Take-Away: A popular estate planning device these days is  a grantor trust. The transferred assets are removed from the settlor’s taxable estate. The settlor is charged with paying the income taxes on the grantor trust’s income, thus reducing the settlor’s taxable estate, while the income tax payments made on behalf of the grantor trust are not treated as gifts from the settlor to the trust beneficiaries. The grantor trust strategy works exceedingly well, that is, until the settlor gets tired of paying the grantor trust’s income tax obligation. Then what?

Background: Grantor trusts are  popular these days as an estate planning device for a variety of reasons.

  • Appreciated assets can be sold by the settlor to the grantor trust, in exchange for a promissory note, and no capital gains will be recognized by the settlor as he/she is treated as transferring the appreciated assets to themselves; this ‘sale’ removes appreciating assets from the settlor’s taxable estate without any taxable gain recognition. [Rev.Rul. 85-15, 1985-1 C.B. 184.]
  • The interest paid by the grantor trust to the settlor, either in an installment sale to the grantor trust, or a loan from the settlor to that trust,  is not taxable; the settlor is treated as paying the interest to himself.
  • If the settlor approaches death and desires  to obtain a ‘step-up’ in income tax basis of the grantor trust’s assets, the settlor exercises his/her retained power to substitute assets to exchange high basis assets with the grantor trust ( for the grantor trust’s low basis assets) so there can be a full basis step-up of the exchanged assets held by the settlor on his/her death.[IRC 675(4)(C).]
  • As noted, the settlor must pay the income taxes on the grantor trust’s income, which results in the settlor depleting his/her taxable estate, thus reducing the settlor’s estate’s exposure to federal estate taxes on the settlor’s death;  the settlor’s estate is burned (lowered) in the payment of the grantor trust’s income tax liabilities over the years.
  • The Service has formally held that the settlor’s payment of the grantor trust’s income tax obligations will not be treated as a taxable gift by the settlor to that trust’s beneficiaries. As a result, the settlor’s obligation to pay the grantor trust’s income taxes results in the assets growing (hopefully) in almost a tax-free environment, which ultimately benefits the grantor trust’s [Rev. Ruling 2004-64, 2004-2 C.B.7.]
  • In the Services’ same Revenue Ruling, it held that the trustee of the grantor trust may exercise its discretion and periodically reimburse the settlor for the grantor trust’s income tax liability that the settlor pays. In order to avoid the Service’s claim that the reimbursement for income taxes paid was pre-arranged between the settlor and the trustee, this ability of the trustee to reimburse the settlor is only be infrequently exercised by the grantor trust [Rev. Ruling, 2004-64, Situation 3, if the trustee of the grantor trust is neither related nor subordinate to the settlor within the meaning of IRC 672(c).]

Questions: What happens when the settlor gets tired of paying the grantor trust’s income taxes, but the trustee refuses to reimburse the settlor for those income tax payments? The simple solution is that he settlor can release the retained power to substitute assets of equivalent value with the grantor trust, so that that power no longer exists. Thereafter,  the trust will cease to be treated for income tax purposes as a grantor trust, which shifts the income tax burden back to the non-grantor trust to pay its own income taxes.

What relief does the settlor have if the trustee refuses to reimburse the settlor for income taxes caused by the grantor trust but the settlor does not avail himself of the ability to release the power to substitute assets of equivalent value? Apparently an Ohio Court concluded that the settlor does not have any ability to escape the trust’s income tax burden if that relief is sought from a court, as announced in an interesting case just reported. Norman Millstein, v Kevan Millstein et. al, Ohio Court of Appeals, No. 10681,  Case No. CV-17-883760 (June 14, 2018)

  • Facts: The facts were pretty simple. Norman created two irrevocable, grantor trusts, in 1987 and 1988. Norman reported the trusts’ income and paid taxes on that trust income for over 20 years. [IRC 671 et. seq.] In 2010 [I suspect the timing for Norman’s change in heart was caused by the Great Recession] Norman asked the trustee to reimburse him for the trusts’ substantial income taxes that Norman had to pay. While the trustee declined that request for a direct reimbursement, arrangements were made to access yet another trust’s assets to help defray Norman’s income tax obligations. In 2013 the trustee informed Norman that the other trust no longer held liquid assets to help defray Norman’s income tax liabilities, thus Norman was on his own when it came to paying the two trusts’ income tax liabilities. As a result, Norman paid federal and state income taxes of $5,225,000 on one grantor trust in 2013 and $1,261,000 in income taxes on the other grantor trust for the years 2013 through 2015.
  • Courts: When the trustee refused to assist Norman with these income tax payments, Norman then filed a petition with the court that sought an equitable reimbursement of the income taxes  from the two grantor trusts. The trustee of the two grantor trusts responded with a motion to dismiss Norman’s petition,  claiming, among a variety of defenses: (i) as the grantor trusts’ settlor, Norman lacked legal standing  in the court to request that the trusts make reimbursement payments to him; and (ii) as the trusts’ settlor, Norman had no claim for equitable reimbursement under Ohio law. The trial court dismissed Norman’s petition. Norman filed an appeal of that dismissal. The Ohio Court of Appeals affirmed the trial court’s dismissal of Norman’s petition, leaving him fully responsible for the income tax obligations of the two grantor trusts.
  • Uniform Trust Code: The Ohio appellate court’s findings would seem to also apply if a similar claim was filed in Michigan courts by the settlor of a grantor trust, since both Ohio and Michigan have substantially adopted the Uniform Trust Code  and its multiple provisions.
  • Tax Objectives Modification: The Michigan Trust Code, like Ohio’s, adopted UTC 416. [MCL 700.7416.] That statute provides: To achieve the settlor’s tax objectives, the court may modify the terms of a trust in a manner that is not contrary to the settlor’s probable intention. The court may provide that the modification has retroactive effect. While this statute is silent on the legal standing question, the Ohio court found that only a trustee or trust beneficiary may commence a proceeding in court to approve or disapprove a modification under this Trust Code section with regard to achieving the tax objectives of an irrevocable trust.
  • Settlor Has No Standing: To reach this conclusion that only the trust beneficiaries or the trustee may petition the court to modify the irrevocable trust, the Ohio court referred to yet another section of the UTC, also adopted in Michigan, which states that a proceeding to modify or terminate a trust [under MCL 700.7411 to 7416, the principal trust modification or termination statutory provisions] may be commenced by a trustee or beneficiary. [MCL 700.7410(2).] Only when trust beneficiaries or the trustee seek to modify the terms of an irrevocable trust, is the consent of the settlor implicated.[MCL 700.7411(3).] In refusing to apply equitable principles to the statute that restricts who may petition the court to modify the trust, the Ohio court noted: “In this instance, the legislature clearly considered the circumstances in which it intended to allow parties to a trust to modify the terms of the trust to achieve a settlor’s tax objectives and decided to reserve the power to initiate such an action to the trustee or beneficiary.” The upshot of MCL 700.7410(2) is that the settlor has no legal standing to initiate a trust modification or termination in Michigan to achieve tax objectives, or in this case, reimburse the settlor for the trust’s income tax liabilities.
  • No Equitable Intervention:  Even after the Ohio Court found that Norman had no legal standing to petition the court to modify the grantor trusts that he had created almost 30 years earlier, it could not resist the opportunity to remark that even if the Trust Code statute would have permitted Norman to file his petition, i.e. he possessed legal standing to ask for the trust’s modification and for reimbursement, equitable principles prevented the court from granting Norman any relief: “Appellant admits that he established the trusts in a manner that allowed him to personally take advantage of tax deductions and credits derived from the trust investments and that he is responsible for taxable income. Appellant has not alleged that Kevan [the trustee] or any of the other parties named in this suit have taken any action inconsistent with the terms of the trusts that he himself created. We agree with the appellee’s position that appellant voluntarily created the situation that he now claims is inequitable.”

Conclusion: While grantor trusts receive a lot of attention these days due to the many income and estate tax attributes that go along with them, it would be wise to spend some time with the settlor to explain the limitations on how the settlor might later try to escape the income tax burdens that go along with a grantor trust. The grantor trust can be established that prohibits the trustee from any reimbursements to the settlor, or it can grant to the trustee the discretion to reimburse the settlor for his/her income tax liability attributed to the grantor trust. If the trustee refuses to reimburse the settlor, believing its fiduciary duty is to preserve and enhance (not deplete) trust assets for the beneficiaries, the settlor’s only recourse is not through the courts, but simply release the retained power to substitute assets of equivalent value with the trust (or one of the other retained powers or conferred powers under the Tax Code that will  cause the trust to be taxed as a grantor trust.) Time needs to be spent discussing the fact that it is the trustee that possesses the discretion to reimburse the settlor for income taxes he/she paid, and not the settlor’s option.  Nor will a probate court come to the rescue of the settlor to relieve the settlor of the trust’s income tax obligations. A grantor trust probably falls into the category of ‘beware of what you ask for, because you will actually get it.’