On August 14, 2007, the IRS issued Notices 2007-72 and 2007-73, identifying two transactions as “transactions of interest” subject to disclosure and list maintenance requirements. The IRS issued these Notices only weeks after finalizing, on July 31, 2007, a series of regulations addressing reportable transactions (including transactions of interest), disclosure requirements, and related list maintenance requirements.
These two transactions, one involving potentially excessive charitable contribution deductions by a successor member interest in a limited liability company and the other involving a potential abuse of grantor trusts, are the first transactions that the IRS has identified as transactions of interest.
Transactions of interest are not necessarily transactions the IRS considers abusive. Instead, they are transactions the IRS believes are the same as or substantially similar to transactions previously identified by the IRS as listed transactions. The IRS believes that these types of transactions have a potential for tax avoidance or evasion, but the IRS lacks sufficient information to determine if the transaction should be specifically identified as a tax avoidance transaction.
Nonetheless, in the proposed regulations issued on November 2, 2006 and finalized on July 31, 2007, the IRS identified transactions of interest as reportable transactions subject to a variety of disclosure rules, list maintenance requirements, and potential penalties. These rules are effective if taxpayers entered into the transactions on or after November 2, 2006 and/or if material advisors made tax statements with respect to the transactions on or after November 2, 2006.
Excessive Charitable Contribution Deduction Transaction
Notice 2007-72 involves a transaction in which a taxpayer acquires certain rights in real property or in an entity that holds real property, transfers the rights more than one year after the acquisition to an organization described in Internal Revenue Code section 170(c) (generally speaking, a charitable organization), and then claims a charitable contribution deduction that is significantly higher than the amount that the taxpayer paid to acquire the rights.
In this transaction, an advisor owns all of the membership interests in a limited liability company that directly or indirectly owns real property (other than a personal residence) that may be subject to a long-term lease. The advisor and the taxpayer enter into an agreement whereby the advisor continues to own the membership interests in the limited liability company for a term of years and the taxpayer purchases the successor member interests in the limited liability company. The successor member interests entitle the taxpayer to own all of the membership interests in the limited liability company upon the expiration of the advisor’s term of years. In some cases, the taxpayer may hold its interests through another entity, such as a single member limited liability company.
After holding the successor member interests for more than one year (in order to treat the interest as a long-term capital gain property), the taxpayer transfers them to a charity. The taxpayer claims an income tax charitable deduction for the value of the successor member interests, in an amount significantly higher than the taxpayer’s original purchase price for the successor member interests. The taxpayer obtains this higher value by using an appraisal which takes into account the value of the underlying real property, not merely the value of the taxpayer’s successor member interests in the limited liability company which owns the real property.
The IRS has four concerns with this transaction. The first concern is the large discrepancy between the amount the taxpayer paid for the successor member interests, and the amount the taxpayer claimed as a charitable contribution. The second is the IRS’s belief that the transaction may mischaracterize the different ownership interests in the limited liability company. The third is the IRS’s interest in whether the charity agreed to retain the successor member interests donated to it for a certain period of time. The fourth is, whether the charity subsequently sells the successor member interests to a party selected by or related to the advisor or the taxpayer.
In addition, although the Notice does not specifically identify charities as accommodation parties, charities ought to be aware that their knowing participation in this transaction may subject them to examination and penalties under the Tax Increase and Prevention Act of 2005, as well as under other rules applicable to charities.
Toggle Off and Toggle On Grantor Trusts
In general, grantor trusts are an important and useful method of tax planning. If a the grantor of a trust or a third person retains certain interests in or holds certain powers over a trust, the grantor or third person will be treated as the owner of the trust or a portion of it. A grantor trust is not a separate taxpayer. Instead, the grantor or the third party will be taxed on all the income generated by the trust and will be entitled to any deductions or credits attributable to the trust. Grantor trusts are used in many successful estate and tax planning strategies, including irrevocable life insurance trusts, grantor retained annuity trusts, and sales of appreciated property to grantor trusts for the benefit of children and other family members, to reduce the exposure to taxes. The grantor’s payment of income tax on the income from property that has previously been effectively transferred to younger generations for estate and gift tax purposes can be one of the most significant estate planning benefits of the transaction.
In Notice 2007-73, however, the IRS has determined that one type of planning involving grantor trusts has the potential for abuse. The identified transaction uses the purported termination and subsequent re-creation of grantor trust status to allow the grantor either to claim a tax loss greater than any actual economic loss sustained by the taxpayer or to avoid inappropriately the recognition of gain. This termination and recreation of grantor trust status is sometimes referred to as “toggling.” The IRS has initially identified two variations of this transaction.
In both variations, the transactions generally occur within a short period of time during the taxable year. In each case, the grantor claims that the “toggling off” and “toggling on” of the grantor trust status, combined with the events regarding the trust’s assets, result in tax consequences that are not achievable without both the toggling off and on of the grantor trust status.
The transactions described in Notice 2007-73 do not include a situation where a trust’s grantor trust status is terminated, unless the original grantor trust status for income tax purposes is subsequently reestablished. Situations in which a trust’s grantor trust status is terminated and not reestablished remain valid and useful planning techniques.
The First Variation
In the first variation with a potential for abuse, a grantor purchases four options. The value of each option is expected to move inversely in relation to at least one of the other options so that, before the expiration of any one of the options, two options will have gains and two will have losses.
The grantor creates a trust and funds the trust with the options and a small amount of cash. The grantor gives a short-term unitrust interest in the trust to a beneficiary and retains a noncontingent remainder interest in the trust. The remainder interest is structured to have a value that equals the fair market value of the options. The grantor takes the position that its remainder interest is a qualified interest (under Internal Revenue Code section 2702). Because of his or her retained remainder interest, the grantor treats the trust as a grantor trust. The trust agreement also gives the grantor the power, exercisable in a nonfiduciary capacity, to reacquire the trust’s corpus by substituting other property of an equivalent value. This substitution power will become effective on a specified date in the future.
After funding the trust, the grantor sells the remainder interest in the trust to an unrelated buyer. The sale price is an amount equal to the fair market value of the remainder interest, which, in turn, is equal to the fair market value of the options. The grantor claims that the basis in the remainder interest is determined by allocating to the remainder interest a portion of the basis in all of the trust assets. The grantor then claims no gain is recognized on the sale of the remainder interest because his or her basis in the remainder interest is the same as the amount realized, which was the same as the fair market value of the options. After the buyer purchases the remainder interest, the grantor claims that the sale has terminated (“toggled off”) the grantor trust status of the trust so that, during the period after the sale and before the effective date of the substitution power, the trust is no longer a grantor trust.
Subsequently, when the substitution power becomes effective, the grantor claims that the trust’s grantor trust status is restarted (“toggled on”). The grantor then closes out the loss options. The basis in these options (the amount the grantor paid for them) is greater than the amount the trust receives when the loss options are closed. As a result, the grantor claims that the trust’s status as a grantor trust causes him or her to recognize the loss on the two loss options. The grantor calculates the loss based on the difference between the amount realized and the original basis in the loss options, even though the grantor previously used a portion of the basis in the trust assets to eliminate his or her gain on the sale of the remainder interest. The trust’s remaining assets then consist of the two gain options, the contributed cash, and amounts received, if any, upon the termination of the loss options.
The third party buyer then purchases the unitrust interest in the trust from the trust beneficiary for an amount equal to the actuarial value of that interest, which approximately equals the amount of cash the grantor contributed to the trust, making the buyer the owner of both the remainder interest and the unitrust interest. The trust then terminates and its assets are distributed to the buyer. The buyer claims a basis in the assets (the gain options and the cash) from the trust equal to the amount it paid for the unitrust interest and remainder interest. At the same time, the grantor does not treat the termination of the trust as a taxable disposition by the grantor of the trust assets.
The buyer then exercises, sells, or terminates the gain options and recognizes gain on the sale only to the extent that the amount realized exceeds the basis the buyer allocated to the gain options. The transaction has been structured so that any gain recognized would be minimal. If the buyer purchased the remainder interest from the grantor with an installment note, the buyer will use the proceeds from the options to pay the installment note. If the grantor borrowed funds to originally purchase the options, the buyer repays the loan from the installment note proceeds.
Thus, the grantor sells the remainder interest and receives an amount substantially equal to the fair market value of the non-cash assets contributed to the trust. However, the grantor nevertheless claims a tax loss attributable to those assets even though he or she has not suffered an equivalent economic loss.
The Second Variation
In this variation of the transaction, the facts are the same as the first variation, except as described below.
The grantor contributes liquid assets such as cash or marketable securities to the trust, rather than options. The grantor’s basis in the assets approximately equals the assets’ fair market value at the time of their contribution. Before the grantor’s substitution power becomes effective, the grantor sells the remainder interest in the trust to the buyer. The sale price is an amount equal to the fair market value of the remainder interest, which is the fair market value of the assets. The grantor then recognizes little or no gain because it claims that the basis in the remainder interest, which he or she determined by allocating a portion of the basis in all of the trust assets, is the same or almost the same as the amount realized, the fair market value of the remainder interest.
Just as before, the grantor claims that the sale terminates (“toggles off”) the trust’s grantor trust status. After the substitution power becomes effective, the grantor substitutes appreciated property for the trust’s liquid assets. The fair market value of the substituted property is equal to the fair market value of the liquid assets. The grantor claims that once the substitution power became effective, prior to the exchange, the trust’s grantor trust status was restarted (“toggled on”) and the substitution will therefore not cause the grantor to recognize any gain.
As in the first variation, the buyer purchases the unitrust interest in the trust from the beneficiary, terminates the trust, and receives the trust’s assets on a distribution. For tax purposes, the grantor does not treat the termination of the trust as a disposition by it of the trust’s appreciated assets. The buyer claims a basis in the assets of the trust equal to the amount the buyer paid for the interests in the trust.
As a result, the grantor avoids the recognition of gain on the disposition of the appreciated assets substituted for the original assets contributed to Trust.
Taxpayers who entered into either of these two transactions or advisors who advised any taxpayers with respect to either of these transactions may face fairly substantial disclosure and list maintenance requirements. There are substantial penalties for both taxpayers and material advisors who fail to comply with these rules in a timely manner. In addition, failure to properly disclose these transactions will extend the statute of limitations for the years in which the transactions occurred (either 2006 or 2007 in this case). As a result, the potential audit risk will be extended.