who “own” grantor trusts, or disregarded entities.

Generally speaking section 61(a)(12) of the Internal Revenue Code (the Code) provides that income from the discharge of indebtedness is includable in gross income. However, such income may be excludable from gross income under section 108 in certain circumstances.

The proposed regulations provide that, for purposes of applying section 108(a)(1)(A) and (B) to discharge of indebtedness income of a grantor trust or a disregarded entity, the term taxpayer, as used in section 108(a)(1) and (d)(1) through (3), refers to the owner(s) of the grantor trust or disregarded entity. The proposed regulations thus have income tax implications to “owners” of grantor trusts with regards to discharge of indebtedness.

The proposed regulations further provide that grantor trusts and disregarded entities themselves will not be considered owners for this purpose. The regulations will therefore cause those “owners” of grantor trusts and disregarded entities to realize income through the discharge of indebtedness.

Lastly, the proposed regulations provide that, in the case of a partnership, the owner rules apply at the partner level to the partners of the partnership to whom the discharge of indebtedness income is allocable.

Proposed Regulation Application Example:

If a partnership holds an interest in a grantor trust or disregarded entity, the applicability of section 108(a)(1)(A) and (B) to discharge of indebtedness income of the grantor trust or disregarded entity is tested by looking to the partners to whom the income is allocable. If any partner is itself a grantor trust or disregarded entity, the applicability of section 108(a)(1)(A) and (B) is determined by looking through such grantor trust or disregarded entity to the ultimate owner(s) of such partner.

Grantor Trust “Owners”

A grantor who retains certain interests in a trust he creates may be treated as the “owner” of all or part of the trust and thus taxed on the income of the trust in proportion to his ownership. There are five categories of interests for which the IRC gives detailed limits as to the amount of control the grantor may have without being taxed on the trust income. These categories are: reversionary interests, power to control beneficial enjoyment, administrative powers, power to revoke, and income for benefit of grantor. [1]

Generally, a grantor will be treated as the owner of any portion of a trust in which he has a reversionary interest in either the corpus or the income, if, as of the date of inception of that portion of the trust, the value of such interest exceeds 5% of the value of the trust.[2]

If the trust income is (or, in the discretion of the grantor or a nonadverse party, or both, may be) distributed or held for the benefit of the grantor or his spouse, he will be treated as the owner of it. [3]

Moreover, if the trust income is (or, in the discretion of the grantor or a nonadverse party, or both, may be) distributed or held for the benefit of the grantor or his spouse, he will be treated as the owner of it. [1]

For a detailed discussion on the taxation of grantor trusts see Tax Facts: What is a grantor trust? How is a grantor trust taxed?

For more information on the discharge of indebtedness in general see Tax Facts: What are the tax consequences of a discharge of indebtedness?

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[1] IRC Sec. 677(a).

Tomorrow blogticle will continue to address issues surrounding the private wealth management practice.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] RC Secs. 673-677.

[2] IRC Sec. 673(a).

[3] IRC Sec. 677(a).

Tags: Debt, estate planning, income tax, Internal Revenue Code, Internal Revenue Service, IRS, Tax, Trust law

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