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George F. Bearup, J.D. Senior Legal Trust Advisor

23-Feb-21

Grantor Trusts- Reimbursement of Settlor’s Income Taxes

Take-Away: One of the benefits of a grantor trust for income tax reporting purposes is the trustee’s ability to reimburse the settlor (grantor) for the payment of the trust’s income tax liability. The reimbursement of those income taxes, however, might expose the trust’s assets to inclusion in the grantor’s taxable estate, while also raising questions of a breach of the trustee’s fiduciary duties to the trust beneficiaries.

Background: A trust that qualifies for grantor trust status means that the trust’s creator, the grantor, is responsible for payment of the income tax liability associated with the trust during the grantor’s lifetime. Consequently, a grantor trust provides several perceived benefits to the grantor, including: (i) the trust’s beneficiaries are relieved of the income tax burden, effectively permitting the trust’s assets to grow in a tax-free environment;  (ii) the grantor’s payment of the grantor trust’s income tax liability is not treated as a taxable gift by the grantor, which thus preserves the grantor’s federal gift tax applicable exemption amount; and (iii) the grantor’s payment of the grantor trust’s income tax liability effectively reduces the size of the grantor’s own estate, which reduces the grantor’s exposure to federal estate taxes on the grantor’s death. Despite these benefits of a grantor trust, times and economies change, and ‘settlor’s remorse’ may set-in, leading to a desire to be reimbursed for the income taxes the grantor pays.

Example: At a time when his business was going swimmingly, Todd created a grantor trust for the benefit of his children. Todd funded the grantor trust with high paying dividend stocks. Todd was content to pay the grantor trust’s income tax liability because he could afford to do so in light of his own closely held business’ success. The pandemic then hit. Several of Todd’s best customers failed or substantially cut back on their inventories, in turn causing Todd’s own business to suffer. Todd now regrets having established the grantor trust for his children because he is on the ‘hook’ to pay that trust’s income tax liability at a time when his own business is suffering. Todd would like the trustee of the grantor trust to reimburse him from trust assets for his obligation to pay the grantor trust’s income tax liability just for this year, until he gets his own business on financially sound footing again, so that he does not have to abandon the grantor trust permanently, just this year. Can the trustee reimburse Todd?

Revenue Ruling 2004-64: Grantor trusts took off in popularity after this publication of this revenue ruling. The Revenue Ruling’s basic premise was that the grantor’s payment of the grantor trust’s income tax liability was not a taxable gift made by the grantor.

  • Estate Tax Exposure: The IRS also provided in the Revenue Ruling that if, pursuant to the trust instrument, or applicable local laws  the grantor of the trust must be reimbursed by the trust for the income tax payable by the grantor that is attributable to the trust’s income, i.e. a right of reimbursement, then the full value of the trust’s assets is includible in the grantor’s gross estate. [IRC 2036(a)(1).] However, the IRS also stated that if the trust instrument or applicable local law gives the trustee the discretion to reimburse the grantor for that portion of the grantor’s income tax liability associated with the grantor trust, the mere existence of that discretion by itself, whether or not exercised, will not cause the value of the grantor trust’s  assets to be includible in the grantor’s gross estate. In short, the grantor might be reimbursed for the trust’s income taxes that the grantor pays on the trust’s taxable income without fear of having the same trust assets taxed in the grantor’s gross estate.
  • Creditor Exposure: If the grantor possessed the right to be reimbursed from the trust’s assets, that right could also expose the trust’s assets to creditor claims against the grantor as a self-settled trust. If the trust is drafted in a way where the trustee possesses the discretion to reimburse the grantor for the grantor trust’s income tax liability, then the trust is not self-settled and creditors cannot obtain access to the trust’s assets. Similarly, if there is a prearrangement that the trustee will always reimburse the grantor for the grantor trust’s income tax liability, the grantor may be treated as possessing a retained interest in the trust, cause not only estate tax exposure, but also access by the grantor’s creditors. Several states have adopted laws that provide that the reimbursement power in an irrevocable trust will not make the trust’s assets subject to claims of the grantor’s creditors nor make the grantor (who may be reimbursed using trust assets) a beneficiary of the irrevocable trust.

Fiduciary Concerns: If a trust instrument is silent on the power of the trustee’s discretion to reimburse the grantor for the grantor trust’s income tax liability, a reimbursement by the trustee of the grantor’s income tax liability using trust assets would be a breach of fiduciary duty to the trust’s beneficiaries because it would benefit the grantor to the detriment of the trust’s beneficiaries. Recall that a trustee must administer a trust ‘solely in the interests of the trust beneficiaries.’ [MCL 700.7802.] To provide the trustee with assurances that it can exercise discretion to reimburse the grantor, the trust instrument should include exculpatory language in the context of the trustee’s reimbursement power. Alternatively, a person other than the trustee could exercise the reimbursement power in a non-fiduciary capacity (which is authorized under the Delaware statute, see below.) Probably the wisest move for a trustee would be to request that all trust beneficiaries execute a release prior to reimbursing the trustee using trust assets.

Grantor Reimbursement Statutes: Some earlier grantor trusts did not expressly give the trustee the authority to reimburse the grantor for the trust’s income tax liability. In those situations the trustee was frustrated, because in the absence of any direction in the trust instrument, the trustee was unable to reimburse the grantor. In response, a handful of states [Colorado, Connecticut, Florida, New Hampshire, New York, and Delaware] adopted statutes to address Revenue Ruling 2004-64 which referred to a reimbursement power authorized under applicable local law to create the reimbursement authorization when the trust instrument is silent.

  • Delaware Statute: Delaware’s statute provides express creditor protection to the grantor as well as authorization for the grantor to be reimbursed from the grantor trust’s assets. [12 Del. C. Section 3344.] Parts of that statute follow:

“Unless the terms of the governing instrument expressly provide otherwise, if the grantor of a trust is treated under 26 USC 672 et seq. [the grantor trust provisions] as the owner of all or part of the trust, the trustee (other than a trustee who is the grantor or a person who is a ‘related or subordinate party’ with respect to the grantor within the meaning of 26 U.S.C. 672(c) may, in the trustee’s sole discretion or with the consent of an advisor (who is not the grantor or a person who is a ‘related or subordinate party’ with respect to the grantor within the meaning of 26 U.S.C. 672(c)) reimburse the grantor for any amount of the grantor’s personal federal or state income tax liability that is attributable to the inclusion of the trust income, capital gains, deductions, and credits in the calculation of the grantor’s taxable income.”

  • Other Statutory Reimbursement Provisions: Each state statute varies somewhat on what authorization is given to the trustee of a grantor trust to reimburse its grantor, and some impose limitations on the trustee’s discretion to reimburse the grantor. Some of the topics and limitations in those statutes include:
  • a prohibition if the trustee’s discretion, coupled with other state laws, would subject the trust’s assets to the claims of the grantor’s creditors;
  • a prohibition if the trustee’s discretion would cause the value of the trust’s assets to be included in the grantor’s gross estate;
  • if the trustee is found to have overpaid the grantor for reimbursable taxes that the grantor paid, then the grantor must repay the excess amount within 30 days;
  • the reimbursed grantor is not treated as a beneficiary of the trust for creditor protection purposes;
  • a life insurance policy, the cash value of the policy, or proceeds from a loan made against the policy may not be used for the reimbursement of income taxes if the grantor is the insured; and
  • the reimbursement authorization is not available if it would disqualify or reduce the marital or charitable gift or estate tax deductions.

Planning With Grantor Trusts: If an irrevocable grantor trust is being considered, and many are due to their benefits while avoiding the compressed income tax brackets irrevocable trusts face, it should include a provision that anticipates that at some future date Michigan might join the other states with a statutory grantor reimbursement authorization. As noted earlier, if the trust contemplates a reimbursement of the grantor by the trustee, then the trustee should be expressly exculpated from claims of breach of fiduciary duty by the trust’s beneficiaries. Nor should there be any written agreement or other pre-existing arrangements between the trustee and the grantor for reimbursement, when the Revenue Ruling clearly states that in those situations the value of the grantor trust’s assets will be included in the grantor’s gross estate at death. Also noted above, if the grantor is reimbursed ‘too frequently’ by the trustee, that pattern may heighten the risk that creditors may be able to access the assets held in the trust, claiming that the grantor is a beneficiary of a self-settled trust. Finally, it should be noted that when grantor trust assets are used to reimburse the grantor for his or her payment of the trust’s income tax liability, that defeats the benefits of the grantor trust, i.e. fewer assets are in the trust growing in an income tax-free environment, and the grantor’s gross taxable estate is not reduced as quickly.

Conclusion: Grantor trusts are popular for a variety of reasons. The ability of the trustee to exercise discretion in using grantor trust assets to periodically reimburse the grantor is an additional benefit that is not to be overlooked. Care just needs to be made to not make those reimbursements inevitable. For those states that have adopted statutes that formally authorize the reimbursement of the grantor, there is even more comfort afforded the trustee when it exercises the discretion to reimburse the trust’s grantor. Hopefully Michigan will someday follow those other states with its own reimbursement statute. If that additional protection is desired, consider changing the situs of the grantor trust to Delaware.