Publication

We will run through a brief overview of the framework for deducting interest, including how to treat certain loans with inadequate stated interest.  Recent cases:

• Sawyer v. Commissioner, T.C. Memo. 2026-33, addressed the deductibility of interest on a policy loan, when the policy terminated, extinguishing the policy loan.  Some of the loan related to the taxpayer’s C corporation’s business, and some was to pay premiums.  Beyond that case, we will discuss how to structure loans in connection with life insurance policies.
• Cardulla v. Commissioner, T.C. Memo. 2023-89, which the Ninth Circuit affirmed in 2025, discussing whether interest to buy real estate was deductible as investment interest or business interest.

Part III.B.1.a.i. Loans cross-references all of my resources on loans.  An overview of income tax deductions generally is in part II.G.20.a Code § 163(j) Limitation on Deducting Business Interest Expense, which includes:

Although Code § 163(a) authorizes deducting “all interest paid or accrued within the 0taxable year on indebtedness,” other parts of Code § 163 deviate from that general rule.  Furthermore, loss limitations elsewhere in the Code may apply.   See also part II.G.26.b Real Estate as a Trade or Business.

Among the many limitations within Code § 163 are:

• Deductions for investment interest cannot exceed the taxpayer’s net investment income, all as described in Code § 163(d); “net investment income” here is very different in scope than the idea in part II.I 3.8% Tax on Excess Net Investment Income (NII).  See part II.G.20.d Investment Interest Expense under Code § 163(d).
• Personal interest is not deductible, except for qualified residence interest.  Code § 163(h).
• Business interest deduction limitations under Code § 163(j) were greatly expanded to need to be considered by all taxpayers incurring interest expense.  This part II.G.20.a elaborates on these limitations.

Part II.G.26.b Real Estate as a Trade or Business describes how these bullet points apply to real estate and is discussed further below.  Part III.B.1.a.i.(b) Term Loans discusses computing interest expense.

One must look to why the taxpayer incurred debt to determine in which category the debt falls.  See part II.C.3.d Deducting Interest Expense on Debt Incurred by a Partnership, which generally also applies to S corporations.   Investment interest and qualified residence interest are itemized deductions and therefore subject to the 2/37 disallowance described in part II.G.4.n.i.(b) Code § 68 “Pease” Limitation on Itemized Deductions, which is found in part II.G.4.n.i Itemized Deductions.

As more fully discussed in part II.Q.4.f.iii.(b). Deductibility of Interest Incurred on Loan to Buy life Insurance, Sawyer involved an individual who owned a cash value life insurance policy that eventually imploded after extensive borrowings.  He invested some of his borrowing in his C corporation in which he materially participated; the Tax Court classified the related interest (which was deemed paid upon implosion) as investment interest expense, deductible to the extent of net investment income for the year of implosion.  The rest of the interest was nondeductible personal interest, because he borrowed it in the policy’s first four of seven years.

Generally, loans should pay interest at least annually and have a reasonable maturity to be bona fide.  See part III.B.1.a.i.(a). Loans Must be Bona Fide; see also part II.G.20.b When Debt Is Recharacterized as Equity.

However, certain arrangements don’t require payments until the insured under a life insurance policy dies.  As described in part II.Q.4.f.ii.(a). Is the Arrangement a Split-Dollar Arrangement? special rules apply to a “split-dollar life insurance arrangement,” which Reg. § 1.61-22(b)(1) defines as “any arrangement between an owner and a non-owner of a life insurance contract that satisfies the following criteria”:

(i)   Either party to the arrangement pays, directly or indirectly, all or any portion of the premiums on the life insurance contract, including a payment by means of a loan to the other party that is secured by the life insurance contract;

(ii)  At least one of the parties to the arrangement paying premiums under paragraph (b)(1)(i) of this section is entitled to recover (either conditionally or unconditionally) all or any portion of those premiums and such recovery is to be made from, or is secured by, the proceeds of the life insurance contract; and

(iii) The arrangement is not part of a group-term life insurance plan described in section 79 unless the group-term life insurance plan provides permanent benefits to employees (as defined in § 1.79-0).

Part II.Q.4.f.iii. Split-Dollar Loans under Reg. § 1.7872-15 provides special rules for such loans, described in more detail in part II.Q.4.f.iii.(a). Details of Split-Dollar Loan Regime:

Reg. § 1.7872-15(a)(2)(i) provides that, generally, a “payment made pursuant to a split-dollar life insurance arrangement is treated as a loan for Federal tax purposes, and the owner and non-owner are treated, respectively, as the borrower and the lender,” if:

(A) The payment is made either directly or indirectly by the non-owner to the owner (including a premium payment made by the non-owner directly or indirectly to the insurance company with respect to the policy held by the owner);

(B) The payment is a loan under general principles of Federal tax law or, if it is not a loan under general principles of Federal tax law (for example, because of the nonrecourse nature of the obligation or otherwise), a reasonable person nevertheless would expect the payment to be repaid in full to the non-owner (whether with or without interest); and

(C) The repayment is to be made from, or is secured by, the policy’s death benefit proceeds, the policy’s cash surrender value, or both.

Reg. § 1.7872-15(j) controls over the usual rules governing contingent payments in making loans at the applicable federal rate (AFR). The lender puts together a projected payment schedule, which everyone directly or indirectly involved in the loan must use. The term of a split-dollar loan payable on the death of an individual is the individual’s life expectancy as determined under the appropriate table in Reg. § 1.72-9 on the day the loan is made; if the insured outlives his or her life expectancy, the split-dollar loan is treated as retired and reissued as a split-dollar demand loan at that time for an amount of cash equal to the loan’s adjusted issue price on that date.  Although a payment is not contingent merely because of the possibility of impairment by insolvency, default, or similar circumstances, if any payment on a split-dollar loan is nonrecourse to the borrower, the payment is a contingent payment for purposes unless the parties to the arrangement make the written representation provided for in Reg. § 1.7872-15(d)(2).  Treating a nonrecourse payment as contingent may cause that payment to assigned a zero value, which would mean that the usual nonrecourse split dollar loan would be assigned a zero value.

Thus, the written representation provided for in Reg. § 1.7872-15(d)(2) is critically important in making sure that a nonrecourse loan is respected. An otherwise noncontingent payment on a split-dollar loan that is nonrecourse to the borrower is not deemed a contingent payment if the parties to the split-dollar life insurance arrangement represent in writing that a reasonable person would expect that all payments under the loan will be made.  Unless the IRS provides otherwise, “both the borrower and the lender must sign the representation not later than the last day (including extensions) for filing the Federal income tax return of the borrower or lender, whichever is earlier, for the taxable year in which the lender makes the first split-dollar loan under the split-dollar life insurance arrangement.” If the interest actually paid on the split-dollar loan is less than the interest required to be accrued on the split-dollar loan according to the representation, “the excess of the interest required to be accrued over the interest actually paid is treated as waived, cancelled, or forgiven by the lender.”

Following these rules facilitates intra-family sales of life insurance policies, whether unwinding part II.Q.4.f.ii.(b). Split-Dollar Economic Benefit Arrangement under Reg. § 1.61-22 or simply having the insured sell the policy to an irrevocable life insurance trust.  Not needing to make payments until the insured days is very helpful.  However, as mentioned in part II.Q.4.f.ii.(a), interest is imputed each year.  Reg. § 1.7872-15(a)(1) provides:

If a split-dollar loan is not a below-market loan, then, except as provided in this section, the loan is governed by the general rules for debt instruments (including the rules for original issue discount (OID) under sections 1271 through 1275 and the regulations thereunder).  If a split-dollar loan is a below-market loan, then, except as provided in this section, the loan is governed by section 7872.  The timing, amount, and characterization of the imputed transfers between the lender and borrower of a below-market split-dollar loan depend upon the relationship between the parties and upon whether the loan is a demand loan or a term loan. 

The OID rules referred to above provide that, if adequate stated interest is not paid annually, payments will be deemed made from the borrower to the lender each year, generating interest income  and generally nondeductible interest,  even though no cash changes hands. If the split-dollar agreement is between a donor and a donee, consider making the donee be an irrevocable grantor trust, so that no interest income is recognized while the trust is deemed owned by the donor.  Presumably any accrued interest at the time that grantor trust treatment is turned off will be considered principal for income tax purposes; perhaps the promissory note might be drafted so that any accrued but unpaid interest is added to principal on the note’s anniversary to further support that treatment.

The OID rules are discussed further in part III.B.1.a.i.(b) Term Loans, which as described in that part was one of the issues in Cardulla v. Commissioner, T.C. Memo. 2023-89, affirmed in an opinion designated as not for publication, 136 A.F.T.R.2d 2025-5189 (9th Cir. 2025). Cardulla provided detailed calculations of OID and also addressed how to convert to accounting for OID when the taxpayer previously failed to apply the OID rules.

Part II.G.26.b Real Estate as a Trade or Business includes the portion of Cardulla determining whether interest expense was investment interest or business interest.  Cardulla reasoned:

Activities relating to undeveloped real property are subject to a facts and circumstances test to determine whether the activities rise to the level of a trade or business. See Polakis v. Commissioner, 91 T.C. 660, 669–70 (1988). It is not a trade or business where development activities are in the exploratory or formative stages. Conner, T.C. Memo. 2018-6, at *25. Among the tests that the courts have come to rely on in determining the nature of the taxpayer’s activities with respect to real estate are the following:

the nature and purpose of the acquisition of the property and the duration of the ownership; the continuity of sales or sales-related activity over a period of time; the volume and frequency of sales; the extent to which the taxpayer or his agents have engaged in sales activities by developing or improving the property, soliciting customers, and advertising; and the substantiality of sales when compared to other sources of taxpayer’s income.

Polakis, 91 T.C. at 670.

X-Way Delta acquired its property after 20 years of petitioner’s failed attempts to develop it and after the Investors lost faith in its potential. X-Way Delta has not sold or developed the property, and the one potential sale of the property in 2007 fell through because of a downturn in the economy…. He has not shown that he advertised the property or otherwise sought purchasers or development opportunities for it.

Petitioner has failed to convince us that, during 2014 and 2015, X-Way Delta’s activities with respect to its property amounted to a trade or business. X-Way Delta was holding its property for long-term appreciation….  Accordingly, petitioner cannot deduct the interest X-Way Delta accrued on the Note for 2014 or 2015 as interest allocable to trade or business.

Perhaps because respondent sees the easement rental as incidental to holding the property for investment (i.e., for appreciation), he does not argue for application of the passive activity loss rules. See Temp. Treas. Reg. 1.469-1T(e)(3)(vi)(B).

And perhaps because under that temporary regulation the easement rental is incidental to holding the property for investment, he is willing to concede that, if the property is not trade or business property, it is property held for investment (and the interest is not personal interest), despite the poor fit under sections 163(d)(5)(A)(i) and 469(e)(1). We accept that X-Way Delta’s 2014 and 2015 interest payments were payments of investment interest. Petitioner’s deduction of that interest for each year cannot exceed his net investment income. See § 163(d)(1)….

Related webinars are Charitable Gifts (incl. Bargain Sales); LLC or Real Estate as Inventory; S Corp. Fid. Inc. Tax (Incl. ESBT NOLs) (delivered 10/31/2023 but posted 12/31/2023) and Code § 199A Safe Harbor for Rental Real Estate; Partnership Structural Issues; Sale of Intangible Assets (10/29/2019).

A C corporation that distributes all its earnings faces tax on its investment returns, and its owner pay dividend tax. This double tax tends to be higher than that paid by an S corporation, although tax breaks given to dividends the C corporation receives from its investments may ameliorate that tax. For an overview, see the body of part II.E.1 Comparing Taxes on Annual Operations of C Corporations and Pass-Through Entities. For details underlying those assumptions, see parts II.E.1.a Taxes Imposed on C Corporations (see the body, which includes that my calculation of the effective tax rate on the C corporation may be overstated unless one accounts for the dividends received deduction) and II.E.1.b Taxes Imposed on S Corporations, Partnerships, and Sole Proprietorships.

Even more important, however is the exit strategy. Suppose a married couple wishes to pass the C corporation to their three children.  Often, each child will have their own investment goals and cash flow needs, so they need to go their own separate ways. However, even if the stock gets a basis step-up in the C corporation stock at the parents’ death, liquidating a C corporation would result in a taxable deemed sale of its assets; see part II.Q.7 Exiting from or Dividing a Corporation, especially part II.Q.7.h.iii Taxation of Corporation When It Distributes Property to Shareholders. However, an S corporation can avoid that tax:

• See part II.H.8.a Depreciable Real Estate in an S Corporation – Possible Way to Replicate Effect of Basis Step-Up If the Stars Align Correctly, especially subpart II.H.8.c Basis Step-Up for Publicly-Traded Stock and Other Nondepreciable Property.
• Part II.H.8.a is covered in my free webinar, P’ship and S Corp Basis Step-Up; Debt vs. Equity (4/28/2026).

Part II.H.8.c, which is integrated into part II.P.3.b.vi Sample Memo to Former C Corporation (a subpart of part II.P.3.b Conversion from C Corporation to S Corporation), converts the S corporation into a partnership, which can then be divided tax-free, as described in part II.Q.8.b.i Distribution of Property by a Partnership. Part II.P.3.b.vi and the related webinar explain operational details.

From part II.P.3.b.vi. Sample Memo to Former C Corporation (which includes detailed cross-references to specific parts of my materials):

This memo explains the short- and long-term planning related to the Company electing to be taxed as an S corporation as of January 1, 2026.

Avoiding Personal Holding Company Tax and Tax on Excessive Accumulated Earnings

As a C corporation with passive investment income, the Company was required to pay dividends to avoid the 20% personal holding company (“PHC”) tax.   If the Company were not a PHC, it would potentially be subject to the 20% tax on excess accumulated earnings.   As an S corporation, it is not subject to either tax.

Avoiding Dividend Tax

You are taxed on the Company’s income earned on or after January 1, 2026.

The Company should invest in only taxable income. You can withdraw tax-free any taxable income earned on or after January 1, 2026.  You cannot withdraw tax-exempt income or pre-January 1, 2026 earnings & profits without paying tax.

Avoiding Built-in Gain Tax

If you sell any asset that had unrealized gain as of January 1, 2026 by January 1, 2031, then both you and the Company would pay tax on gain recognized to the extent of that asset’s January 1, 2026 unrealized gain.  You would be able to deduct the Company’s income tax on that gain.  The Company’s December 31, 2025 records showed $_____ of unrealized gain.

Maintaining S Election

Because the Company has very significant earnings & profits from its life as a C corporation, it must avoid having excess passive investment income.  If, for each of 3 consecutive taxable years, it has gross receipts for each of years more than 25% of which are passive investment income, the S election will terminate.  If the Company violates that test for any one taxable year, the excessive net passive income will be taxed at regular corporate income tax rates (currently 21%).  That excess net passive income tax is calculated using the same procedure as the 3-consecutive-taxable-year test.

“Passive investment income” means gross receipts derived from royalties, rents, dividends, interest, and annuities.  Thus, it does not include capital gains; however, net capital gain from the sale of stock or securities is included in the denominator of the gross receipts test,  making the test easier to satisfy.

When investing in a partnership, the Company would count its allocable share of gross receipts, rather than net income.  Oil and gas investments tend to have very high gross receipts relative to their net income and therefore very high gross receipts relative to their value.

Thus, investing in one or more oil/gas partnerships that generate gross receipts substantially in excess of 4 times the dividends and interest generated by your portfolio would protect against violating the excess net passive income prohibition.

Officer Compensation

Whether the Company is a C corporation or an S corporation, it should pay its officers reasonable compensation for any substantial services they provide.  An S corporation tends to have higher scrutiny than a C corporation.

Rev. Rul. 73-361 held (highlighting mine), “Since the stockholder-officer in the instant case performed substantial services for the electing small business corporation, for which he received remuneration, he is an employee of the corporation.”  Similarly, Rev. Rul. 82-83 addressed compensating officers for “substantial services typical of officers” (highlighting mine), discussing decisions that are “rarely delegated to independent contractors.”

Here, the officers merely set investment policy, and the investment advisor runs the portfolio. They might not be performing “substantial” services. Reg. § 31.3121(d)-1(b), “Corporate officers,” provides (highlighting mine):

Generally, an officer of a corporation is an employee of the corporation. However, an officer of a corporation who as such does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is considered not to be an employee of the corporation. A director of a corporation in his capacity as such is not an employee of the corporation.

Your situation seems to fit within the highlighted sentence of that regulation; however, whether that is the case is a matter between you and your income tax preparer.

Basis Step-Up Strategy

We recommend that you convert the Company to an LLC taxed as an S corporation and place it into a marital estate trust.

Using a marital estate trust is a nontaxable gift and provides you with a new tax basis on the death of the first of you to die.  It is wholly includible in the grantor spouse’s estate because of the grantor spouse’s control  and wholly includible in the beneficiary spouse’s estate because it is payable to the beneficiary spouse’s probate estate.  Your ownership would then have a basis equal to its value on the triggering death.

Here is an example of how that would work.  Suppose that, at the death of the first spouse, the Company has assets with $2.3M basis and $3M value.  The basis of your ownership of the S corporation would be $3M.  The Company converts from being taxed as an S corporation to being a disregarded LLC, triggering a $700K gain from the deemed sale of all of the Company’s assets.  That $700K gain is added to the $3M basis of your ownership,  generating a $3.7M basis.  When the Company liquidates, the survivor is treated as having received $3M assets against a $3.7M basis, generating a $700K capital loss.  The $700K capital loss on liquidation offsets the $70K gain on the deemed sale of assets, making the conversion from an S corporation to a disregarded entity be a nontaxable event, with the assets having a full basis step-up to date-of-death value.  A complete liquidation of the corporation bypasses dividend treatment.

Converting to an LLC taxed as an S corporation now is a nontaxable event.  The surviving spouse would file Form 8832 within 75 days after the date of the first spouse’s death, making the deemed liquidation retroactive to date of death.   That prevents any post-mortem gain from generating net gain on liquidation.

Being able to separate a multiple grantor trust into trusts with more than one owner is important to be able to isolate the treatment of transaction with a grantor that are disregarded for grantor trust purposes (see part III.B.2.d.i Federal Income Tax and Irrevocable Grantor Trust Treatment) and to be able to isolate grantor trust status after one grantor dies. This is important notwithstanding being able to use one social security number when the happy couple files joint returns.  Being able to separate who is the grantor for state law purposes can be important in modifications requiring the grantor’s consent; for more on trust modifications, see parts III.B.1.b.ii Trust Modifications (which is part of part III.B.1.b Transfers for Insufficient Consideration, Including Restructuring Businesses or Trusts and a sister to subpart III.B.1.b.i Chronological Review of a Potpourri of Transfers) and II.J.18 Trust Divisions, Mergers, and Commutations; Decanting).  And the grantor often corresponds to the transferor for purposes of part III.B.1.d Generation-Skipping Transfer (GST) Issues; regarding separating trusts with multiple transfers, causing a mixed GST inclusion ratio, see part III.B.1.d.iv Qualified Severances, income tax consequences of which are discussed further in this part III.B.2.h.i.(b).

Some very smart estate planning experts assert that having multiple grantors is like “cream in the coffee” – one cannot separate multiple owner trusts.  The discussion below rebuts that argument, but the end of this part III.B.2.h.i.(b) discusses practical aspects of commingling grantor trust portions.  Dividing trusts according to who contributed assets has much precedent in the transfer tax system, including parts III.B.1.d.iv Qualified Severances (which can result after multiple transfer events complicate matters – see part III.B.1.d.vii Computing Inclusion Ratio (derived from the “applicable fraction”) and III.C.7 Portion of Trust Includible under Code § 2036.

Reg. § 1.671-2(e)(6), Example (7), illustrates how to treat a trust that has more than one grantor:

A, B’s brother, creates a trust, T, for B’s benefit and transfers $50,000 to T.  The trustee invests the $50,000 in stock of Company X.  C, B’s uncle, purportedly sells property with a fair [child]et value of $1,000,000 to T in exchange for the stock when it has appreciated to a fair [child]et value of $100,000.  Under paragraph (e)(2)(ii) of this section, the $900,000 excess value is a gratuitous transfer by C.  Therefore, under paragraph (e)(1) of this section, A is a grantor with respect to the portion of the trust valued at $100,000, and C is a grantor of T with respect to the portion of the trust valued at $900,000.  In addition, A or C or both will be treated as the owners of the respective portions of the trust of which each person is a grantor if A or C or both retain powers over or interests in such portions under sections 673 through 677.

With more than one grantor, each person is grantor with respect to the portions that person funded, and all tax items relating to those portions are allocated to each portion.   For how much each person is treated as owning, see parts III.B.2.d.i.(b) Portions of Irrevocable Grantor Trust Deemed Owned for Federal Income Taxation and III.B.2.i.vii.(b) Determining Portion Owned When Trust Is Only a Partial Grantor Trust.

Reg. § 1.671-2(e)(6), Example (7), above, does not say how the bargain sale is taxed.  Here is my take:

• If A is a deemed owner of the Company X stock, A would be taxed on the $50,000 gain on the Company X stock ($100,000 value minus $50,000 basis) exchanged with C.
• If A is not the deemed owner, then the trust is taxed on that $50,000 gain.
• Whether or not C is the deemed owner of a portion of the trust, C would recognize gain if and to the extent $100,000 exceeds the basis in the $1,000,000 property.  Because C is not the grantor of that $100,000 portion, Rev. Rul. 85-13 could not apply to that portion.

Both A and C are now the grantors of the $1,000,000 property, in a 10%/90% ratio.

Suppose we change the facts, and the Company X stock says in the trust and C contributes land worth $900,000 instead of doing a bargain sale.  A is a grantor with respect to the portion of the trust valued at $100,000, and C is a grantor of T with respect to the portion of the trust valued at $900,000.  If we did a qualified severance, can we make the severed trusts pristine as to who is the grantor?  If we did a pick-and-choose allocation of 10% to A and 90% to C and mixed up the assets, that would work for GST purposes but should not work for grantor trust purposes.  Under the Reg. § 1.671-3 portion rules that David cited, the trust with respect to which A is the transferor must have the stock to make A be the sole grantor, and the trust with respect to which C is the transferor must have the land to make C be the sole grantor.

Carrying this hypothetical further, what are the consequences of a qualified severance in various scenarios?  Reg. § 1.1001-1(h) provides, “In general,”:

The severance of a trust (including without limitation a severance that meets the requirements of § 26.2642-6 or of § 26.2654-1(b) of this chapter) is not an exchange of property for other property differing materially either in kind or in extent if—

(i)   An applicable state statute or the governing instrument authorizes or directs the trustee to sever the trust; and

(ii)  Any non-pro rata funding of the separate trusts resulting from the severance (including non-pro rata funding as described in § 26.2642-6(d)(4) or § 26.2654-1(b)(1)(ii)(C) of this chapter), whether mandatory or in the discretion of the trustee, is authorized by an applicable state statute or the governing instrument.

Reg. § 1.1002-1(b) provides that nonrecognition of gain is to be strictly construed.  In light of Reg. § 1.1002-1(b), I suggest that a conservative reading of Reg. § 1.1001-1(h) is merely to protect trust divisions from being a considered an exchange of beneficial interests under Cottage Savings, although neither the preamble to the proposed regulations nor the preamble to the final regulations that adopted Reg. § 1.1001-1(h) suggests that reading.  Therefore, I suggest that a pick-and-choose fractional funding of a trust division in our hypothetical would be treated as a deemed sale if and the extent that A or C is the deemed owner and A or C is treated as having received other assets in exchange for the assets that A or C was deemed to own before the trust division.  For more on Reg. §§ 1.1002-1(b) and 1.1001-1(h), see parts II.J.18.f Commutation vs Mere Division and III.B.1.d.iv Qualified Severances, the latter being a strategy relating to part III.B.1.d Generation-Skipping Transfer (GST) Issues.

Carrying the pick-and-choose fractional division further, what if neither the original trust nor either divided trust is a grantor trust?  In that case, the division would not be taxable:

• Does that relieve A or C of responsibility for unrealized appreciation?  No – if the original trust were not a grantor trust, neither A nor C would be taxed on the gain, so they already don’t have responsibility for unrealized appreciation.
• What if A or C later became the deemed owner of A’s or C’s respective trust later, and that trust had other property in it? Would that constitute an abusive shift of grantor status? As mentioned above, I think that the divided trusts would be A’s or C’s from the viewpoint of being a GST transferor, but A or C being a grantor would follow the property attributed to A or C under the Reg. § 1.671-3 portion rules rather than according the transferor designation.

Reg. § 1.671-2(e)(6), Example (8), addresses who is the grantor after a grantor dies:

G creates and funds a trust, T1, for the benefit of G’s children and grandchildren.  After G’s death, under authority granted to the trustees in the trust instrument, the trustees of T1 transfer a portion of the assets of T1 to another trust, T2, and retain a power to revoke T2 and revest the assets of T2 in T1.  Under paragraphs (e)(1) and (5) of this section, G is the grantor of T1 and T2.  In addition, because the trustees of T1 have retained a power to revest the assets of T2 in T1, T1 is treated as the owner of T2 under section 678(a).

The next-to-the-last sentence of Example (8) confirms that G’s status as a grantor does not terminate upon G’s death.

Letter Ruling 9304017 glossed over this distinction for a married couple (C and D) that together were grantors of a separate trust for each child, holding:

… because C and D are treated as the owners of all of the income and corpus of the Trusts, we conclude that Trust A and Trust B may be shareholders of an S corporation under section 1361(C)(2)(A)(i) of the Code. Accordingly, X’s S corporation status will not terminate as a result of the transfer of X stock to Trust A and Trust B.

After the deaths of C and D, Trust A, Trust B, and any separate share trust created thereunder will be considered a qualified subchapter S trust under section 1361(d)(3) of the Code, provided that each beneficiary is a citizen or resident of the United States and that a valid election is made by or on the behalf of the respective beneficiary under section 1361(d)(2).

What would happen if only one of C or D died?  Letter Ruling 9304017 did not expressly address that time period and failed to mention Reg. § 1.671-2(e)(5).  However, the ruling seems intended to approve the trust during all time periods before and after the deaths of C and D, so the taxpayer in that ruling is likely protected.  On the other hand, the ruling’s failure to address Reg. § 1.671-2(e)(5) makes it unwise for taxpayers to rely on Letter Ruling 9304017, and any suggestion that a trust deemed owned by more than one grantor is treated as owned 100% by the surviving grantor when one of the grantor’s dies  is wrong because it contradicts Example (8), which continues a person’s status as the grantor after that person dies.

Consider contributions to a spouse where both spouses are intended to be the grantors.  This could be a community property trust, a qualified spousal trust,  or another revocable  trust.  Code § 678(b) provides that a withdrawal right does not supersede the grantor being the deemed owner,  and the clear implication of Reg. § 1.671-2(e)(5)  (illustrated in Reg. § 1.671-2(e)(6), Example (4))  is that failure to exercise a withdrawal right does not make the holder become the grantor.  Under this authority:

• Until a grantor of a joint revocable trust dies, each spouse is the grantor with respect to property (or the fruits of that property) that the spouse gratuitously transferred to the trust.
• When a spouse dies and property is transferred, that spouse is exercising a general power of appointment over any property the other spouse contributed.  Between gratuitous transfer to the trust and this exercise of a general power of appointment, the decedent is the grantor regarding any property the decedent transfers upon death:
  • The decedent and the decedent’s estate cannot be the deemed owner.
  • A beneficiary, including the surviving spouse, may be the deemed owner under Code § 678.
• Suppose a spouse dies and does not transfer property (or the fruits of that property) that the decedent gratuitously transferred to the trust.  The decedent remains the grantor of that property and cannot be the deemed owner.  However, the surviving spouse may become the Code § 678 deemed owner as a beneficiary.  Upon the surviving spouse’s death, the surviving spouse is exercising a general power of appointment over property the first decedent contributed and becomes the grantor, but of course the second decedent cannot be the deemed owner.

Most fiduciary income tax practitioners assume that, no matter the circumstances, each spouse is an equal grantor of the joint trust.  That assumption has no grounding in the law described in this part III.B.2.h.i.(b):

• While both spouses are living, that assumption usually has no consequences, given that a trust that is deemed owned solely by spouse who file a joint return may use either spouse’s social security number while the grantors file joint returns.
• If any asset is readily traceable to one spouse’s gratuitous transfer, the grantor should be assigned correctly (unless the issue is moot or immaterial).
• If any asset is not readily traceable to one spouse’s gratuitous transfer, consider using a simplifying assumption.  If the assumption is made in good faith, I seriously doubt that the IRS will disturb that assumption, given all parties’ inability to determine that the assumption is incorrect – especially considering that the IRS does not devote much effort to examining fiduciary income tax returns.
• I don’t perceive any abuse in dividing trusts in this manner.  If the division mistakenly attributes assets to one grantor that should be attributed to another grantor, the correct grantor remains responsible when the mistake is determined.
• As described in part III.C.7 Portion of Trust Includible under Code § 2036, courts and the IRS have addressed issues on how much of a trust to attribute a donor.

In many ways, the income tax concept of “grantor” matches up with state trust law defining a “settlor.”  Given the state law impact of isolating who is the settlor, generally state trust law should recognize the value in diving a trust so that each trust has only one settlor.

Steve Gorin has several upcoming speaking engagements and educational programs focused on estate, trust, and tax planning. This October, he will present at the Montana Tax Institute, where he will discuss nongrantor trusts that hold partnership interests.

Looking ahead to 2026, Steve is scheduled to speak at the Hawaii Tax Institute in November on choice-of-entity considerations following the 2017 and 2025 tax law changes. In addition to these live presentations, he continues to offer free quarterly webinars through CPA Academy that qualify for CPE credit. Professionals interested in staying current on estate and tax planning topics are encouraged to visit Steve’s CPA Academy page regularly for newly released webinars and additional CPE opportunities.

Upcoming events and registration details:

• Montana Tax Institute
  Nongrantor Trusts Holding Partnership Interests
  October 9-10. 2026 – Register here.
• Hawaii Tax Institute
  Choice of Entity After 2017 & 2025 Tax Law Changes
  November 15-29, 2026 – Register here.
• Free Quarterly Webinars (CPE Eligible)
  Offered through CPA Academy
  Visit Steve’s CPA Academy webpage monthly for the latest webinar links and CPE information

Save the Date!

Join Steve on October 27, 2026 for a webinar discussing the Third Quarter 2026 newsletter.