The Treasury Department has finally issued proposed regulations that provide some clarity for grantor trusts saddled with cancellation of debt (“COD”) income. Under the proposed regulations, if a grantor trust has COD income, the grantor’s—and not the trust’s—solvency is relevant for purposes of the insolvency exception.
Why COD income of trusts is a hot topic right now
The characterization and taxation of trust COD income is a hot topic right now because a considerable number of life insurance trusts have handed back (or are contemplating handing back) life insurance policies in satisfaction of premium finance loans.
For a detailed discussion of the income tax consequences of handing back a life insurance policy in satisfaction of a premium finance loan, see Professor Robert Bloink’s Tax Lawyer article, Premium Financed Surprises: Cancellation of Indebtedness Income and Financed Life Insurance (Vol. 63, 2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1615080.
The topic also is hot right now because there’s a lot of ambiguity when applying the COD income rules to trusts.
Ambiguities when a Trust’s Premium Finance Debt is Discharged
Professor Bloink pointed out two of the glaring ambiguities present when a trust’s premium finance debt is discharged: “There is an ambiguity as to whether the trust, the grantor, or the beneficiaries recognize the COD income and whether exceptions to the general rule including COD income in gross income apply at the trust, grantor, or beneficiary level.” (p. 235)
Exceptions to the Taxation of COD Income
Although COD income is taxable, there is an exception to that rule if the taxpayer is bankrupt or insolvent [IRC Sec. 108(a)]. If the taxpayer is insolvent when the debt is cancelled, the COD income is excluded from the taxpayer’s income and won’t be taxed.
Whose Insolvency Controls?
As pointed out by Professor Bloink prior to release of the proposed regulations, “There is no clear answer to the question of whether the insolvency of a trust, its beneficiaries, or the grantor is relevant for the purposes of the insolvency exception.”
How the rule is applied can have a profound tax effect.
If the trust’s solvency is relevant for purposes of the exception, and the trust owned only the life insurance policy, there’s a great chance that the trust is insolvent and the COD income won’t be included in anyone’s gross income. If the grantor’s solvency is relevant, and the grantor is solvent—which is often the case since premium finance is typically used by the wealthy—then the grantor is going to realize the trust’s COD income. If the beneficiaries’ solvency is operative, the result is mixed, with some beneficiaries escaping taxation and others getting hit with a big tax bill.
As you can imagine, advisors have been scrambling to answer these questions, and there hasn’t been much useful information coming out of the IRS.
This is where the proposed regulations provide some certainty. The proposed regulations settle a part of the overall ambiguity: Whose insolvency is relevant for purposes of applying the insolvency exception?
The Proposed Insolvency Exception Regs
The proposed regulations clarify that the solvency of the entity—whether a trust or a disregarded entity—is not relevant for purposes of the insolvency and bankruptcy exceptions. Instead, as many commentators, including Professor Bloink, suspected all along, the grantor’s insolvency is key.
As stated in the proposed regulations:
If indebtedness of a grantor trust or disregarded entity is discharged in a Title 11 case, [the bankruptcy exception] will apply only to an owner of the grantor trust or disregarded entity that is under the jurisdiction of the court in a Title 11 case. If the grantor trust or disregarded entity is under the jurisdiction of the court in a Title 11 case, but the owner of the grantor trust or disregarded entity is not, [the bankruptcy exception] will not apply to the discharge of indebtedness income. If indebtedness of a grantor trust or disregarded entity is otherwise discharged, [the insolvency exception] will apply only to the extent the owner of the grantor trust or disregarded entity is insolvent. If the grantor trust or disregarded entity is insolvent, but the owner of the grantor trust or disregarded entity is not, [the insolvency exception] will not apply to the discharge of indebtedness income.
It’s the Grantor’s Problem
The preamble to the proposed regs says that taxpayers have claimed that the insolvency exception applies to a grantor trust when the trust itself is insolvent and regardless of the grantor’s solvency. “The IRS and the Treasury Department do not believe this is an appropriate application of the relevant statutory provisions” (p. 4).
Some taxpayers have taken a similar position respecting the bankruptcy exception:
Some taxpayers have taken the position that the insolvency exception is available to the extent a grantor trust or disregarded entity is insolvent, even if its owner is not. The IRS and the Treasury Department do not believe this is an appropriate application of the relevant statutory provisions.
Grantors taking a position contrary to the proposed regs have a long uphill battle.
Application to the Insolvency Exception to Partnerships
In addition to settling the ambiguities arising from applying the insolvency exception to trusts, the proposed regs also state the rule applicable to partnerships:
Under section 108(d)(6), in the case of a partnership, section 108(a)(1)(A) and (B) applies at the partner level. Accordingly, in the case of a partnership, paragraph (a) of this section applies to the partners of such partnership to whom the discharge of indebtedness income is allocable.