Grantor Trusts: Revenue Ruling 2004 Under Attack?

Take-Away: The recent Chief Counsel Advice 202352018 casts a cloud over the favorable tax treatment of grantor trusts, which leads to some concerns that the IRS may take future steps to erode the income and estate tax benefits of a grantor trust, or the gift tax implications when a beneficiary of a decanted trust does not object to the trustee’s decanting decision.

Background: CCA 202352018 distinguishes the tax treatment of grantor trusts, first announced in Revenue Ruling 2004-64. It does so on the ground that the trustee’s discretionary authority identified in the Revenue Ruling was granted under the terms of the original governing instrument, not under a trust modification consented to by the trust beneficiaries. The facts in the CCA were straight-forward. A discretionary grantor trust was created for the settlor’s child. On the child’s death, the trust corpus was to be distributed to the child’s descendants, per stirpes. The trust instrument was silent on the trustee’s discretion to reimburse the settlor for income taxes the settlor paid on the trust’s income. Pursuant to a state statute, the child and the child’s children consented to a trust modification that allowed the trustee to exercise its discretion to reimburse the settlor for income taxes paid using the trust’s assets. The IRS held that the result of the trust’s modification was that the child and the child’s children each made a gift of a portion of their respective interests in the income and/or principal in the discretionary trust. The CCA then added some vague language that clearly suggests that if the trust had been modified via a trust decanting with notice being given by the trustee to the trust beneficiaries and the beneficiaries had the right to object, that a similar taxable gift would result if the trust beneficiaries failed to exercise their right to object.

Revenue Ruling 2004-64: Revenue Ruling 2004-64 has been the ‘Bible’ about the tax treatment of a grantor trust for 20 years. This Revenue Ruling confirmed that the grantor’s payment of income tax is not a gift by the grantor to the trust’s beneficiaries because it is paid in discharge of the grantor’s own liability, imposed by IRC 671. It also confirmed that if the terms of the trust require the trustee to reimburse the grantor for those income tax payments, the grantor has ‘retained the right to have trust property expended in discharge of the grantor’s legal obligations’ that would cause the full value of the trust assets to be included in the grantor’s gross estate. [IRC 2036(a)(1).] However, more importantly, the Revenue Ruling also held that if the reimbursement is only discretionary with the trustee under the terms of the trust or applicable state law, and the trustee is not ‘related or subordinate’ to the grantor, that discretion, whether exercised,

“would not alone cause the inclusion of the trust in the grantor’s gross estate for federal estate tax purposes…However, such discretion combined with other facts (including but not limited to: an understanding or pre-existing arrangement between the grantor and the trustee regarding the trustee’s exercise of this discretion; a power retrained by the grantor to remove the trustee and name the grantor as successor trustee; or applicable local law subjecting the trust assets to the claims of the grantor’s creditors may cause inclusion of the trust’s assets in the grantor’s gross estate for federal estate tax purposes.”

More relevant to the CCA’s change in the IRS’s position is that the Revenue Ruling also held that the reimbursement of the grantor for payment of income tax on the trust’s income pursuant to a discretionary reimbursement authority held by an independent trustee “is not a gift by the trust beneficiaries,” apparently even if there is an understanding or pre-arrangement or similar ‘bad facts’ that are relevant under the Revenue Ruling to the grantor’s own estate tax consequences.

2016 Private Letter Ruling: The 2023 CCA contradicts an earlier private letter ruling issued by the IRS. In PLR 201647001, issued August 8, 2016, released on November 18, 2016, the IRS concluded its analysis “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.” The IRS only mentions in a footnote to the CCA that this PLR ‘no longer reflects the position of this office.’

Lingering Questions:

• No Property Interest:  The Michigan Trust Code expressly states that a beneficiary of a discretionary trust does not possess any property interest in the trust. Therefore,  if the beneficiary of the discretionary trust possesses no property interest to be conveyed, how can that beneficiary, per the IRS, have made a taxable gift when no property was involved?
• Valuation Guidance: The IRS provides absolutely no guidance on how to value the purported gifts by the trust beneficiaries. It only notes in a footnote that ‘the determination of the values of the gifts requires complex calculations, Child and Child’s issue cannot escape gift tax on the basis that the value of the gift is difficult to calculate.”  Gee, that’s great. The Service concedes that the trust modification-deemed gift will entail complex calculations, but not how to value those discretionary non-property interests in the trust.
• Existing Valuation Principles: Without definitive guidance from the IRS on how to go about valuing these beneficiaries’ deemed gifts, one worry is that the IRS might be tempted to apply Regulation 25.2511-1(e). That Regulation tells us that “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.”  If this valuation ‘rule’ is applied, then you have the extreme result of the trust beneficiaries giving the entire trust corpus back to the settlor, when the beneficiaries have no property  interest in the trust, and apparently, the settlor is then deemed to own the entire trust corpus that he/she previously gave away using his/her applicable exclusion amount to shelter that initial gift for federal estate tax purposes.

Conclusion: This CCA is troubling on many fronts. While the big ‘take-away’ is if a trust being drafted is intended to function as a grantor trust, the trustee’s discretion to reimburse the settlor for the trust’s income tax liability should be included in the governing instrument. Less clear is its impact on deemed gifts by trust beneficiaries in trust modification proceedings or even in a trust decanting situation where the trust beneficiaries are given notice of the trustee’s decision to decant trust assets and those beneficiaries do not formally object to the trustee’s proposed actions. There is a lot to worry about with this CCA and virtually no guidance from the IRS to deal with the questions it raises.