BEWARE OF POTENTIAL NEW TAX CONSEQUENCES

WHEN MODIFYING GRANTOR TRUSTS TO INCLUDE

TAX REIMBURSEMENT PROVISIONS

February 27, 2024

On December 29, 2023, the IRS released a memorandum dated November 28, 2023 (the “Memo”) which can be found here, discussing the implications of modifying or amending an irrevocable grantor trust to include a tax reimbursement clause that grants the trustee discretionary power to make distributions of trust income or principal to reimburse the grantor for tax attributable to the inclusion of the trust’s income in the grantor’s taxable income.

A trust is classified as either a grantor trust or a non-grantor trust for Federal income tax purposes. When a trust is classified as a grantor trust, the grantor is typically seen as the owner of the trust assets and the trust is disregarded for income tax purposes. Consequently, the grantor of a grantor trust pays income taxes on any income and gain earned by the trust assets. For this reason, a grantor trust may include provisions which would allow the trustee to have discretion in reimbursing the grantor for paying such income taxes (the “tax reimbursement clause”).

The IRS has found that if the trust agreement provides the trustee with such discretion to reimburse the grantor for the income taxes, the discretion itself does not cause the trust assets to be includable in the grantor’s gross estate for Federal estate tax purposes. However, according to this newest Memo, modifying an existing trust to add such a tax reimbursement clause it would cause the trust assets to be includable in the grantor’s gross estate.

For illustrative purposes, the facts of the Memo provide as follows:

• In year 1, A (the grantor) establishes and funds an irrevocable grantor trust for the benefit of A’s child and the child’s descendants (the beneficiaries).
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• The Trustee is not related to or subordinate to A within the meaning of Section 672(c) of the Internal Revenue Code.
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• Neither the trust agreement nor State law provides for tax reimbursement to the grantor.
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• In year 2, the trustee petitions the State Court to modify the trust agreement to include a tax reimbursement clause with the consent of the beneficiaries pursuant to State law.

Under the above fact scenario, the IRS concluded that the modification of the trust in year 2 is a taxable gift by the beneficiaries to the grantor because the addition of the tax reimbursement clause is a relinquishment of a portion of the beneficiaries’ interest in the trust. The IRS goes on to say that the result would be the same if the modification was pursuant to a State statute that provides the beneficiaries with a right to notice and a right to object to the modification, and the beneficiaries failed to exercise their right to object. The gift should thus be valued in accordance with the general rules for valuing interests in property for gift tax purposes.

If you are considering modifying a trust, this Memo could have impact on your desired planning and related goals and should be considered before proceeding. As rulings and regulations change over the years, it is important to review your existing estate planning documents and keep them up to date and consistent with the current law as well as your current life circumstances. Our Trusts & Estates attorneys at Pashman Stein Walder Hayden P.C. are available to assist you with such needs.

Learn more about our Trust & Estates and Elder Law & Special Needs Planning Practices.

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