• Internal Revenue Service Chief Counsel issues guidance on gift tax consequences of adding a tax reimbursement clause with beneficiaries’ consent—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 that case, 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 Memorandum (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?
• U.S. Supreme Court to resolve split over estate tax valuation—The Supreme Court has agreed to consider a dispute regarding the valuation of a closely held business for estate tax purposes when the company received life insurance proceeds to redeem a deceased shareholder’s stock.
In Connelly v. IRS, No. 21-3683 (8th Cir. 2023), brothers Michael and Thomas Connelly owned a Missouri corporation . The corporation obtained life insurance on each brother so that the corporation could use the insurance proceeds to redeem the shares of a brother on his death. Following Michael’s death, the business used $3 million in life insurance proceeds to redeem his shares. The estate tax return valued Michael’s stock at $3 million. The IRS disagreed, arguing that the fair market value of the company must be increased by the amount of the life insurance proceeds and valuing Michael’s shares at $5.3 million. Michael’s estate took the position that the life insurance proceeds don’t add value to the company because that value was immediately offset by the company’s obligation to redeem. The U.S. Court of Appeals for the Eighth Circuit held in favor of the IRS, likening the use of the insurance proceeds to redeem shares to “moving money from one pocket to another” and noting that such proceeds increased the value of the remaining shareholder’s equity.
The Eighth Circuit case created a potential split with other circuits, including the Eleventh Circuit, which held in Estate of Blount v. Commissioner, 428 F.3d 1338 (2005) that a closely held business’ obligation to redeem shares offsets the life insurance proceeds used in that redemption. The Supreme Court’s decision to accept review may resolve the current split among the circuits.
• Revenue Procedure provides new options for tax-exempt organization registration—Rev. Proc. 2024-5 is the expected annual update that the IRS issues each year regarding procedures for issuing exempt organization (EO) determination letters.
New this year, the IRS may now issue EO determination letters to tax-exempt organizations seeking to change the paragraph under which they qualify for tax-exempt status. This applies to organizations currently recognized as described in IRC Section 501(c)(3) that seek recognition as described in a different paragraph of Section 501(c). Previously, the IRS wouldn’t issue a determination under this circumstance.
If an organization wants to be recognized as tax exempt under a different category described in Section 501(c)(3), it must:
Show that it distributed its assets to another Section 501(c)(3) organization or government entity; and
Demonstrate that it meets the requirements for the Section 501(c) status in the new category.
The new determination letter will be effective as of the submission date of the application.