Reimbursement of Grantor on Trust Income Taxes: When, Why, and How

“Reimbursement of Grantor on Trust Income Taxes: When, Why, and How,” that is the subject of today’s ACTEC Trust and Estate Talk.

This is ACTEC Fellow Margaret Van Houten of West Des Moines, Iowa.

When a grantor trust generates a taxable income, the grantor is typically responsible for the income tax, even when the income stays inside the trust. That can raise important questions about fairness, cash flow, and whether the trust should reimburse the grantor. But reimbursement provisions can carry significant tax, fiduciary, and drafting implications, if not carefully handled.

Joining us today are ACTEC Fellows Kristen Curatolo of New York and Jenny Smith of Wilmington, Delaware. Kristen and Jenny will walk us through the key considerations in drafting reimbursement provisions, how courts and the IRS have approached these issues, and best practices for navigating trustee discretion and grantor expectations. Welcome Kristen and Jenny.

Revenue Ruling 2004-64: The Foundation of Grantor Trust Reimbursement

Jenny Smith:  This is Jenny. To get us started, we’re going to talk about the background here, which comes from Revenue Ruling 2004-64. This is kind of the critical authority when we’re talking about all things having to do with reimbursement of the grantor.

And in this revenue ruling, there were two critical holdings.

• First, the IRS held that when a grantor, who’s treated as the owner of the trust for tax purposes, pays the income tax for that trust’s income, the grantor is not treated as making the gift in the amount of the taxes paid. So that’s huge. That’s critical.
• The second critical holding here is the trustee’s discretion to reimburse the grantor for income tax of the trust payable by the grantor does not by itself cause the inclusion of the full value of the trust assets in that grantor’s estate.

A little caveat there is that while it’s okay to have a discretionary power to reimburse, there cannot be any kind of mandate, either explicit or implicit. If there is that kind of mandatory requirement to reimburse the trustor then you’ve got estate tax inclusion problems.

Understanding the ‘Burn’ of Grantor Trust Status

Now let’s turn to taking a look at the burn of grantor trust status. And as we know, grantor trusts are standardly used when creating an irrevocable trust for wealth transfer purposes. And there are so many benefits to this structure. One of those huge benefits is that the financial aspect of allowing the trust to grow without being reduced by the value of those taxes paid. Over a long period of time, the transfer tax shifting of value from grantor trust status has a far greater impact than valuation discounts and the shifting of future income and appreciation in value combined. So that is just huge; it’s a huge benefit that your trustor can pay these income taxes every year and it’s not treated as an additional taxable gift by the trustor.

But as we know, sometimes that what we would view as a blessing can become a burden and it’s just simply too much. There are two different facets to it. One of course is the financial burn and maybe sometimes the trust just becomes too successful. It just explodes in value. But then this results as a true economic hardship to the trustor to be able to continue to shoulder the tax burden. So, I think the one critical aspect for estate planners is to be able to working with the other professionals on the team, illustrate that financial burn to the client so that the client understands what is the appropriate amount to gift to this trust going into it with the assumption that you will continue to be responsible for paying those income taxes. So illustrating that financial burn is critical.

Kristen Curatolo: This is Kristin, and Jenny, what I call that scenario is “when our client is the victim of their own success.” The other side of the coin with the financial burn is the emotional burn. A lot of our clients have had the generosity of paying the income taxes on behalf of these irrevocable trust for decades. And maybe it made sense when the children were younger and becoming more established in their careers. But as they’ve grown older and have established their own income streams, their own families, and they are financially independent themselves, clients are less inclined to continue making those gifts. They think the kids has enough and it is time for the trust to take the term bearing the income tax burden.

But we keep on telling our clients there is an order of operations here to think about how to solve this burn of grantor trust status short of triggering the reimbursement clause. So, Jenny, can you take us through our first few solutions to mitigate that burn?

Alternatives to Reimbursement: Planning Before Problems Arise

Jenny Smith: Absolutely. Thanks, Kristin. That’s exactly right. Before we jump into reimbursement as the auction, there are a number of other choices available to the client that should be considered.

• One of them is toggling off grantor trust status, though, frankly, this is usually a last resort because it can be problematic to switch back and forth between grantor and non-grantor status.
• Another potential option is a loan, making a loan to the grantor. Of course, it has to be supported by adequate interest, but that might allow the grantor to kind of bridge the gap and get the liquidity needed to pay the tax and then have an appropriate time frame to repay the trust.
• Another option is swapping out an asset, right? One of the great benefits of a grantor trust is that swap power by the grantor. So perhaps there’s an asset that is just creating a huge amount of income for the trustor. They could exercise their power to substitute that asset with something else of equivalent value that is not going to potentially create as much income tax for the trustor.

Drafting Strategies That Provide Long-Term Flexibility

Kristen Curatolo: Our next solution is “beginning with the end in mind.” At the time that you’re drafting the trust agreement itself, you can embed the automatic expiration of grantor trust status. You can say, “hey, maybe in 30 years from now, based on our financial modeling, I will have paid enough income taxes so that we will shut it off at a certain date.” It could also be based at a certain time or event, such as the sale of a business. That is what’s going to trigger turning off grantor trust status. So, by financial modeling in the beginning and some clear planning, that can be built into the trust agreement itself.

The next solution, which a lot of clients like to keep in their back pocket is having a “spouse as a beneficiary of the trust.” By including a spouse, it enables the distribution to the spouse of assets from the trust, which can then be transferred, gift tax free to their spouse to offset the income tax burden. Of course, this could be a tricky one to fall back on if there’s a divorce or your spouse dies prematurely before the client. But nonetheless, that could be one of the safeguards inside the trust agreement.

Our final idea on how to mitigate this burn short of “toggling off grantor trust status and reimbursement is including a power of appointment in the trust.” This can also be considered a decanting power where you could take the high-income producing asset and the trust that’s causing all this income heartburn for the client and decanting that or appointing that asset into a new non-grantor trust where the trust itself is the taxpayer from the beginning. But as we’ll talk about in another moment in that new trust that you are moving the assets into, you can’t include a reimbursement clause. So, we’ll talk a bit more about that in a moment.

Jenny, I know that we spent a lot of time doing a lot of this research. Can you take us through the 50-state survey that you and I conducted together?

How State Laws Affect Grantor Trust Reimbursement

Jenny Smith:  Yes. Based on our review, we found that we currently have 13 different states that have enacted legislation expressly authorizing income tax reimbursement. In these states, you may be able to reimburse even if the trust agreement is silent on the issue of reimbursement.

And then the next tranche of states, there are 25 states that do not expressly authorize the trustee to reimburse the trustor for income tax liability, but they have enacted statutes preventing a trustor’s creditors from reaching trust assets based on a trustee’s power to reimburse the trustor for tax payments. These are the states where reimbursement is possible provided that the trust agreement expressly authorizes it.

Next, there are 10 states, plus the District of Columbia, that have enacted statutes that provide if a creditor or as any of the settlor may reach the maximum amount that can be distributed to or for the settlor’s benefit. So those are danger-danger, because there’s not creditor protection in those states. So, you want to be very cautious in those states, even if there was potentially language in the trust agreement.

In roughly a dozen states, be very, very cautious about it. However, we’ve got 13 states that explicitly authorize it, 25 states where it’s possible if you’ve got language in your trust agreement already.

How Recent IRS Guidance Changed Planning Options

Kristen Curatolo: One development that’s happened since we began speaking on this topic is the CCA, the Chief Counsel Advice that came out in November 28, 2023. And that is Chief Counsel Advice 202352018. And in that Chief Counsel Advice, the landscape that has changed is that you can no longer decant modify or enter into a non-judicial settlement agreement that has the effect of including a reimbursement clause inside an irrevocable trust without causing gift tax issues as to the beneficiaries of the trust.

And a quick recap of that Chief Counsel Advice is that there was a judicial modification of an irrevocable grant or a trust with beneficiary consent that edited a tax reimbursement clause and that was considered a taxable gift by the beneficiaries as to the settlor. There was also foreboding language inside this CCA that said that a decanting would have the same effect as a modification in terms of that adverse tax result.

Using Trust Situs When Reimbursement Isn’t Available

So what that means is if you have a client who is in a jurisdiction that does not have a reimbursement statute, and your trust agreement is silent on whether or not the settlor can be reimbursed, the way to avail yourself of that relief would be to change the situs of the trust or the place of administration to a state that has a statute that expressly authorizes reimbursement of income taxes to the settlor. And then even though the trust is silent on reimbursement, the statute of that state governs and the settler can receive that reimbursement relief.

Our goal is to provide our fellow practitioners different ideas on how to mitigate the burn of grantor trust status short of using the reimbursement clause or toggling off grantor trust status.

Key Takeaways for Estate Planning Attorneys

Jenny Smith So now we’d like to talk about recent state law developments specifically in the context of grantor trust reimbursement statutes. As it currently stands, there are 13 states that enacted legislation expressly authorizing income tax reimbursement. In these states, you may be able to reimburse even if the trust agreement is silent on the issue of reimbursement, which is very important as we’ll hear in a little bit. And these 13 states are in alphabetical order: Colorado, Connecticut, Delaware, Florida, Indiana, Nebraska, Nevada, New Hampshire, New York, South Carolina, Tennessee, Virginia, and Wyoming.

In addition, we also found that there are many states where there is no explicit authorization by statute to reimburse, but there is creditor protection. So, there are 25 states we identified that do not expressly authorize the trustee to reimburse the trustor for income tax liability, but they have enacted statutes preventing a trustor’s creditors from reaching trust assets based on a trustee’s power to reimburse the trustor for those tax payments. So, in these 25 states where reimbursement is possible, provided that the trust agreement expressly authorizes it. Again, this is something a drafting consideration. If you’re in one of these 25 states that you would want to have that language in your trust agreement in order to authorize reimbursement.

And then last, based on our review, we found that there are 10 states, plus the District of Columbia, that have actually enacted statutes that provide if a creditor or assignee any of the settlor may reach the maximum amount that can be distributed to or for the settlor’s benefit. So in those states, you wouldn’t want to reimburse the settlor because you’re just opening them up to potential liability. Kristin and I typically refer to those as the red states because danger, danger, beware. And then last, there were just about two states we found where unclear authority and it’s just not totally clear based on the available statutes, whether or not reimbursement would cause a problem in those particular jurisdictions.

Margaret Van Houten: Thank you, Kristin and Jenny, for addressing so well this important and complicated topic.

 

This podcast was produced by The American College of Trust and Estate Counsel, ACTEC. Listeners, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel. The material in this podcast is for information purposes only and is not intended to and should not be treated as legal advice or tax advice. The views expressed are those of speakers as of the date noted and not necessarily those of ACTEC or any speaker’s employer or firm. The information, opinions, and recommendations presented in this Podcast are for general information only and any reliance on the information provided in this Podcast is done at your own risk. The entire contents and design of this Podcast, are the property of ACTEC, or used by ACTEC with permission, and are protected under U.S. and international copyright and trademark laws. Except as otherwise provided herein, users of this Podcast may save and use information contained in the Podcast only for personal or other non-commercial, educational purposes. No other use, including, without limitation, reproduction, retransmission or editing, of this Podcast may be made without the prior written permission of The American College of Trust and Estate Counsel. If you have ideas for a future ACTEC Trust & Estate Talk topic, please contact us at ACTECpodcast@ACTEC.org. © 2018 – 2026 The American College of Trust and Estate Counsel. All rights reserved.