IRS Modifies Position on Grantor Trust Tax Reimbursement Clauses

On November 28, 2023, the Internal Revenue Service (“IRS”) took the estate planning world by surprise by issuing a memorandum (the “CCA”) concluding that the modification of a grantor trust to add a tax reimbursement clause will constitute a taxable gift. 

The CCA marks a stark departure from the IRS’s previous position that such modifications will not trigger gift taxes. This new guidance will reshape how practitioners plan for grantor trusts in the future. 
Irrevocable grantor trusts are a valuable tool in the estate planner’s toolbox. These trusts are structured such that the grantor remains responsible for income taxes, while the trust assets are excluded from the grantor’s estate for federal estate tax purposes. This favorable treatment allows assets such as stocks and real estate to appreciate within the trust without being subject to estate taxes, and also permits transactions between the grantor and the trust, such as sales and loans, to be executed free of income taxes.  

Despite their advantages, grantor trusts can create liquidity concerns for taxpayers who must pay taxes on trust income. A solution many advisors felt comfortable with, until the release of the CCA, is to modify the trust instrument to add a tax reimbursement clause that permits, but does not require, the trustee to reimburse the grantor for the income taxes paid. In 2016, the IRS noted its approval of this strategy, holding in a private ruling that the modification of a trust to add a tax reimbursement clause was administrative in nature and did not trigger transfer taxes.   

The CCA reverses the IRS’s previous taxpayer-friendly stance. In direct contradiction to its 2016 position, the IRS now concludes that modifying a grantor trust to add a tax reimbursement clause, with the consent of the beneficiaries, constitutes a taxable gift from the trust beneficiaries to the grantor. In reaching this conclusion, the IRS reasoned that, under a governing trust instrument, trust beneficiaries have an interest in the trust property. When a trust is modified to include a tax reimbursement clause, a portion of this interest is transferred from the beneficiaries to the grantor, and the value of the interest transferred will be categorized as a taxable gift. 

It is crucial to note that the CCA only applies if a trust agreement is modified to incorporate the tax reimbursement clause. The IRS maintains its position, established in 2004, that a discretionary tax reimbursement clause contained in an original, unmodified trust agreement will not trigger transfer taxes. The CCH does not change this outcome, provided there is no preexisting agreement between the grantor and the trustee to exercise the reimbursement clause. 

The CCA leaves many unanswered questions in terms of its scope and application. For example, will gift tax be triggered if the trust is somehow amended without the consent of the beneficiaries? What if, instead of amending the trust, the trustee simply decants the trust assets into a new trust that is drafted to contain a tax reimbursement clause? If a taxable gift is triggered by the addition of a tax reimbursement clause, how is the gift measured?  We will be closely tracking new developments in this area and will keep you informed with respect to any pertinent updates.   

CCA 202352018
PLR 201647001
Rev. Rul. 2004-64

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