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IRS Memo Has Chilling Effect on Irrevocable Trust Modifications

IRS Memo Has Chilling Effect on Irrevocable Trust Modifications

Practitioners need to be aware of the tax consequences of Chief Counsel Memorandum 202352018.

A recent Chief Counsel Memorandum (CCM) issued by the Internal Revenue Service may have a chilling effect on modifications to all types of irrevocable trusts. CCM 202352018 addressed the gift tax consequences of modifying a grantor trust to add a tax reimbursement clause. The CCM’s conclusion is a departure from precedent and creates many unanswered questions. There’s simply no way to predict how far the IRS might try to extend the reasoning and conclusions in the CCM to other steps taken to modify irrevocable trusts. Practitioners will need to consider these unknown consequences when advising clients, and many practitioners might choose to formally warn clients about this uncertainty.

Modifying Irrevocable Trusts

In the old days, practitioners explained to clients that “irrevocable” trusts were unchangeable. But over the years, several different approaches to modifying irrevocable trusts have become common. This has evolved to the point where estate planners routinely modify irrevocable trusts, although avoiding certain changes to minimize the risk of an unintended tax consequence. The approaches might include decanting, which is merging an existing or old trust into a new one with different terms. All those involved with a trust might agree to modify the trust contractually, under state law, in what’s called a non-judicial modification; a trust protector or powerholder may be able to effectuate certain changes; or a court may be asked to modify a trust agreement.

CCM Background

Here are the facts leading up to the CCM. A grantor established an irrevocable trust for the benefit of his child and descendants, but at the time, the child was the only beneficiary. The grantor retained certain grantor trust powers causing the income of the trust to be taxed to the grantor. An independent trustee was appointed with discretion to distribute income and principal to the beneficiaries.

The trust didn’t include a tax reimbursement clause, and applicable state law didn’t provide authority to the trustee to reimburse the grantor for taxes paid. Tax reimbursement can’t be mandated, or it would cause trust assets to be included in the settlor’s estate.

The trustee petitioned the state court to amend the trust to allow the trustee discretion to reimburse the grantor for the income tax liability, and the beneficiaries consented to the modification.

Was Gift Triggered?

The CCM determined whether the addition of a tax reimbursement clause triggered a gift.

The CCM noted the specific issue addressed:

What are the gift tax consequences to the beneficiaries when the trustee of an irrevocable trust, with respect to which the grantor is treated as the …, modifies the trust, with the beneficiaries’ consent, to add a tax reimbursement clause that provides the trustee the discretionary power to make distributions of income or principal from the trust in an amount sufficient to reimburse the grantor for the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income?

The CCM determined that the modification in this case constituted a gift by the beneficiaries to the grantor. The CCM expressly departed from the IRS’ previously articulated position in Private Letter Ruling 201647001 (Nov. 18, 2016) and distinguished a situation in which the tax reimbursement clause was included in the original instrument as addressed in Revenue Ruling 2004-64. The CCM also noted that the result would be the same if the state statute provided beneficiaries with a right to object to the modification, and they failed to do so.

Complications Abound

The IRS analysis is limited and creates more questions than answers. First, as the CCM acknowledges, the determination of the value of the gift in such a situation will be difficult to measure. The IRS argues that’s not a good enough reason to avoid gift tax, potentially arguing that the entire value of the property could be subject to gift tax if the interest isn’t susceptible to measurement. This almost certainly doesn’t seem like the correct result.

Low Precedential Value; But High Concerns

It’s important to note that CCM rank low on the IRS’ list of guidance. They’re issued to service personnel to administer their programs, have no precedential value and can’t be relied on by taxpayers. However, they do provide published insight into the Chief Counsel’s position on an issue, and publication often indicates that further guidance should be forthcoming.

The CCM might create a chilling effect on a host of potential transactions and modifications of irrevocable trusts. If there are adverse tax consequences in this case, practitioners now must be cautious that adverse tax consequences could exist in a variety of other situations as well involving decantings, non-judicial modifications, exercise of powers of appointments or actions by trust protectors.

Alternatively, perhaps the trustee in this case should have first decanted to a state that had an express provision authorizing tax reimbursement legislation. But would the IRS have argued that the move, if not objected to by the beneficiaries, also triggered a gift?

Take-Home Message

Even poorly reasoned guidance can be instructive in outlining the IRS’ evolving views. CCM 202352018 creates more questions than answers and potentially, but most significantly, signals that the carefree days of modifying irrevocable trusts require more caution and may not always be feasible. A take-home message for all practitioners is to spend more time evaluating planning options before an irrevocable trust is created to avoid future modifications.

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