“CCA 202352018 seems curious. Given the identities of the IRS Area Counsel to whom the CCA was issued, both significant, experienced IRS litigators, we strongly suspect this involves potentially more than one pending audit, and perhaps some rethinking in related areas of trust modifications – not just grantor income tax reimbursement clauses.”

 

Paul Hood and Ed Morrow provide members with commentary on CCA 202352018.

Members who wish to learn more about this topic should consider joining Paul and Ed for their exclusive 3-part LISI Webinar titled: Trust Modifications, Terminations, and Decantings: State and Tax Law Ramifications Morrow/Hood LISI Three-Part Webinar Series - Part 1 of a 3 Part Series. Click this link to learn more or to register: Paul/Ed

A native of Louisiana (and a double LSU Tiger), Paul Hood obtained his undergraduate and law degrees from Louisiana State University and an LL.M. in taxation from Georgetown University Law Center before settling down to practice tax and estate planning law in the New Orleans area. Paul has taught at the University of New Orleans, Northeastern University, The University of Toledo College of Law and Ohio Northern University Pettit College of Law. Paul has authored or co-authored nine books, including his most recent book, Yours, Mine & Ours: Estate Planning for People in Blended or Stepfamilies and hundreds of professional articles on estate and tax planning and business valuation. He can be contacted at paul@paulhoodservices.com.  

Edwin P. Morrow III, J.D., LL.M. (Tax), CFP®, CM&AA®, is a board-certified specialist in estate planning and trust law through the Ohio State Bar Association and a Fellow of the American College of Trust and Estate Counsel (ACTEC).  He is a wealth strategist for Huntington National Bank and can be reached at edwin.morrow@huntington.com. Ed is also a co-author with Paul Hood and the late Steve Leimberg of The Tools & Techniques of Estate Planning 21st Ed. 

Here is their commentary:

 

EXECUTIVE SUMMARY:

 

In Chief Counsel Advice (CCA) 202352018, the IRS ruled that if the beneficiary of an irrevocable grantor trust consented to an amendment to the trust instrument via a state court modification giving the trustee a discretionary power to reimburse the settlor/grantor for income tax payable on the trust’s income, the beneficiary made a taxable gift by merely consenting to add such terms to the grantor trust.

 

FACTS:

 

In this newsletter, long-time LISI teammates and frequent co-authors/presenters Ed Morrow and Paul Hood first discuss the recent, curious CCA 202352018 and then consider the broader issue of the efficacy vel non of giving a trustee a discretionary power to “reimburse” the settlor/grantor of an irrevocable grantor trust for the income taxes that the settlor/grantor paid on the trust’s income, and the broader implications of the CCA in other contexts.

 

On November 28, 2023, in CCA 202352018, the IRS National Office, via Holly Porter, Associate Chief Counsel (Passthroughs & Special Industries) to two IRS Associate Area Counsel in Austin TX and Portland OR, issued CCA 202352018, regarding the later addition of a grantor income tax “reimbursement” clause to a pre-existing irrevocable grantor trust via state court modification action.

 

In Year 1, A establishes and funds Trust, an irrevocable inter vivos trust, for the benefit of A’s Child and Child’s descendants. Trustee is the current trustee of Trust and satisfies the governing instrument requirement that a trustee of Trust must be a person not related or subordinate to A within the meaning of § 672(c) of the Code. Under the governing instrument of Trust, a trustee of Trust may distribute income and principal to or for the benefit of Child in the trustee’s absolute discretion. Upon Child’s death, Trust’s remainder is to be distributed to Child’s issue, per stirpes. Under the governing instrument of Trust, A retains a power that causes A to be the deemed owner of Trust under § 671 of the Code, and, accordingly, all items of income, deductions, and credits attributable to Trust are included in A’s taxable income.

…

Neither State law nor the governing instrument of Trust requires or provides authority to a trustee of Trust to distribute to A amounts sufficient to satisfy A’s income tax liability attributable to the inclusion of Trust’s income in A’s taxable income.

 

In Year 2, when Child has no living grandchildren or more remote descendants, Trustee petitions State Court to modify the terms of Trust. Pursuant to State Statute, Child and Child’s issue consent to the modification. Later that year, State Court grants the petition and issues an Order modifying Trust to provide a trustee of Trust the discretionary power to reimburse A for any income taxes A pays as a result of the inclusion of Trust’s income in A’s taxable income. [emphasis added]

 

The CCA concluded:

 

In substance, the modification constitutes a transfer by Child and Child’s issue for the benefit of A [the grantor]. This is distinguishable from the situations in Rev. Rul. 2004-64 where the original governing instrument provided for a mandatory or discretionary right to reimbursement for the grantor’s payment of the income tax. Thus, as a result of the Year 2 modification [adding the reimbursement power], Child and Child’s issue each have made a gift of a portion of their respective interest in income and/or principal.¹ See § 25.2511-1(e) and § 25.2511-2(b). [emphasis added]

 

Footnote 1 from the immediately preceding quote states:

 

PLR 201647001 concludes that the modification of a trust to add a discretionary trustee power to reimburse the grantor for the income tax paid attributable to the trust income is administrative in nature and does not result in a change of beneficial interests in the trust. These conclusions no longer reflect the position of this office. [emphasis added]

 

In CCA 202352018, the IRA National Office further concluded:

 

As a result of the Year 2 modification of Trust, A [the settlor] acquires a beneficial interest in the trust property in that A becomes entitled to discretionary distributions of income or principal from Trust in an amount sufficient to reimburse A for any taxes A pays as a result of inclusion of Trust’s income in A’s gross taxable income. In substance, the modification constitutes a transfer by Child and Child’s issue for the benefit of A. [emphasis added]

 

COMMENT:

 

At the outset, we believe that CCA 202352018 is wrong about the finding of a gift by the consenting trust beneficiary on judicial modification of the trust instrument, even though the IRS has some authority for the general proposition that consent to a modification that reduces the value of one’s interest may be a taxable gift. But we’re going to use the occasion of the issuance of CCA 202352018 to further address the issues attendant to the trustee’s discretionary power to “reimburse” the settlor/grantor for the income tax on the trust’s income that the settlor/grantor legally owes by virtue of the grantor trust rules contained in Subpart E of Subchapter J of the Internal Revenue Code of 1986.

 

Efficacy/Wisdom of Including a Discretionary “Reimbursement” Right. The more that we think about clauses authorizing a trustee discretion to “reimburse” the settlor/grantor for the income tax that the settlor/grantor legally owed by virtue of application of the income tax grantor trust rules, the more we are reticent about advising to ever include such discretion.

 

The Merriam-Webster Dictionary defines “reimburse,” a transitive verb and the root word of “reimbursement,” as follows:

 

1. to pay back to someone: REPAY. 2. to make restoration or payment of an equivalent to.

 

Reimbursements are usually made when one expends funds for the benefit of another that are the responsibility of the latter. In the case of “reimbursement” of the settlor/grantor’s income tax paid on the trust’s income, Subpart E of Subchapter J makes the income tax on the trust’s income the legal obligation of the settlor/grantor, a result that the settlor/grantor usually intentionally wants, at least initially.

 

Setting aside the caveats in Rev. Rul. 2004-64 about expressed or implied understandings (the pesky problem of having to prove a negative, i.e., absence of a prearranged plan), we question the very basis for a fiduciary to exercise discretion to distribute money that belongs to the beneficiaries to someone to "reimburse" the settlor/grantor for taxes that the settlor/grantor legally owed. On what basis is such discretion exercised or withheld? We directly address that question in the next section below.

 

In our opinion, absent rare, unique reasons to “reimburse” the settlor/grantor, i.e., a settlor/grantor’s threat to cease grantor trust status (assuming such ability exists), a trustee’s exercise of the “reimbursement” power should be used very sparingly. Many conservative attorneys advise against it altogether (even if they’re perfectly okay with grantors controlling their own payment/reimbursement of state income tax by making a state PTE tax election).[1]  If the grantor threatens to turn off grantor trust status (and can), this gives the trustee ample cover to justify a discretionary distribution to pay/reimburse a grantor’s income taxes, but doesn’t a quid pro quo simply invite the IRS to claim there is a binding contract and consideration received on both sides, which may give them cover to argue that there is a taxable exchange for IRC 1001 purposes?

 

We’ve not seen anyone suggest this, but why shouldn’t the trustee be expressly authorized to loan the settlor/grantor the tax money? While this probably could be handled pursuant to the trustee’s general lending authority under the trust instrument, why not spell it out specifically, no differently than most ILITs that provide for lending to estates for liquidity to pay estate taxes?

 

If the grantor merely has a short-term cash flow need, a swap or substitution power can be used (which would not even require an active decision by the trustee since this non-fiduciary power of the grantor is commonly added as a trigger for IRC § 675(4)). That or a short-term bona fide loan would solve the quandary just as easily as an outright distribution, and both of these solutions would be much more estate tax efficient than adding to the grantor’s estate and depleting trust assets (assuming the grantor may have a taxable estate). 

 

If the grantor has a more permanent and long-term prognosis and/or desire not to pay the income taxes, then the settlor should just release any power causing grantor trust status altogether (or pay back loans or remove a related/subordinate trustee or other situation causing it).  This has less risk of later triggering estate inclusion under an implied agreement or arrangement as threatened in Rev. Rul. 2004-64.  Of course, this ability to simply turn off grantor trust status may not necessarily be available for certain situations such as a SLAT if the spouses are no longer getting along and a floating spouse provision has not removed the spouse as beneficiary upon divorce (in which case, the SLAT might require adverse party consent for any distributions to the donee-spouse upon divorce filing to avoid IRC Section 677(a) from applying).

 

Alternatives to a Discretionary ”Reimbursement” Power. Many estate planning commentators, us included, have touted the benefits of the so-called “burn” of income tax grantor trusts, i.e., the settlor/grantor’s assumption of the income tax on the trust’s income (what Professor Jeff Pennell used to call “Dad buys dinner”), with its estate reduction effects but without gift tax consequences due to the grantor trust rules contained in Subpart E of Subchapter J of the Internal Revenue Code of 1986, as amended, which the Treasury Department confirmed in Rev. Rul. 2004-64.

 

But, sometimes, the “burn” can actually singe the settlor/grantor’s finances, which in turn can cause heartburn to the estate planner who put the client into a grantor trust without considering Stephen Covey’s Second Habit of his Seven Habits of Highly Successful People, i.e., “Begin with the end in mind,” such that there was no exit strategy considered or built in. Of course, there’s no way out of grantor trust status for some income tax grantor trusts, e.g., SLATs and certain “IRC Section 678 trusts,” e.g., BDITs, etc. For more, see Kristen A. Curatolo and Jennifer E. Smith, “Strategies for Mitigating the ‘Burn’ of Grantor Trust Status,” 48 Tax Management Estates, Gifts, and Trusts Journal, No. 3 (May 11, 2023).

 

To understand how onerous grantor trust responsibility can get for a settlor/grantor, consider a case that we’ve each written about and discussed several times, Millstein v. Millstein, 2018-Ohio-2295 (OH App. 8^th Cir. 2018), where the settlor/grantor was responsible for $5,225,837 in state and federal tax for that trust in 2013 (and more for another trust).

 

The trust had been a grantor trust for approximately 20 years, and the settlor/grantor had been “reimbursed” from another trust until it ran out of liquidity. When the trustee of the subject grantor trust, one of his sons, declined the settlor/grantor’s request for “reimbursement” of the significant income tax, the settlor/grantor asked the court to order “reimbursement,” but the Ohio trial court and court of appeal ruled against the settlor/grantor.

 

Query: What are some alternatives to a discretionary “reimbursement” power:

 

•       Toggle off grantor trust status/automatic termination.
•       Loans (discussed elsewhere herein).
•       Using powers of substitution (a.k.a. “swap powers”) or simply selling illiquid assets to the trust for cash of equal value
•       Making doubly sure that the grantor retains sufficient liquid assets to pay the income tax as the settlor/grantor trust (hard to predict).
•       Lifetime powers of appointment.

 

Problems with Beneficiary-Trustees. If the beneficiary also is also a trustee (which is not uncommon), the trustee/beneficiary has probably made a taxable gift by “reimbursing” the settlor/grantor – and this proposition has regulatory authority for it! In Treas. Reg. Sec. 25.2511-1(g)(2), the regulations conclude that a trustee/beneficiary who makes distributions to other beneficiaries pursuant to ascertainable standards has not made a taxable gift, but of course the converse of that conclusion is that a trustee/beneficiary who makes distributions to another pursuant to a purely discretionary standard has made a taxable gift.  Your typical trustee “reimbursement” clause discussed in Rev. Rul. 2004-64 and included in many trusts (and all of the various state statutes that permit such payments) are discretionary, not subject to ascertainable standards, although some trusts forbid a related/subordinate party to the settlor/grantor (who are usually, but not always, the same people who are beneficiaries) from making such a payment. Therefore, many payments/”reimbursements” for the settlor/grantor done by beneficiary/trustees are already taxable gifts, with clear authority for that conclusion.  Check your trust instrument for clauses that address this issue, even if the trust instrument does not provide for “reimbursement,” since there are several state statutes that permit “reimbursement” without need for a clause in the trust, and none of these state statutes prohibit a beneficiary/trustee from making the “reimbursement.[2]”

 

Timing and Value of Any Such Gift. CCA 202352018 concluded that the single beneficiary who consented to the judicial modification had made a gift to the settlor/grantor on judicial modification.

 

But what would the result have been had the trust had more than one beneficiary? If there were more than one beneficiary, under the IRS’s theory in the CCA, might the situation possibly involve transfers not only from the beneficiaries to the settlor/grantor, but possibly some gifts between the trust beneficiaries, which would throw significant metaphysical complexity into the situation.

 

Given the IRS’s avoidance of many issues in CCA 202352018, color us unsurprised that the IRS National Office stuck with a trust that had only one beneficiary. But make no mistake: the existence of more than one beneficiary potentially significantly complicates the situation, both in the gift determinations and the associated valuation of said gifts.

 

Beneficiary exercises of lifetime powers of appointment can cause taxable gifts to the extent that the value of their interest is depleted.[3]  However, how can anyone argue that the beneficiary’s interest is worth less after a discretionary reimbursement clause is added?  It may be worth more if the settlor/grantor can simply turn off grantor trust status, because now there is much less incentive for the settlor/grantor to turn grantor trust status off, a prospect which would severely devalue the beneficiary’s interest to a much greater extent.  However, there may be an argument it is worth slightly less if the settlor/grantor cannot turn grantor trust status off.

 

Query: what if a trustee was granted the discretionary reimbursement authority by passage of a state law such as the one recently passed in Florida wherein trustees were granted the discretionary “reimbursement” power unless the the trustee elects out?[4]  If the trustee was also a beneficiary who failed to object, isn’t this similar to the situation of beneficiary acquiescence in CCA 202352018?  Would the IRS even try to stretch this concept further to include beneficiaries who did not object to the trustee not electing out of the new statute applying?  It’s doubtful the IRS would run out the reasoning in the CCA to such outlandish conclusions, but it's not impossible to rule out.

 

Valuation and Timing of Any Such Gift. What is the value of the alleged gift by the trust beneficiary to the settlor/grantor, if any? CCA 202352018 concluded:

 

The measure of the gift is the value of the interest passing from the donor with respect to which they have relinquished their rights without full and adequate consideration in money or money’s worth. [emphasis added]

 

As to the value of any such gift, the IRS National Office essentially punted, saying:

 

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 § 2512 and any other relevant valuation principles under subtitle B of the Code.²

 

Footnote 2 from the immediately preceding quote states:

 

Although the determination of the values of the gifts requires complex calculations, Child and Child’s issue cannot escape gift tax on the basis that the value of the gift is difficult to calculate. See Smith v. Shaughnessy, 318 U.S. 176, 180 (1943) (“The language of the gift tax statute, ’property . . . real or personal, tangible or intangible,’ is broad enough to include property, however conceptual or contingent.”) [emphasis added]

 

The ”complex calculations” statement in Footnote 2 annihilates the “general rule” comment in the CCA sentence footnoted and is laughable. We doubt seriously that many qualified professional appraisers are going to want to wade into this valuation exercise, especially given that many of these engagements are probably going to cost much more to appraise than the value of the alleged gift.

 

However, if the IRS pushes one of these gifts on audit, it’s going to have to have some valuation basis to propose an adjustment in an audit, the unlucky taxpayer, who bears the burden of proof in court, is going to have to present more persuasive valuation expert testimony in order to prevail. But it might take that if the IRS pushes the gift on judicial modification issue.

 

What is the beneficiary giving up exactly by merely consenting to judicial modification? Doesn’t the trustee, and the trustee alone, have the discretion concerning future “reimbursement?” Does it matter whether the settlor/grantor could easily or did threaten to cut off grantor trust status entirely? If so, perhaps their interest becomes more valuable.

 

Potential Solution: What if beneficiary consent was needed for later exercise of the trustee’s discretionary “reimbursement?” Might this make any alleged gift incomplete initially, and only complete the gift to the extent of later consented reimbursement? It should, but it’s unclear if the IRS would agree based on the CCA’s conclusion quoted above.

 

Potential Solution: Some trust modifications/decantings can be done without any beneficiary consent. CCA 202352018 claims this doesn’t matter, presumably in reliance upon Rev. Rul. 67-370, which the CCA states:

 

concludes that a defeasible remainder interest in trust which is subject to termination at the will of another is an interest in property within the meaning of § 2033 of the Code.

 

With all due respect to the IRS National Office, the trust beneficiary consenting to a trust modification that merely arms the trustee with the discretionary “reimbursement” power is quite a different kettle of fish than the defeasible remainder interest that was the subject of Rev. Rul. 67-370, where the holder of the defeasible interest possessed the right at death, subject to defeasance. In fact, we assert that the conclusion of Rev. Rul. 67-370, stated below, actually supports a finding of no gift on the judicial modification:

 

It is accordingly held that if a defeasible interest in property survives the decedent's death, its fair market value is includible in the decedent's gross estate. [emphasis added]

 

And the CCA’s conclusion that the result would be the same if the beneficiaries didn’t object is just wrong:

 

The result would be the same if the modification was pursuant to 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. [emphasis added]

 

The law should not require a futile act.  Absent from the IRS analysis is whether the beneficiary could actually thwart the modification in the first place even if they tried.

 

Potential Solution: Swapping assets, or loaning funds to the settlor/grantor would often be better than reimbursement” for various reasons, but the trustee must verify the equivalency of assets for a swap and loans must be reasonable bona fide loans that protect the trust beneficiaries and that would be reasonably prudent to make.

 

Applicability of IRC Sec. 2702. Could the IRS try to apply Chapter 14 principles and ignore the value of the interest retained by the purported “donors” so that the entire value of their interest is a gift? We don’t think so, for the reasons stated below, but it’s still a scary prospect.

 

IRC Sec. 2702(d) provides:

 

(d) Treatment of transfers of interests in portion of trust. In the case of a transfer of an income or remainder interest with respect to a specified portion of the property in a trust, only such portion shall be taken into account in applying this section to such transfer. [emphasis added]

 

If there’s been a “transfer” by the consenting beneficiaries on mere consent to modify the trust instrument to give the trustee sole discretion to make future “reimbursement” to the settlor/grantor, which is highly debatable in this instance, given that no distributions have been made, we submit that the mere consent doesn’t rise to the level of the type of “transfer” and retention that Congress intended to cover when it enacted Chapter 14, which includes IRC Sec. 2702.

 

But even if it is a transfer, we submit that IRC Sec. 2702(d), quoted above, limits the amount of the gift of the consenting beneficiaries to the present value of future exercises by the trustee of “reimbursement” discretion for the remainder of the settlor/grantor’s actuarial life expectancy. Then the question becomes valuation, which would be highly speculative, in fact, so highly speculative that we submit will prevent most qualified appraisers to decline to value the gift.

 

While such valuation difficulties don’t prevent the existence of a gift, we strongly suspect that both the valuation difficulty and the likely very small taxable gift that might result will effectively preclude the IRS from employing its limited resources in cases like these to the most low-hanging fruit.  We submit that the IRS may be using this occasion to rethink other more substantial trust modifications that might more clearly involve a true transfer of wealth.

 

In drafting such a discretionary power, we caution to define the amount of any such “reimbursement” and that it be limited to future income tax of the settlor/grantor to prevent a retroactive “reimbursement” distribution by the trustee of up to all the past income tax that the settlor/grantor paid on the trust’s income. We fear that absent such limitation, neither the trustee nor the IRS would be limited in the amount of the “reimbursement” to settlor/grantor or the inclusion (up to the total date of death value of the trust) by the IRS. We fear that absent such limitation, neither the trustee nor the IRS would be precluded from taking such a position.

 

Analysis of Various State Legislative Action in the Area of a Trustee’s Discretionary “Reimbursement” Power. After Rev. Rul. 2004-64 spoke about the parameters of a discretionary “reimbursement” power, states began to weigh in with legislation to help. For more about this state legislation, see, e.g., Jennifer E. Smith & Kristen A. Curatolo, “Grantor Trust Reimbursement Statutes, Trusts & Estates (Feb. 2021), pp. 25-30.

 

The most helpful statutes provide a trustee with an express discretionary “reimbursement” power unless the trust instrument prohibits it. The most helpful statutes further provide that the discretionary “reimbursement” power doesn’t make the grantor a trust beneficiary (although CCA 202352018 concludes that a judicial modification of the trust to add the discretionary “reimbursement” power gives the settlor/grantor a beneficial interest in the trust).  Could the trustee involved in CCA 202352018 have simply changed situs to one of these states to avoid the whole question of whether the beneficiary consent to the modification was a taxable gift?  It may depend on whether the beneficiary could have thwarted or consented to the change in situs!

 

Additionally, and directly addressing a qualification in Rev. Rul. 2004-64, the most helpful state legislation provides that the discretionary “reimbursement” power doesn’t make the trust assets available to the settlor/grantor’s creditors. The majority of states that don’t expressly authorize the discretionary reimbursement power to the trustee nevertheless prevent the creditors of the settlor/grantor from reaching trust property based on a trustee’s discretionary” reimbursement” power.  But check your state law!

 

Why the Different Treatment for the Addition of Discretionary”Reimbursement” Versus Initial Inclusion? Had the grantor included the trustee’s discretionary “reimbursement” authority in the trust instrument at the beginning, this is squarely within Situation 3 from Rev. Rul. 2004-64, which, on the potential estate tax inclusion exposure of the settlor/grantor, held as follows:

 

In addition, assuming there is no understanding, express or implied, between A and the trustee regarding the trustee’s exercise of discretion, the trustee’s discretion to satisfy A’s obligation would not alone cause the inclusion of the trust in A’s gross estate for federal estate tax purposes. This is the case regardless of whether or not the trustee actually reimburses A from Trust assets for the amount of income tax A pays that is attributable to Trust’s income. The result would be the same if the trustee’s discretion to reimburse A for this income tax is granted under applicable state law rather than under the governing instrument.

 

The HOLDINGS section of Rev. Rul. 2004-64 concluded:

 

If, pursuant to the trust’s governing instrument or applicable local law, the grantor must be reimbursed by the trust for the income tax payable by the grantor that is attributable to the trust’s income, the full value of the trust’s assets is includible in the grantor’s gross estate under § 2036(a)(1). If, however, the trust’s governing instrument or applicable local law gives the trustee the discretion to reimburse the grantor for that portion of the grantor’s income tax liability, the existence of that discretion, by itself (whether or not exercised) will not cause the value of the trust’s assets to be includible in the grantor’s gross estate. [emphasis added]

 

In CCA 202352018, with scant analysis, the IRS concluded that the settlor/grantor had acquired a beneficial interest in the trust on modification or addition of a settlor/grantor income tax “reimbursement” power for the trustee. But, if the settlor/grantor included the trustee’s “reimbursement” discretionary right initially on execution/formation of the trust, using the same conclusion as in CCA 202305218, why wouldn't this also be a retention by the settlor/grantor of a beneficial interest in the trust that shouldn’t at least partially trigger IRC Secs. 2036(a)(1), even where the trustee’s discretionary “reimbursement” distribution power was never exercised? Why the difference in treatment?  It’s a difficult one for the IRS to parse.

 

Clearly, if there is inclusion in the settlor/grantor’s estate associated with the trustee’s power to make discretionary “reimbursement” distribution under IRC Sec. 2036(a)(1), unless the income tax “reimbursed” to the settlor/grantor equals the entire fiduciary accounting income of the trust, it’s only a proportional inclusion under IRC Sec. 2036(a)(1). Treas. Reg. Sec. 20.2036-1(c)(1) provides in pertinent part:

 

If the decedent retained or reserved an interest or right with respect to all of the property transferred by him, the amount to be included in his gross estate under section 2036 is the value of the entire property, less only the value of any outstanding income interest which is not subject to the decedent's interest or right and which is actually being enjoyed by another person at the time of the decedent's death. If the decedent retained or reserved an interest or right with respect to a part only of the property transferred by him, the amount to be included in his gross estate under section 2036 is only a corresponding proportion of the amount described in the preceding sentence. [emphasis added]

 

Does the Settlor/Grantor Have a Legal Right to Complain About the Trustee’s Abuse of Discretion Concerning the Discretionary Reimbursement Authority? Here's the $64,000 question: Assuming that the trust instrument gives the trustee such “reimbursement” discretion, does the settlor/grantor of such a trust, with no other continuing rights in said trust, have a claim against a trustee who refuses to exercise discretion to “reimburse” the settlor/grantor for abuse of discretion?

 

We assume that trust beneficiaries who object to the trustee's exercise or refusal to exercise discretion regarding "reimbursement" of the settlor/grantor have rights, subject to the trust instrument and applicable state law, to object in court on the basis of abuse of discretion, as per usual. In our opinion, if state law doesn’t allow a settlor/grantor to question a trustee’s use of discretion about whether to reimburse the settlor/grantor for the income tax on the trust’s income, query whether a ‘right” whose non-use can’t be questioned is any right at all, especially one with potential adverse transfer tax consequences.

 

The UTC clearly gives a settlor/grantor the right to define the beneficiaries who receive the benefit and protection of the trustee’s duties and loyalties and delineates the various rights. However, UTC Sec. 814, which was subject to significant revision recently, one of which moved the old "ascertainable standard," which heretofore had only applied to UTC Sec. 814, to a defined term of UTC-wide use, a trustee must exercise discretion "in the interests of the beneficiaries."

 

But does the settlor/grantor have a right to complain under the UTC?  Does the settlor/grantor become a beneficiary under UTC Sec. 103(3), entitled to reporting and accounting like other discretionary beneficiaries?  Probably so.  Does this mean that any irrevocable grantor trust with a reimbursement clause may come within the bankruptcy code’s additional prohibitions against fraudulent transfers to “self-settled trusts or similar devices”?  Perhaps so as well, though this should probably not impact most estate planning transfers.

 

Reasons for Exercising/Declining to Exercise “Reimbursement” Power. In our opinion, there are few valid reasons for a trustee exercising this discretionary “reimbursement” power. In fact, there may only be one good reason: if the settlor/grantor (or someone sympathetic to the grantor) has the ability to and threatens to turn off grantor trust status, then it makes perfect economic sense to “reimburse” a portion - even all, because that saves the other beneficiaries and the trust more in the long run to have partial payment, which is better than none or even if it were all of it, to pay tax at often lower tax rates of an Individual.

 

If there were $200k of income and grantor is paying a 32% tax rate and trust is paying 37%, the family may be $10,000 better off! The beneficiaries would not be making a gift at all if they allow such a clause- they are often better off when there is a “reimbursement” especially when the trustee only makes partial “reimbursement.” In the above example, if the trustee fully reimburses the grantor, the beneficiaries are still $10,000 better off than if the grantor trust status had been turned off altogether!  Grantors are often in lower marginal tax rates than non-grantor trusts. That said, this may not always be the case. What if the grantor trust is a SLAT or a beneficiary defective inheritor’s trust (BDIT), where neither the grantor nor anyone else can just turn off grantor trust status?  Our analysis may differ.

 

Criteria for Exercising/Declining to Exercise “Reimbursement” Power; Avoiding a Claim of Abuse of Discretion. When a trustee has discretionary distribution authority, or when a beneficiary is entitled to HEMS distributions, commercial trustees often require a beneficiary to submit a budget and statements of need that the trustee’s distribution committee would then evaluate. The trustee’s decisions regarding exercise vel non of the discretionary distribution authority are subject to question on the grounds of abuse of discretion.

 

So, what are the relevant criteria for the trustee’s consideration of exercising the trustee’s “reimbursement” discretion?

 

•       The settlor/grantor’s financial condition? Is the trustee asking for draft copies of the grantor’s projected tax return to confirm the amount of tax?
•       Can the trust afford it? Again, the trustee has duties of fairness to all the beneficiaries, not primarily to the grantor.

 

As we discussed in the previous section, absent the settlor/grantor’s real ability to turn off grantor trust status, there may be no other solid ground for exercising “reimbursement” discretion.

 

So, how does the trustee protect itself from claims of abuse of “reimbursement” discretion by either the settlor/grantor or the beneficiaries? In our view, this is a real problem for the trustee with respect to any discretionary “reimbursement” power. As trustees, we wouldn’t want this discretion, because anything that the trustee does is almost inexplicable other than to say something that coaches of college or professional teams say in the stats or post-game presser when a player who’s not hurt but who doesn’t play in the game, i.e., “coach’s decision,” due to a lack of clear, safe guidance regarding the prudent use of the discretionary “reimbursement” power.  If beneficiary waivers or consents are obtained for the reimbursement, doesn’t this bring us right back to square one and the potential gift tax problem with beneficiary consents noted in CCA 202352018?

 

In short, the usual way that trustees protect themselves from claims of abuse of discretion, i.e., consistently following a prudent process is harder to follow here, save the one reason we identified above for a trustee to exercise such discretion: the settlor/grantor’s threat of turning off grantor trust status, which would cost the trust beneficiaries.

 

Conclusion:

 

CCA 202352018 seems curious. Given the identities of the IRS Area Counsel to whom the CCA was issued, both significant, experienced IRS litigators, we strongly suspect this involves potentially more than one pending audit, and perhaps some rethinking in related areas of trust modifications – not just grantor income tax reimbursement clauses. For an excellent article about CCA 202352018, see Ronald D. Aucutt, Esq., Reimbursement of Grantor for Income Tax Paid on a Grantor Trust’s Income , ACTEC Capital Letter No. 61 (January 19, 2024). Stay tuned for further developments.

 

 

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

 

Paul Hood

Ed Morrow

 

CITE AS:

LISI Estate Planning Newsletter #3098 (February 5, 2024) at http://www.leimbergservices.com. Copyright 2024 L. Paul Hood, Jr. and Edwin Morrow. Reproduction in Any Form or Forwarding to Any Person Prohibited - Without Express Permission. Our agreement with you does not allow you to use or upload content from LISI into any hardware, software, bot, or external application, including any use(s) for artificial intelligence technologies such as large language models, generative AI, machine learning or AI system. This newsletter is designed to provide accurate and authoritative information regarding the subject matter covered. It is provided with the understanding that LISI is not engaged in rendering legal, accounting, or other professional advice or services. If such advice is required, the services of a competent professional should be sought. Statements of fact or opinion are the responsibility of the authors and do not represent an opinion on the part of the officers or staff of LISI.

CITES:

 

CCA 202352018; IRC Sec. 2036(a)(1); Treas. Reg. Sec. 20.2036-1(c)(1); Rev. Rul. 67-370; and Rev. Rul. 2004-64.

 

CITATIONS:

 

[1] Grantors and their related/subordinate parties often control closely held pass through entities transferred to irrevocable grantor trusts that make pass-through entity (PTE) state income tax elections that effectively shift wealth from the trust back to the grantor (though it would be the entire state income tax burden, not just partial).  Many attorneys who worry about hypothetical discretionary reimbursement of tax by independent trustees have no problem with consistent annual reimbursement being done by the grantor through a trust-owned entity, because it is done through an optional tax election rather than through an optional trust distribution.  Not every attorney is so optimistic about such arrangements clearly avoiding IRC Sections 2036 and 2038, however. See Ed Morrow: Risks and Opportunities when Irrevocable Grantor Trusts Own Pass-Through Entities that Pay State Income Tax for Their Grantors, LISI Income Tax Planning Newsletter #249 (June 14, 2023).

 

[2] See the 50-state chart State Asset Protection for IGTs (or PTEs owned by IGTs) that May Pay Income Tax Burden on Trust Income for Grantors, available through the ACTEC State Survey Website or by emailing the authors, which summarizes and provides excerpts of various state reimbursement protection and/or authorization statutes.

 

[3] Rev. Rul. 79-327, Estate of Regester, 83 T.C. 1 (1984), though contrary is Self v. United States, 142 F. Supp. 939 (1956).  The IRS, in TAM 9419007, has indicated it will follow Regester (finding a gift) and not Self.

 

[4] Fla Stat. 736.08145