A new IRS legal memorandum concludes that modifying a grantor trust to add a tax reimbursement clause constitutes a taxable gift by the trust beneficiaries to the grantor — a reversal of the agency’s position in a 2016 letter ruling.
The IRS’s conclusion in ILM 202352018, dated November 28, 2023, and released December 29, will likely come as a big surprise to most tax professionals who work in the estate and gift tax space, Justin Miller of Evercore Wealth Management LLC told Tax Notes.
That’s because the new memo essentially revokes the position the IRS took in a 2016 letter ruling (LTR 201647001), Miller said. In that ruling, the IRS concluded that modifying a grantor trust to add a tax reimbursement clause — that is, giving the trustee discretionary power to reimburse the grantor for paying income tax on the income earned by the trust — was “administrative in nature” and wouldn’t cause the trust property to be included in either the grantor’s or the beneficiaries’ gross estates.
The IRS said in the 2016 letter ruling that modification of the trust to include a tax reimbursement clause was permissible under Rev. Rul. 2004-64, 2004-2 C.B. 7. In that 2004 revenue ruling, the IRS said that if a trust’s governing instrument gives the trustee the discretion to reimburse the grantor for paying income tax on the trust income, the existence of that discretion — whether exercised or not — wouldn’t cause the value of the trust’s assets to be includable in the grantor’s gross estate.
According to Miller, because of Rev. Rul. 2004-64 and LTR 201647001, most tax professionals believed it didn’t matter whether a tax reimbursement clause was included in the original trust document or was added later by modification, as long as the trustee was independent and there was no preexisting arrangement between the trustee and the grantor.
But in the new legal memorandum, the IRS is saying that having a tax reimbursement clause in the original trust document (as in Rev. Rul. 2004-64) is OK, but adding one later by modification (as in LTR 201647001) will result in adverse tax consequences, Miller said.
“The IRS has not only revoked its position in the 2016 letter ruling, it has limited the 2004 revenue ruling and arguably gone against the spirit of it as well,” Miller said.
New IRS Position
The new memorandum addresses a situation in which A (the grantor) in year 1 established and funded an irrevocable inter vivos trust for the benefit of A’s child and the child’s descendants (the beneficiaries). The current trustee satisfies the governing instrument’s requirement that the trustee be a person not related to or subordinate to A within the meaning of section 672(c).
Because A retains a power under the trust’s governing instrument that causes him or her to be the trust’s deemed owner under section 671, all items of income, deductions, and credits attributable to the trust are included in A’s taxable income, the memo states. It adds that neither state law nor the trust’s governing instrument requires or provides authority to a trustee to distribute to A amounts sufficient to satisfy A’s income tax liability attributable to including the trust’s income in taxable income.
In year 2, the trustee petitions the state court to modify the terms of the trust, to which the beneficiaries consent under state law. Later that year, the state court grants the petition and issues an order modifying the trust to provide the trustee the discretionary power to reimburse A for any income taxes A pays as a result of including the trust’s income in A’s taxable income.
The memo states that under the trust’s governing instrument, each beneficiary (A’s child and his or her issue) has an interest in the trust property. It concludes that as a result of the year 2 modification of the trust, A acquires a beneficial interest in the trust property because A is now entitled to discretionary distributions of income or principal from the trust in an amount sufficient to reimburse A for any taxes he or she pays as a result of including the trust’s income in their gross taxable income.
“In substance, the modification constitutes a transfer by Child and Child’s issue for the benefit of A,” the memo says.
The IRS says the situation is distinguishable from the facts in Rev. Rul. 2004-64 because the tax reimbursement provision in that revenue ruling was in the original governing instrument.
“Thus, as a result of the Year 2 modification, Child and Child’s issue each have made a gift of a portion of their respective interest in income and/or principal,” the new memo says. In a footnote, the IRS said that its conclusions in LTR 201647001 “no longer reflect the position of this office.”
The memo states that the result would be the same if the modification was made under a state statute that provides beneficiaries with a right to notice and a right to object to the modification and a beneficiary fails to exercise their right to object.
The memo further states that “the gift from Child and Child’s issue of a portion of their interests in trust should be valued in accordance with the general rule for valuing interests in property for gift tax purposes in accordance with the regulations under section 2512 and any other relevant valuation principles under subtitle B of the Code.”
Thorny Questions
David A. Handler of Kirkland & Ellis LLP told Tax Notes that grantors are frequently concerned about not having sufficient assets to pay the income taxes resulting from the grantor trust’s income.
“Lawyers should always advise clients of this risk and build in options to mitigate this issue, such as including a spouse as a beneficiary or building in the ability to convert it to a non-grantor trust,” Handler said.
While the IRS concluded in Rev. Rul. 2004-64 that a tax reimbursement clause won’t cause the assets to be included in the grantor’s estate — unless there is an express or implied understanding that the grantor will be reimbursed when needed or requested — Handler said that “actual use of such a power carries the risk that the IRS would make such an argument that a gift has occurred, and should be used sparingly and with caution.”
Thomas H. Norelli, also with Kirkland & Ellis, said there will be several thorny questions to answer because of the memo’s conclusion that a tax reimbursement power is considered a gift by the trust beneficiaries if it is added to an existing trust.
“How would the amount of such a gift be measured, especially if no current reimbursement is made?” Norelli asked. “The trustee merely has the power to reimburse, which may or may not be exercised in the future based on uncertain amounts of income or other circumstances in the future. This seems too uncertain to give rise to a current taxable gift. And the 2004 revenue ruling states that actual exercise of the trustee’s power to reimburse the grantor is not a gift either.”
Handler added that the memo seems to say that for the reimbursement power to constitute a taxable gift, it couldn’t be added without the agreement, acquiescence, or non-objection of the beneficiaries. “If the trust agreement gives another person the power to grant the reimbursement power to the trustee without agreement, acquiescence, or non-objection of the beneficiaries, arguably there should be no gift under this” memorandum, he said.