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Adding a Tax Reimbursement Clause with Beneficiaries’ Consent

The Internal Revenue Service issues new guidance on whether it’s a taxable gift.

On Dec. 29, 2023, the IRS Chief Counsel’s Office released Memorandum 202352018 stating its position that the modification of a trust to add a tax reimbursement clause could constitute a taxable gift.

In the case at issue, the grantor established an irrevocable trust for the benefit of his child and further descendants. The trust was structured as a grantor trust so all trust income was taxable to the grantor. Neither state law nor the trust mandated or authorized the trustee to reimburse the grantor for such income tax liability attributable to the trust. The trustee petitioned for a modification of the trust terms to provide the trustee with discretionary power to distribute income and principal to reimburse the grantor for income tax liability attributable to the trust. The beneficiaries consented to the modification pursuant to state law, and the court approved it.

The IRS ruled that the modification gave the grantor a beneficial interest in the trust. Under prior rulings (notably Revenue Ruling 2004-64), the trust instrument could mandate reimbursement of the grantor or give the trustee discretionary authority to reimburse the grantor without creating a gift by the beneficiaries. There’s no gift in these scenarios outlined in Rev. Rul. 2004-64 because the reimbursements are being made pursuant to the original terms of the trust. However, here, the beneficiaries consented to a modification. The modification was a relinquishment of a portion of the beneficiaries’ interest in the trust and therefore was a gift to the grantor. The ruling noted the same result would apply if the state law gave the beneficiaries a right to object to the modification, and they failed to do so.

This Chief Counsel Memo (CCM) leaves open several issues. First, how is the gift measured? How can one predict the amount of future gains, losses and income that will be realized by a trust, let alone how much of the tax will be reimbursed to the grantor in the trustee’s discretion? Citing Treasury Regulations Section 25.2511-1(e), the CCM states if the donor’s retained interest isn’t 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. Does this mean the gift is the full value of the trust? Even if it isn’t, would Internal Revenue Code Section 2702 apply to treat it as a gift of the entire trust value?

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