IRS Clarifies “Grantor Trust” Definition in Bankruptcy and Insolvency Settings

07.26.2016

       The IRS has issued final regulations clarifying the definition of grantor trusts within the context of the bankruptcy and insolvency exclusions for cancellation of debt (COD) income.   COD income is includable in gross income; however, the Code provides for a number of pertinent exclusions. For example, gross income does not include any amount which would otherwise be includible in gross income by reason of the discharge of indebtedness of the taxpayer if the discharge occurs during bankruptcy or to the extent the taxpayer is insolvent. The terms “indebtedness of the taxpayer,” “Title 11 case,” and “insolvent” are all defined using the term “taxpayer.” The Code broadly defines a “taxpayer” as any person subject to any internal revenue tax.

       Notably, a grantor trust is any part of a trust that is treated as being owned by the grantor or another person. All items of income, deductions, and credits attributable to the trust are includable in computing the owner's taxable income and credits. For example, a parent may create a grantor trust for estate and succession planning. Where the parent is the grantor, the parent reports the grantor trust’s income on their own Form 1040. Stated another way, the grantor and their own trust are considered the same economic unit.

       Nevertheless, some taxpayers have taken the position that the bankruptcy exception is available if a grantor trust or disregarded entity is under the jurisdiction of a bankruptcy court, even if its owner is not. Similarly, some taxpayers maintain that the insolvency exception is available to the extent a grantor trust or disregarded entity is insolvent, even if its owner is not. The taxpayers argue that because, for Federal income tax purposes, the disregarded entity is disregarded and the “taxpayer” is the owner of the disregarded entity's assets and liabilities, the owner is properly seen as being subject to the bankruptcy court's jurisdiction, or being insolvent, even though, technically, they are not.

       The IRS has rejected this position and now clarifies in the final regulations that when applying the bankruptcy or insolvency exceptions to the discharge of indebtedness income of a grantor trust or a disregarded entity, the term “taxpayer,” refers to the owner(s) of the grantor trust or disregarded entity. The regulations provide that the insolvency exception is available only to the extent the owner is insolvent, and the bankruptcy exception is available only if the owner of the grantor trust or disregarded entity is subject to the bankruptcy court's jurisdiction. Thus, the regulations provide that grantor trusts and disregarded entities themselves will not be considered owners for this purpose.

       With respect to partnerships, the regulations state that the owner rules apply at the partner level to the partners of the partnership to whom the discharge of indebtedness income is allocable. For example, if a partnership holds an interest in a grantor trust or disregarded entity, the applicability of the bankruptcy and insolvency exceptions to COD income of the grantor trust or disregarded entity is tested by looking to the partners to whom the income is allocable.

        For more information or if you have any questions about estate planning, please contact Judson M. Stein, Esq., Director of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or John A. Grey, Esq., member of the Trusts & Estates Practice Group, at 973-230-2088 or jgrey@genovaburns.com.  

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