IRS warns change to grantor trust could be taxable gift


The IRS has held in new Chief Counsel Advice (CCA 202352018) that the addition of a tax reimbursement clause to an existing grantor trust would result in a taxable gift to the grantor from the beneficiaries of the trust.


In this instance, the grantor established a trust for the benefit of his child and the child’s issue. The grantor retained certain powers over the trust that resulted in the trust being classified as a grantor trust, and all of the income of the trust was taxed to the grantor. The following year, the trustee petitioned a state court to modify the terms of the trust in order to allow the trustee the discretion to reimburse the grantor for the income tax liability, which resulted in the grantor’s  trust income being included in the grantor’s taxable income. 


Contrary to previous private letter rulings, the IRS concluded that this modification to the terms of the trust would result in a gift by the beneficiaries to the grantor of the trust, and that gift tax would apply to the entire value of the property if the interest transferred is not susceptible to measurement. This would be an unusual circumstance, and the CCA does not give much detail regarding the facts of this case.


More commonly, if the grantor of the trust no longer wants to pay income tax on the trust income, the grantor would relinquish the power over the trust, which would result in the trust being considered a grantor trust. From the facts presented, it is not clear if this modification of the trust terms was the result of the grantor’s intention to relinquish his grantor powers. Alternatively, the trust could have decanted to another state where state law provides that trustees have a statutory right to reimburse the grantor for income taxes paid on trust income. More generally, a grantor’s obligation to pay the income tax of the trust can be considered a nontaxable benefit to the beneficiaries of the trust. 


Whether this results in litigation and what the courts have to say on this situation will be closely watched. Taxpayers who are grantors of trusts where they pick up trust income when determining their income tax liability need to take into account this change in the IRS’s position on this issue.  


Grant Thornton Insight

Grantors should evaluate all possible tax impacts on themselves, the trust, and beneficiaries when considering terminating the burden of the tax reimbursement. The beneficiaries in this case appear to have refrained from objecting to this change. The advice does not address the remainder of the trust beneficiaries’ possible gifts and how the beneficiaries would be treated if some of the beneficiaries objected to the change in trust terms. Since the power in this case is discretionary by the trustee, how a possible gift is valued will be a difficult discussion.   



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