When the grantor of a trust maintains certain powers with respect to the property that’s transferred in trust, that grantor will be treated as the owner of the trust property for income tax purposes and will remain responsible for income tax owed on that property. Intentionally maintaining such powers to create “grantor trusts” is a popular wealth transfer and estate planning technique, as income taxes paid by the grantor aren’t treated as further taxable gifts to the trust, effectively allowing the trust property to grow income tax free. Additionally, the grantor may engage in certain transactions with the trust that are disregarded for income tax purposes, which allows for the use of various effective tax planning strategies.
Grantor trusts aren’t always the right solution, and the use of them requires careful long-term cash flow planning. Given that the grantor is responsible for the taxes, large recognition events or the increasing value of property over time can result in a substantial tax bill the grantor may not wish, or may be unable, to cover. A variety of solutions exist to keep a grantor trust from impoverishing the grantor. Options can include “turning off” grantor trust status so the trust will be responsible for the liability, making a loan to the grantor, making a distribution to the grantor’s spouse, if that spouse is a permissible beneficiary and/or segregating just the asset(s) that will produce the unpalatable income tax liability for the grantor in a non-grantor trust. Another option that some practitioners’ use is permitting the trustees of a trust the discretion to reimburse the grantor for taxes incurred on behalf of the trust, however, a recent Chief Counsel Advice (CCA) may limit the ability to add these provisions in certain circumstances.
Overview of Tax Reimbursement Provisions
The use of tax reimbursement provisions, while common, isn’t without concern. Given these provisions grant the trustee the discretion to pay a liability of the grantor, Internal Revenue Code Section 2036(a)(1) could arguably be implicated, causing trust property to be included in the grantor’s gross estate. Revenue Ruling 2004-64 is the foundation for the use of tax reimbursement provisions in a grantor trust. (For a thorough overview of tax reimbursement provisions see: Jennifer E. Smith & Kristen A. Curatolo, “Grantor Trust Reimbursement Statutes.”)
Two relevant determinations were made in that ruling. First, when a trustee is required to reimburse the grantor for income taxes, whether by the trust instrument or local law, the trust property will be includible in the grantor’s estate under Section 2036(a)(1). Second, when the trustees are merely permitted to reimburse the grantor for such taxes, whether by the trust instrument or local law, that alone won’t cause trust property to be includible in the grantor’s estate.
It's important to note that while permissive tax reimbursement provisions alone won’t cause estate tax inclusion, the ruling explicitly states that “such discretion combined with other factors… may cause inclusion” in the grantor’s estate. So while Rev. Rul. 2004-64 gives some comfort in using a permissive tax reimbursement provision, concerns of the application of IRC Section 2036(a)(1) remain.
CCA Memorandum
Rev. Rul. 2004-64 addressed only the permissive power to reimburse taxes from the inception of the trust. On Dec. 29, 2023, the IRS released CCA 202352018, stating the current IRS position when a permissive tax reimbursement provision is added through modification of a trust with the consent of the beneficiaries (or their failure to object).
Specifically, the CCA outlines a fact pattern in which a grantor establishes a fully discretionary grantor trust for the grantor’s child and the child’s descendants with income distributable to the child during its life and to that child’s descendants per stirpes. Neither the trust provisions nor applicable state law permit the trustee to reimburse the grantor for taxes incurred on behalf of the trust. In a subsequent year, the trustee, with the consent of the child and the child’s issue, petitions the state court to modify the terms of the trust to grant the trustee the discretion to reimburse the grantor for taxes incurred.
Citing to Treasury Regulations Sections 25.2511-1(e) and 25.2511-2(b), as well as Robinette v. Helvering, 318 U.S. 184 (1943), the CCA holds that such a modification would be a gift from the child and the child’s issue. The IRS further indicates that the result would be the same if the modification was made pursuant to a state statute providing the beneficiaries with the right to notice and a right to object to the modification, if the beneficiaries fail to object.
Impact on Existing Guidance
This CCA distinguishes its reasoning from Rev. Rul. 2004-64 on the basis that the revenue ruling applied when the reimbursement provisions were provided for in the original instrument, while not addressing the expressed applicability of the ruling when reimbursement is permitted by local law. However, this new guidance is directly contrary to Private Letter Ruling 201647001 (Nov. 18, 2016), which concluded that a modification of a trust to allow for tax reimbursement provisions was “administrative in nature and will not result in a change in beneficial interests” in the trust, and that guidance was expressly overruled. The CCA acknowledges this change of position stating in a footnote that the conclusions in that PLR “no longer reflect the position of this office.”
More Questions than Answers
This CCA gives guidance only on a subset of fact patterns in which the ability to reimburse is created after the trust was established. It’s clear from the CCA that the IRS’ position is if the beneficiaries consent to a judicial modification to a trust creating a reimbursement right, then there’s a deemed gift from the beneficiaries to the grantor. However, that position only neatly works if all of the beneficiaries are adults with capacity. What if, under local law, the consent wasn’t given by the beneficiary but a designated or virtual representative. Under many state laws, these representatives (who may be other beneficiaries themselves) aren’t agents of the beneficiary they’re representing and don’t necessarily owe a fiduciary duty to that beneficiary. If a judicial modification is done with the consent of the representative can the beneficiaries be deemed to have made a taxable gift?
There’s also the question of what must be done to “object to a modification” so that a beneficiary isn’t deemed to have made a gift. A beneficiary may not be able, due to age, capacity or resources, to make a decision on whether to consent, stay silent or object to a modification proceeding. In states that have enacted the Uniform Trust Code’s provision on modification, a court may still approve a modification if a beneficiary objects, provided certain factors are met (Uniform Trust Code Section 411(e) (2023)). What’s the result if only some beneficiaries object (whether vigorously or nominally in hopes of avoiding the new deemed gift treatment)? Are only the consenting and silent beneficiaries treated as making the gift? Presumably not, as donative intent isn’t relevant to whether there was a gift and the impact of the modification to the beneficiaries is the same.
The CCA is also silent on other mechanisms to add reimbursement provisions. For example, a trust that doesn’t explicitly permit or prohibit reimbursement provisions and is moved from a state that has no statute to a state that has a statute that permits reimbursements. If the beneficiaries provide consent to the change of situs that in turn creates a state law permissible power to reimburse the grantor, can that too be deemed as a gift even if the reason for the move had nothing to do with grantor trust reimbursement provisions? A conservative view of this CCA would suggest that a gift may be triggered in this situation and not just in a judicial modification, as outlined in the CCA.
Further, even in a situation in which beneficiary notice is required, it’s fair to wonder whether approving a release or a trust accounting covering a modification would be sufficient action on the part of the beneficiaries to raise concerns about a potential gift. This wouldn’t implicate just form of transfer, but also the timing of the deemed gift. A trustee could use a power of amendment under the trust or a decanting power (that doesn’t require advance consent) to have the property be held by a trust that contains a reimbursement provision. If a trustee decants the trust in 2024, provides an accounting of that action late in 2025, receives some beneficiary consents in 2025 and receives no response from other beneficiaries but a court approves the accounting which becomes non-appealable in 2026—when did the deemed gift occur? Is the answer different for different beneficiaries?
One of the most difficult questions is the valuation of the deemed gift. The CCA notes that the gift of a portion of the beneficiaries’ interests in the trust should be valued in accordance with the “general rule for valuing interests.” The obvious question that this begs is what’s the value of a gift of the right to receive reimbursement at the discretion of a trustee? The CCA states in a footnote that the transfer “cannot escape gift tax on the basis that the value of the gift is difficult to calculate” and references Treas. Regs. Section 25.2511-(e), noting that if the retained interest is “not susceptible of measurement on the basis of generally accepted valuation principles, the gift tax is applicable to the entire value of the property subject to the gift.” When followed to its extreme, this logic may lead to inequitable results. Could a purely discretionary ability to receive reimbursement limited to taxes incurred on trust property lead to a gift of the entire value of the trust property from beneficiaries who themselves can only access the trust property at the discretion of the trustee?
Further, in the valuation exercise, what credit do we give for the consideration to the trust? The grantor is well within their rights to relinquish rights to make a trust non-grantor, and neither the trustee nor beneficiaries can stop the grantor under the terms of the trust or state law. However, a permissible power to reimburse the grantor may entice the grantor not convert the trust to a non-grantor trust because of one exceptional year. Should the potential benefit of continued grantor trust treatment not be considered in the valuation?
Planning Considerations
The CCA raises the risk of unintended tax consequences when adding reimbursement provisions. This reinforces the need for practitioners to work with clients on cash flow issues that may occur with grantor trusts at the time the trusts are set up, as opposed to when the tax payments become excessively burdensome. The CCA highlights the concerns of using grantor trust reimbursement provisions, especially for those relying on the guidance in Rev. Rul. 2004-64. Exercise caution when relying on IRS guidance. It is much easier to change, requiring less process and administrative effort than more binding authority, so relying on such authority may be upended as easily as the IRS stating in a footnote that the positions held in prior guidance “no longer reflect the position of this office.”