The IRS recently released proposed regulations that address the income tax treatment of cancellation of debt income of trusts. Although this highly technical area of the law may not be of interest to lay audiences, it’s particularly important for advisors who are selling high-value life insurance policies.
The implosion of the secondary market for life insurance during the recent financial crisis left a lot of trusts scrambling to dispose of large-face-value life insurance policies. Trusts that handed back policies in satisfaction of premium finance loans were then struck, along with their grantors, with massive tax bills for what is known as cancellation of indebtedness or cancellation of debt (COD) income.
[Although a comprehensive review of this complex issue is impossible here, you can find a detailed discussion of premium finance debt forgiveness in my colleague Robert Bloink’s Tax Lawyer article, Premium Financed Surprises: Cancellation of Indebtedness Income and Financed Life Insurance (Vol. 63, 2010), freely available from SSRN.]
Basics of Cancellation of Debt Income
For tax purposes, when a debt is cancelled, the cancelled debt is treated like any other form of income. If, for instance, a client purchases a car for $40,000 and the lender forgives the full amount of the loan, the lient must report that $40,000 as income on his tax return. Although a car loan is unlikely to be forgiven, cancellation of debt issues arose for many homeowners during the recent financial crisis. (Congress did step in to modify the rules to exclude most home indebtedness from the cancellation of debt rules.)
Cancellation of Trust Debt
Cancellation of debt issues arise for trusts that finance premiums on life insurance policies, using the policies for collateral. If the trust is unwilling or unable to continue making premium payments, the trust, like a homeowner, often has the ability to walk away from the loan without incurring any liability on the loan. Surrendering a policy in satisfaction of a premium finance loan can then give rise to COD income.
Ambiguity arises when a trust’s debt is cancelled. Because income often flows through entities like partnerships and trusts, landing on someone else’s 1040, the question arises as to who is taxed when a trust has COD income. Generally, if the trust is a grantor trust, then the COD income flows through the trust to the grantor. And if the trust is a nongrantor trust, the trust—not the grantor—realizes COD income.
Insolvency Exception to the Cancellation of Debt Rules
The big question that’s answered (in part) by the proposed regs is how exceptions to the cancellation of debt rules apply when the debtor is a trust. Although the general rule is that COD income is taxed, there’s an exception when the debtor is insolvent at the time the debt is forgiven. When an insolvent debtor’s debt is forgiven, that forgiven debt is not taxed as COD income.
The ambiguity here is how to apply the insolvency exception: Is the exception applicable if the trust is insolvent, or is the exception applicable if the grantor is insolvent? In most cases, a life insurance trust’s only asset will be a life insurance policy. So if the outstanding loans on the policy exceed the value of the policy, the trust will be insolvent. As a result, grantors want to apply the insolvency exception by examining the trust’s solvency.
Robert Bloink’s Tax Lawyer article, Premium Financed Surprises: Cancellation of Indebtedness Income and Financed Life Insurance (Vol. 63, 2010) focuses on the result where the trust is a nongrantor trust. He concludes that it is probably the trust’s solvency that’s at issue with a nongrantor trust. The proposed regulations deal with the situation where the trust is a grantor trust.
Treasury’s Proposed Regulations
The Treasury Department recently issued proposed regulations that sort out the confusion surrounding the
income tax treatment of cancelled trust debt when the trust is a grantor trust.
Under the proposed regulations, the insolvency exception is applied to grantor trusts at the grantor level. In other words, if a grantor trust has COD income, the grantor will be taxed on that income unless the grantor was insolvent (or another exception applies) at the time the debt was forgiven. According to the release accompanying the proposed regs:
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.
Although some grantors are still going to argue that they should not be on the hook for their trust’s COD income since the trust was insolvent at the time the debt was forgiven, their argument will be even harder to make now that the Treasury has taken a conclusive position on the issue.
Danger for “Nongrantor” Trusts
Although grantors of what are obviously grantor trusts are essentially out of luck with the proposed regs, grantors to what they believe to be nongrantor trusts aren’t entirely out of hot water. First, the Treasury and IRS haven’t yet announced their position about application of the insolvency exception to nongrantor trusts; although it’s unlikely, they could rule that the insolvency exception is applicable to nongrantor trusts in the same way that it is applicable to grantor trusts.
The bigger issue for grantors of “nongrantor” trusts is that they may be mistaken about the nature of their trust. Some operations pump out cookie cutter life insurance trusts that are never carefully examined by counsel. Accordingly, writes Bloink in his paper, “advisors want to carefully review the one-size-fits-all language of a given irrevocable life insurance trust before making a determination that it is a nongrantor trust” (232). What could have been intended as a nongrantor trust could indeed be a grantor trust. As discussed here, that could have devastating tax consequences for the grantor.
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See also The Law Professor's blog at AdvisorFYI.