Having publicly reserved to itself the right to challenge transactions in which a grantor of a personal residence trust (PRT) swapped a promissory note for the residence, the Internal Revenue Service initially challenged but ultimately allowed such a transaction in a recent audit.

1996 Regulations

Before 1996, grantors of a PRT could swap cash or a promissory note for the residence without income tax consequences.  As a result, upon termination of the trust, the beneficiaries would receive something other than a personal residence.  If the grantor used cash, the beneficiaries would receive something without a tax basis, avoiding the capital gain that might otherwise apply.

That all changed in April 1996, when the IRS characterized this type of transaction as a “bait and switch” and proposed regulations to prevent the practice.  Prop. Reg. 25.2702-5 (April 16, 1996), Fed. Reg. Vol. 61, No. 74, p. 16624.  As to PRTs executed before the effective date of May 16, 1996, the IRS reserved the right to challenge swaps as not qualifying under Internal Revenue Code Section 2702, “by using established legal doctrines such as substance over form doctrine.” Id. 

On Aug. 27, 1996, P.L. 104-188 added Section 2702(a)(3)(A)(iii) to the IRC.  Rather than giving the IRS authority to disqualify offensive PRTs, this new provision gave express authority to the IRS to make regulations that qualify PRTs.  The new provision added a new exception to the general rule set forth in IRC Section 2702, supplementing the existing exceptions already set forth in subsections (i) and (ii).  As amended, Section 2702(a)(3) gives the IRS authority by regulation to create additional exceptions to the general rule—that is, the IRS could make regulations that would qualify PRTs.  But the converse isn’t true; the amended language can’t be read to give the IRS authority to reopen closed transactions and take away a statutory exception that Congress didn’t change. A taxpayer who fully complied with applicable law would have relied on this section.  Indeed, it’s arguable that Congressional silence is loud on this point, and the one-way phrasing of this statutory provision reflects an intention to undercut the IRS’ previously announced attack on bait and switch transactions.

On Dec. 22, 1997, the IRS implemented Treasury Regulations Section 25.2702-5(a)(2) that provides: “In the case of a trust created before January 1, 1997, the reformation [adding language precluding the swap transaction] must be commenced within 90-days after December 23, 1997, and must be completed within a reasonable time after commencement.”

Background of Audit

In February 1995, a husband and wife divided a personal residence into separate shares, each keeping a 50 percent tenancy-in-common interest.  The owner of each interest transferred it to a separate PRT that by its terms was intended to qualify as such under IRC Section 2702(a)(3)(A)(ii).  Each PRT was dated February 1995, and terminated after a 10-year term (or, if sooner, upon the death of the grantor).  The overall property was valued at $890,000, each gift was valued at $445,000, and timely 1995 gift tax returns were filed for each grantor.  As of the date the gift tax return was filed in April 1996, therefore, the husband and wife had done all that could be done to comply with the law in effect at that time.

On or about Aug. 12, 2002, the husband swapped a promissory note with a face amount of $353,840 for his PRT’s half-interest in the property.  The face value of the note was equal to the remaindermen’s actuarial interest in the property as of the date of the swap.  The trust terminated at the end of the 10-year term, in February 2005, and the note was distributed to the remaindermen—the husband’s children.

IRS’ Position

In the audit, the IRS initially took the position that the word “must” in the last sentence of Treas. Regs. Section 25.2702-5(a)(2) meant that if a taxpayer failed to reform a pre-effective date trust on or before the deadline set forth in the statute, the PRT would be disqualified. The IRS argued that there was a second gift of the retained interest from the grantor to the remainderman that was effective as of the deadline for the start of the reformation (90 days from Dec. 23, 1997).  Curiously, the IRS didn’t resort to any other established doctrines to attack the transaction.

But the inappropriateness of the IRS’ avenue of attack is evident by examining the IRS’ own commentary to the final regulations: “Finally, commentators objected to the statement in the preamble to the proposed regulations to the effect that if the IRS finds a pre-effective date trust to be inconsistent with the purposes of section 2702, the IRS, by established legal doctrines, may treat the trust as non-qualifying.  Treasury and the IRS wish to clarify that the IRS will apply these regulations only to post-effective date trusts.”  TD 8743 (12/22/1997), 1998-1 C.B. 547, 548 (1997).  The auditor reportedly confirmed with the IRS’ national office that the final regulations weren’t to be applied retroactively. 

The IRS recognized that the regulations have no application to pre-effective date PRTs and ultimately dropped its challenge. But there’s a more fundamental problem with the IRS’ position: the regulation itself (whether applied retroactively or prospectively) isn’t supported by the statute.  While the final regulations (consistent with new IRC Section 2702(a)(3)(A)(iii)) establish additional safe harbors for qualification, the statute itself doesn’t provide authority for disqualification of a PRT.  The statute provides authority only to add exceptions to the rule; there’s no statutory authority for removing exceptions or adding additional restrictions. 

It’s fair to ask then, whether the regulation itself is vulnerable to attack.  See Estate of Boeshore v. Commission, 28 TC 523 (1982) (“Treasury regulations are entitled to considerable weight; however, respondent may not usurp the authority of Congress by adding restrictions that are not there”); Walton v. Commissioner, 115 TC 589 (2000) (“[t]here exists no rationale for refusing to take into account for valuation purposes a retained interest of which both the form and the effect are consistent with the statute.”).  The regulation may be vulnerable to attack based on the grounds cited in these cases.