7761 / Does the grantor of a grantor trust that owns a partnership interest realize gain when the grantor renounces retained powers and the trust ceases to be treated as a grantor trust?

The IRS and the Tax Court take the position that there is gain. They reason that where a grantor of a trust retains certain powers, and as a result is treated as owner of the trust for tax purposes, the grantor is considered, for tax purposes, owner of a partnership interest purchased by the trust. As owner, the grantor reports the distributive share of partnership income, gains, losses, deductions, and credits allocable to the trust. When the grantor renounces the retained powers that resulted in the trust’s being classified as a grantor trust, the grantor is no longer considered owner of the trust’s assets. In effect, the grantor has transferred ownership of the partnership interest to the trust. On the transfer, the grantor is deemed to receive a share of partnership liabilities.¹ The amount realized is taxable as proceeds of a sale, as discussed in Q 7755. The fair market value of the interest in excess of the liability is a gift to the trust. See Q 7760.

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1. Madorin v. Comm., 84 TC 667 (1985); Treas. Reg. § 1.1001(c)(Ex. 5); Rev. Rul. 77-402, 1977 CB 222.

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