Grantor Trust Tax Reimbursements

Take-Away: There are several tax benefits associated with the use of a grantor trust. One danger to stay away from, however, is establishing a ‘pattern, practice or routine’ where the trustee exercises its discretion to reimburse the settlor using the trust’s assets with regard to the settlor’s obligation to pay the income tax liability of the grantor trust.

Background: While originally intended to punish settlors who tried to evade income taxes by transferring income producing assets to a trust, grantor trusts have become an essential estate planning strategy, especially with the high income tax burden placed on non-grantor trusts. With a grantor trust status the trust can accelerate growth without any income tax drag. In addition, a grantor trust can utilize the settlor’s social security number as its taxpayer identification number and avoid income tax preparation complications and fees. Moreover, a grantor trust can engage in desirable transactions with the settlor, such as leasing residential real estate, purchasing assets in an installment sale at low interest rates, and ‘swapping’ out low income tax basis assets for higher basis assets. These are all terrific tax attributes, which may explain why several bills this past summer filed in Congress sought to eliminate the tax benefits of a grantor trust.

Turning Off Grantor Trust Status: Almost all grantor trusts include the settlor’s ability to turn off grantor trust status when the settlor tires of paying the trust’s income tax liability. For example, in a year when there is an unusually large capital gain or a year in which the settlor may face a cash-flow shortage, the settlor might be inclined to turn off the grantor trust status by a release of a retained power that causes the grantor trust classification rather than incur the trust’s income tax liability. That said, sometimes turning off the grantor trust status can be harmful to the trust. In addition, turning off the grantor trust status seems to be always contrary to the best interests of the trust beneficiaries. Turning off a grantor trust status can also carry unintentional consequences if the settlor is engaged in otherwise non-recognized transactions with the trust, such as a lease of qualified personal residence trust (QPRT), or an installment sale to an intentionally defective grantor trust. In these situations, it would be preferable for the trust to contain a discretionary trustee power to reimburse the settlor for the income taxes the settlor pays with regard to the grantor trust’s income, as opposed to completely turning off the trust’s grantor trust status. Therefore, it is common to read language intentionally inserted in a grantor trust instrument that gives the trustee the authority to reimburse the settlor for income taxes (or to directly pay the trust’s share of the income tax liability) as a disincentive to permanently turning grantor trust status altogether, and thus build more flexibility into the grantor trust and preserve its long-range intended tax benefits.

Tax Reimbursement: The IRS permits this reimbursement of income taxes and it will not include the amount of the income tax reimbursement, or the trust corpus, in the settlor’s gross estate at death [IRC 2036(a)(1)], as long as the trustee’s payment of the income taxes (or reimbursement of the settlor) meets three conditions. [Revenue Ruling 2004-64.] Those three conditions include the following:

the reimbursement is not forbidden by state law;
the reimbursement is not subject to a pattern of abuse that suggests an agreement between the settlor and the trustee to reimburse; and
the reimbursement is not mandatory, but subject to the trustee’s discretion.

Accordingly, if the applicable local law, or the trust’s governing instrument requires a mandatory payment for the settlor’s income tax liability associated with the grantor trust, that state law or that trust provision will result in the inclusion in the settlor’s taxable gross estate for any grantor trust that is created after October 4, 2004. [IRC 2036(a)(1).] Conditions (i) and (iii) usually do not present much of a risk. It is condition (ii) that the IRS will scrutinize carefully and which poses the greatest risk that the grantor trust assets will be included in the settlor’s gross estate at death. The key part of Revenue Ruling 2004-64 is the following: “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 included in the grantor’s gross estate.”

Example: An example of such a reimbursement clause used in a grantor trust instrument might look like the following:

Income Tax Reimbursement or Payment: If the settlor is treated (under Subpart E, Part 1, Subchapter J, Chapter 1 of the Tax Code) as the owner of all or part of any trust that is created under this Trust, the independent Trustee may in its absolute discretion, reimburse the settlor for any amount of the settlor’s personal income tax liability that is attributable to the inclusion of such trust’s income, capital gains, deductions and credits in the calculation of the settlor’s taxable income. The Trustee may pay the settlor directly or the Trustee may pay the reimbursement amount to any appropriate taxing authority on the settlor’s behalf.

Waiver of Right of Reimbursement: The settlor negates any right the settlor may have under state law to require the Trustee to reimburse him for any federal or state income tax liability the settlor pays as a result of the existence of the settlor’s power to substitute assets with this Trust. Notwithstanding this power, during the settlor’s lifetime the independent Trustee is authorized, in its sole and absolute discretion, by an instrument filed with this Trust’s records, to irrevocably release the right to satisfy any such tax liability. Under no circumstances shall the provisions of this paragraph result in the settlor being considered a beneficiary of any trust that is created under this Trust.

State Laws: A few states, to provide more comfort on the issue of contrary state laws, have enacted statutes that address a grantor trust tax reimbursement provision: New York, New Hampshire, Virginia, Idaho and Delaware. For example, Delaware’s statute, which was adopted in 2019, provides that when a trust is taxed as a grantor trust for federal income tax purposes, unless the governing trust instrument expressly provides otherwise, the trustee may in its discretion (or at the direction of a trust director or advisor) reimburse the settlor for the income taxes attributable to the ordinary income and capital gains of the trust, even when the trust instrument does not expressly authorize such distributions by the trustee. [Section 3344 of Title 12 of the Delaware Code.]

Delaware Statute: This state’s statute is deliberately phrased to provide the protection contemplated by the IRS’ Revenue Ruling. The statute provides, in part, (paraphrasing) that “unless the terms of the trust instrument expressly provide otherwise, if the settlor of a trust is treated under the grantor trust rules as the owner of all or part of the trust, the trustee (other than a trustee who is the settlor, or a person who is a related or subordinate party with respect to the settlor within the meaning of IRC 672(c), may, in the trustee’s sole discretion, or at the direction or with the consent of an advisor (who is not the settlor or a related or subordinate party with respect to the settlor), reimburse the settlor for any amount of the settlor’s personal federal or state income tax liability that is attributable to the inclusion of trust income, capital gains, deductions and credits in the calculation of the settlor’s taxable income.” Thus, Delaware’s statute provides great protection by limiting the trustees who may exercise such discretion to reimburse with reference to IRC 672(c) [which statute assumes that ‘related or subordinate’ parties are subservient to the settlor, which can cause such powers to be imputed to the settlor.] Other specific provisions of the Delaware statute that are unique, include: (i) it contemplates the use of trust directors in exercising discretion; (ii) it contemplates direct payment by the trustee of the settlor’s income tax obligation, as opposed to only reimbursement; (iii) it expressly states that the reimbursement of the settlor’s income tax obligation will not cause the settlor to be treated as a trust beneficiary, which addresses some problems associated with the scope of spendthrift provisions; (iv) it prohibits the use of income derived from a policy of insurance on the life of the settlor; and (v) it contains protective language that reimbursement will not apply to a trust if the application of tax reimbursement would reduce a charitable deduction that is otherwise available.

Settlor’s Control: While in the Revenue Ruling the IRS held that there would be no estate inclusion in the settlor’s gross estate for federal estate tax purposes if the trustee possessed discretionary authority under the trust instrument, or under state law, to reimburse the settlor for the income tax liability associated with the grantor trust, the IRS also concluded that certain facts may give rise to gross estate inclusion of the grantor trust, such as either a (i) pre-existing express or implied understanding between the settlor and the trustee with regard to the trustee’s exercise of discretion to reimburse the settlor, (ii) a power retained by the settlor to remove the trustee and name the settlor himself as trustee, or (iii) local applicable law that subjects trust assets to the claims of the settlor’s creditors. Therefore, the trust instrument cannot require a reimbursement of the settlor’s income tax liability associated with the trust, nor can there be any implied understanding that the trustee will reimburse the settlor when asked. Additionally, there can be no facts that indicate any control by the settlor, or pre-existing arrangements, powers to remove the trustee and name the settlor as trustee. Accordingly, no state statute that expressly authorizes the reimbursement of the settlor is needed as long as the reimbursement is expressly authorized by the trust instrument, and there is no state law that subjects the trust’s assets to the settlor’s creditor claims. It is the possibility of an implied agreement between the settlor and the grantor trust’s trustee that creates the possibility of a risk of estate inclusion.

The discretionary tax reimbursement clause is thus not a risk, standing by itself, but only as long as there is no understanding, express or implied, that the independent trustee would exercise the discretion to reimburse the settlor for the income taxes that the settlor is obligated to pay on the grantor trust’s income. The trustee’s reimbursement discretion will not, standing alone, cause the inclusion of the trust’s corpus in the settlor’s gross estate for federal estate tax purposes. Yet, the IRS cautions that such discretion, combined with other facts, may cause inclusion of the trust’s assets in the settlor’s gross estate. If tax reimbursement distributions are never made, then there should not be any estate tax inclusion exposure. However, if discretionary tax distributions are eventually made because the settlor needs financial support provided by such distributions, that could be sufficient to convince the IRS, and possibly a judge, that other facts exist to find that there was an implied understanding that the grantor trust assets would be used for the settlor’s benefit. Because of this potential risk, some legal commentators have recommended that discretionary tax reimbursement clauses not be used. [Jerry Hesch & the Financial Danger of Maximizing Taxable Gifts (2012).] Other commentators suggest that any tax reimbursements be infrequent, without any pattern or routine, and that on those limited occasions when a tax reimbursement is made to the settlor, that the trustee clearly document the reasons why in that instance it decided to exercise its discretion to reimburse. Other commentators have also suggested that even though the decision to reimburse the settlor is within the trustee’s exercise of discretion, soliciting the consent of trust beneficiaries to that discretionary reimbursement might also indicate the merits of the circumstances that warranted a reimbursement.

Conclusion: A tax reimbursement clause in a grantor trust is transferring money in the wrong direction. So hopefully, the reimbursement of the settlor’s income tax liability will be infrequent at best. It would be helpful if Michigan would follow the lead of Delaware and adopt a statute that expressly addresses the trustee’s discretion to reimburse the settlor of a grantor trust for his or her income tax liability. Finally, if a trustee exercises its discretion to reimburse the settlor of a grantor trust for his or her income tax liability, the unique facts and circumstances that surround that request should be documented by the trustee and made a part of the trust’s records in anticipation that at a future date the IRS will closely scrutinize that decision in search of an implied understanding.