The benefits of creating a trust that qualifies for grantor trust status can be enticing—for both the beneficiaries and the trustor. Because grantor trust status means the trustor will be responsible for payment of the income tax liability associated with the trust during the trustor’s lifetime, the beneficiaries are relieved of the tax burden, and the growth of trust property is enhanced. The payment of the trust’s income taxes reduces the trustor’s estate, and, because the tax payment by the trustor isn’t considered a gift, it doesn’t require any additional allocation of the trustor’s unified lifetime gift and estate exemption or generation-skipping transfer tax exemption.
But what happens when a client has a case of the grantor trust tax payment blues? The new trend among jurisdictions is to offer trustors an out by way of legislation that expressly authorizes reimbursement of taxes paid by the trustor from the trust. Furthermore, some jurisdictions have also enacted statutes stating the inclusion of the reimbursement power in an irrevocable trust won’t make the trust’s assets subject to the claims of the trustor’s creditors.
Some of you might be thinking that’s great news for trustors in states where these reimbursement statutes have been enacted, but what do those not fortunate enough to have such legislation do? Luckily, the option to migrate or decant a trust to a jurisdiction with a reimbursement statute and other options to “fix” a trust to get the desired result exist.
New State Legislation
In 2020, Connecticut and Florida joined the ranks of Colorado, Delaware, New Hampshire and New York to enact laws that expressly authorize reimbursement of taxes paid by the trustor from the trust. Let’s explore these most recent additions.
Connecticut. This state’s reimbursement statute became effective Jan. 1, 2020. The focus of the Connecticut statute is creditor protection, one of the factors set forth in Revenue Ruling 2004-64. (By way of background, Rev. Rul. 2004-64 is the muse that inspired grantor trust reimbursement legislation.) Notably, the statute doesn’t permit reimbursement unless the trust agreement or “any other provision of law” authorizes such reimbursement. This statute, therefore, doesn’t serve as an independent basis on which reimbursement can be sought. In addition, the statute is silent with respect to other Rev. Rul. 2004-64 factors such as whether there’s an implied or express agreement to reimburse the trustor or if the trustor holds the power to remove and replace the trustee with themself or someone who’s related or subordinate under IRC Section 672(c), a violation of which could cause estate tax inclusion.
Florida. This state’s reimbursement statute became effective July 1, 2020. The Florida statute is similar to Delaware’s statute in many respects and provides that a trustee of a grantor trust may reimburse or pay the trustor’s income tax liability related to the trust, provided that the trust agreement doesn’t prohibit such actions. Reimbursement may be made only if the trustee isn’t a beneficiary of the trust or an individual who’s related or subordinate to the trustor under Section 672(c).
Similar to Delaware’s statute, the Florida statute also specifies that a life insurance policy, the cash value of the policy or proceeds from a loan made against the policy may not be used for the reimbursement of income taxes if the trustor is the insured. Recognizing that a fiduciary other than the trustee may be responsible for directing distributions from the trust, the Florida statute provides (again, like Delaware’s statute) that if the trust agreement requires the trustee to act on the direction of an advisor, trust protector or other person, or if the reimbursement power is exercisable only by an advisor, trust protector or other person, then the powers granted to the trustee under the statute must also or instead be granted to that person, subject to the same criteria applicable to the trustee. Additionally, the statute provides that a person won’t be considered a beneficiary of the trust solely due to the application of the reimbursement or payment provision under the statute, including for purposes of determining the elective estate under Florida law.
Delaware. Although the state’s reimbursement statute isn’t new, a proposed 2021 amendment would notably expand the types of income tax liabilities reimbursable by the trustee and provide further exceptions to the statute’s application when it would negatively affect tax deductions.
Moving or Modifying Trusts as an Alternative Solution
It’s possible to move or modify a trust to get the benefits of a reimbursement statute—an option for a client who, for example, created an irrevocable trust in a jurisdiction that doesn’t allow the trustee to reimburse the trustor for income taxes paid.
Migrating to a favorable jurisdiction. Review the trust agreement to see if the governing law or situs of the trust may be changed. If the governing instrument allows the situs of the trust to be changed, it may be possible to appoint a trustee (or an administrative trustee) in the favorable jurisdiction to avail the trust of that jurisdiction’s trust laws.
Decanting a trust in the wrong place to a trust in the right one. It may be possible to decant a trust that was established in one state into a new trust established in a different state (if the state where the trust was established has a decanting statute). However, consider the state income tax consequences of such transfer.
Amending the trust. Consider whether the trust may be amended under state law.
Non-judicial settlement agreement. Consider whether the trust’s governing law and/or situs may be changed to a favorable jurisdiction pursuant to a non-judicial settlement agreement. Non-judicial settlement agreements are permitted under the Uniform Trust Code. Under a non-judicial settlement agreement, the parties interested in the trust agreement may agree to transfer of a trust’s principal place of administration or to change the law governing administration of the trust to a state authorizing reimbursement of the trustor’s income taxes.
*This article is an abbreviated summary of “Grantor Trust Reimbursement Statutes,” which originally appeared in the February 2021 issue of Trusts & Estates.