News, Articles & Resources

Chief Counsel Advice (“CCA”) 202352018, an internal legal advice memo from the IRS National Office to field agents, released December 29, 2023, addressed the gift tax consequences to the beneficiaries of modifying an irrevocable trust that is a “grantor trust” under the tax code provisions of Internal Revenue Code (“I.R.C.” or “Code”) 671 through 679. The “grantor trust” tax rules require that in certain situations, the original grantor must pay the income tax on trust earnings. This memo addressed the situation when the trustee of the trust modifies the trust, with the beneficiaries’ consent. In the situation, the trustee wanted to add a tax reimbursement clause to provide the trustee the discretionary power to make distributions of income or principal from the trust in an amount sufficient to reimburse the grantor for the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income. While it addressed facts that relate to one type of trust modification, it could have broader implications to other trust modification. In fact, the modification in question was a fairly innocuous change.

As background, under Sections 671 through 679 of the Code, the grantor of an irrevocable trust will still be treated as if he or she owns the assets of the trust for income tax purposes, despite no longer owning the assets he or she has gifted to the trust, if he or she has retained certain powers under the trust. In other words, as was held in Revenue Ruling 85-13, in these situations the assets in the trust are treated as the alter ego of the grantor, and the trust is ignored for income tax purposes. Such trusts are known as “grantor trusts.”

Because the grantor of a “grantor trust” is still treated as owning the assets of the trust for income tax purposes, the grantor is responsible for reporting on his or her own income tax return all of the income of the trust and for paying the income tax liability. Some trusts will provide in its terms that an independent trustee may, in the trustee’s sole discretion, reimburse the grantor from the income and/or principal of the trust for the tax liability the grantor must pay as a result of this grantor trust treatment. Certain states also have statutory law which allows for grantor trust tax reimbursement (see, for example, N.J.S.A. 3B:11-1(b)). The IRS agreed under Revenue Ruling 2004-64 that such clauses included in the trust document are permissible and do not create a gift tax issue.

Before the IRS issued Revenue Ruling 2004-64, there was a concern that this type of tax reimbursement power could cause the assets of the trust to be included in the grantor’s estate for estate tax purposes under Section 2036(a)(1) of the Code. The property in the trust could result in estate tax inclusion at death because the power to reimburse the grantor from the trust assets could be treated as if the grantor had retained possession or enjoyment of the trust. Despite the concern, the IRS held that where the trust’s governing instrument (or applicable local law) gave the trustee the discretion to reimburse the grantor for the income tax payable, 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. It is important to note that the trustee’s power must be discretionary, and not mandatory, since the IRS held in that same ruling that a mandatory reimbursement provision would cause the full value of the trust’s assets to be includible in the grantor’s gross estate at death.

CCA 202352018 then addressed the gift tax consequences to the beneficiaries of a grantor trust when a trust, which does not already contain such a tax reimbursement clause, is modified by the trustee, with the beneficiaries’ consent, to include such a clause. In the CCA, the IRS, to the surprise of many practitioners, held that the modification of the trust to add a clause to allow the tax reimbursement will constitute a taxable gift by the trust beneficiaries. It found that the addition of a discretionary power to distribute income and principal to the grantor is a relinquishment of a portion of the beneficiaries’ interest in the trust.

Under the facts of the CCA, the grantor established an irrevocable grantor trust for the benefit of his child and the child’s descendants, naming an independent and unrelated person as trustee. By the trust terms, the trust was a “grantor trust.” Also, under the terms of the trust, the trustee had the absolute discretion to distribute income and principal to or for the benefit of the child, and on the child’s death, the remainder of the trust was to be distributed to the child’s descendants, per stirpes. Neither state law nor the governing instrument provided authority to the trustee to distribute to the grantor amounts sufficient to satisfy the grantor’s income tax liability attributable to the inclusion of the trust’s income in the grantor’s taxable income.

In a following year, when the child had no living grandchildren (or more remote descendants), the trustee petitioned the state court to modify the terms of the trust, and the child consented to the modification. The court granted the petition and issued an order modifying the trust to provide the trustee with the discretionary power to reimburse the grantor for income tax the grantor pays as a result of the inclusion of the trust’s income in the grantor’s taxable income.

In addressing the gift tax consequences of the trust modification, the IRS explained that the Code[1] imposes a tax for each calendar year on the transfer of property by gift during the calendar year by any individual, and that the Code[2] also applies the gift tax whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. Citing the Treasury Regulations,[3] the IRS noted that the gift tax applies to gifts indirectly made, and if a donor (in this example, the child as trust beneficiary) transfers by gift less than their entire interest in the property, the gift tax is applicable to the interest transferred.  If the donor’s retained interest is not susceptible of measurement on the basis of generally accepted valuation principles, the gift tax is applicable to the entire value of the property subject to the gift.[4] In addition, donative intent on the part of the transferor is not required, and instead the application of the gift tax is based on the objective facts of the transfer and the circumstances under which it is made.[5]

In analyzing the facts as compared to the law, the IRS found that the child and the child’s issue each have an interest in the trust property. As a result of the trust modification, the grantor would be acquiring a beneficial interest in the trust property due to possible discretionary distributions of income or principal from the trust to reimburse the grantor for any taxes grantor pays because of the trust’s income in the grantor’s gross taxable income. The IRS held that, in substance, the modification constitutes a “transfer” by the child and the child’s issue for the benefit of the grantor.

As a result of the trust modification, the IRS asserted that the child and the child’s issue each made a gift of a portion of their respective interest in income and/or principal. Although, in the facts of the CCA, the child consented to the modification, the IRS stated that 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 the beneficiary failed to exercise their right to object. The IRS distinguished the facts of the CCA from the facts in Revenue Ruling 2004-64, because there, the trust agreement itself initially provided for a discretionary right to reimburse the grantor for payment of the income tax.

Lastly the IRS found that the gift from the beneficiaries should be valued in accordance with the general rule for valuing interests.[6] The IRS recognized that “although the determination of the values of the gifts requires complex calculations, [the beneficiaries] cannot escape gift tax on the basis that the value of the gift is difficult to calculate.”

Tax advisors have been quick to criticize this new IRS tax provision. Notably, the IRS’s holding in CCA 202352018 reverses its prior position in PLR 201647001, in which the IRS concluded 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. In CCA 202352018 the IRS stated that its holding in PLR 201647001 “no longer reflects the position of this office.”

The holding of CCA 202352018 is concerning, given the IRS’s aggressive position it is now taking with respect to trust modifications, the reversal of its prior position, and the many unanswered questions it leaves open. For example: (i) how can a beneficiary’s failure to object to a modification (as opposed to his or her affirmative consent) be treated as the beneficiary making a gift? (ii) what if an independent trustee (or other third party) unilaterally has the power to modify the trust, and the beneficiary has no right to consent or object to the modification? (iii) what if the trustee moves the governing law of the trust from a state without a trust reimbursement statute, to a state with a trust reimbursement statute? (iv) what is the value of the gift, since the trustee’s power to reimburse the grantor is discretionary and the trustee may never exercise the power? (v) isn’t it an incomplete gift until the trustee actually exercises the power to reimburse the grantor?

This new tax position could have significant implications on many other types of trust modifications. Since the enactment of the Uniform Trust Code in many states, including New Jersey and Pennsylvania, trustees and beneficiaries have been entering into “nonjudicial settlement agreements” to modify various provisions of irrevocable trusts. The ability to modify irrevocable trusts under these types of nonjudicial settlement agreements has become an important and valuable tool for allowing flexibility to an irrevocable trust document. Generally, before the enactment of the Uniform Trust Code, there were questions of whether a trust could be modified without court intervention. Prior to entering into these nonjudicial settlement agreements to modify trusts, the trustees and beneficiaries must address whether any changes to the trust may create gift tax issues, and now, even minor changes may have consequences.

The consensus amongst practitioners seems to be that the IRS has taken an overly aggressive, and possibly incorrect, position under CCA 202352018. While CCAs are not intended to be precedential or relied upon for future analysis, the IRS’s position is troubling. At least until the IRS clarifies or reverses its holding under CCA 202352018, practitioners should consider including discretionary tax reimbursement clauses in trust documents from the outset, rather than later modifying a trust to include a discretionary tax reimbursement clause. The IRS is continuing to adhere to its position under Revenue Ruling 2004-64 (for now) that such clauses, if included in the trust document initially, do not create a gift tax issue.

 

[1] Section 2501(a)(1).

[2] Section 2511(a).

[3] Treas. Reg. 25.2511-1(c)(1), (e).

[4] Treas. Reg. 25.2511-1(e).

[5] Treas. Reg. 25.2511-1(g)(1).

[6] See Section 2512 and the Treasury Regulations clarifying that statute.