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In Revenue Ruling 2004-64, the IRS settled a long-standing question about the gift and estate taxation of grantor trusts. As a result of this favorable ruling, many more advisers will recommend that clients place income-producing assets into irrevo­cable trusts in order to achieve estate tax benefits. A grantor trust is a trust for which the income from the trust assets is income taxable to the grantor. The pur­pose of the grantor trust rules contained in IRC Sec. 671-679 has been to prevent a grantor from placing assets in a trust in order to “shift” income to a taxpayer who is in a lower income tax bracket than the grantor. However, through a series of income tax rate increases to trusts, trusts now fall in the highest income tax bracket with the exception of a very modest income tax progressive rate bracket.

It has become popular to use the income tax grantor trust as an estate tax planning vehicle. This occurs because the gift, estate, and income tax rules are not sym­metrical. It is possible to create an irrevo­cable trust for the benefit of the grantor’s heirs that is excluded from the taxable estate under IRC Sec. 2036-2038 by its irrevocable nature and treated as a “com­pleted gift” for gift tax purposes within the meaning of IRC Sec. 2511. However, the income tax rules are broader to allow treatment as a grantor trust under provisions of IRC Sec. 671-679. Thus a grantor could make an irrevocable gift to a trust and still remain obli­gated to pay the income tax on the trust income.

The manner in which a grantor could create a grantor trust is beyond the scope of this article; however, generally any reversion or power to affect beneficial enjoyment, alter, modify, or use the trust income will cause the income to be taxable to the grantor.

For example, suppose the grantor places $1 million in an irrevocable trust for the benefit of his son. If the trust is a completed gift and the trust is not includ­ed in the grantor’s estate, the trust corpus and all of the earnings are removed from the grantor’s estate for estate tax purpos­es. Suppose the trust earns $100,000 per year in income. If the trust is established as a grantor trust under IRC Sec. 671-679, the grantor must pay the income tax associated with the trust earnings, even though the corpus and income benefits the trust beneficiaries.

In the example above, the grantor is obligated to pay the income taxes associat­ed with the $100,000 income of the trust. The grantor would be obligated for pay­ment each year the trust remains a grantor trust. Since the grantor is paying his or her legal obligation generated by the tax code, it is believed that the grantor is not mak­ing an additional taxable gift to the bene­ficiaries of the trust. Grantors can sell assets to a grantor trust without recogniz­ing taxable income because a grantor trust is treated as the grantor’s alter ego.

In the early 1990s, the IRS informally suggested that a grantor should reserve the right to be reimbursed for income taxes. Some tax planners were concerned that a reserved power over income would cause inclusion of the trust corpus in the estate for estate tax purposes.

In Rev. Rul. 2004-64, the IRS settled the previous confusion concerning this issue. A grantor can now establish a trust and pay the income tax on trust earnings without concern of an IRS challenge under the gift tax rules. Rev. Rul. 2004-64 pro­vided three situations based upon the above-mentioned fact pattern. In the ruling, the trust is a grantor trust for income tax purposes and is not included in the estate. In situation one, the IRS concludes that the grantor does not make an additional gift by paying the income tax obligation.

Situation two modifies the facts to state that the trust requires payment of income tax back to the grantor. Here, the IRS concludes that the entire trust is included in the estate of the grantor. The ruling provided that the IRS was making a change of position, thus allowing the rule of situation two to be applied only to irrevocable trusts cat­ed after October 4, 2004. In the future, tax advisers must be aware of the adverse estate tax issue if a power of reimbursement is included in the trust.

In the third situation, the trust gives the trustee discretion to repay the income tax. The IRS says that the exis­tence of the right will not cause the trust to be included the grantor’s estate for estate tax purposes. If the trustee repays income tax, the danger is that the trust will be reclaimed into the estate. It would be prudent to add a provision that prohibits the repayment of the income tax to eliminate the pos­sible applicability of situation three.

State laws vary about the require­ment that the trustee reimburse a grantor for an income tax obligation when the trust is silent. Prudence dic­tates that a provision be included in the trust to prohibit the payment of income taxes in all irrevocable trusts that are expected to be excluded from the grantor’s estate.

This ruling will present a roadmap for planning where the family goal is to provide as much as possible to the heirs. Some families may be concerned that the obligation for the income tax is too oner­ous. However, for maximum benefit to the trust’s heirs, a grantor trust is another planning opportunity to consider.