Grantor Trusts and Tax Liability: Revenue Ruling 2004-64

By Nathan Szerlip

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A grantor trust is a trust for which someone other than the trust bears some or all of the income tax liability. IRC sections 673–677 and 679, and the related regulations, determine whether a trust is a grantor trust. Originally, these rules were meant to discourage trusts from shifting income to lower-bracket taxpayers. Subsequent legislation lowered the tax rates and compressed the trust tax brackets, which made the grantor trust an attractive way to transfer wealth. A properly structured grantor trust allows the trust assets to grow for future generations, with the income tax consequences borne by the grantor.

In Private Letter Ruling (PLR) 9444033 (November 4, 1994), the IRS raised the gift tax consequences of the grantor’s payment of income taxes. In this ruling, irrevocable grantor trusts were established to pay annuities for seven years or until the death of the grantors, if earlier. The independent trustee would also reimburse the grantors for any tax liability on income not distributed to the grantors. The IRS concluded that, without this reimbursement provision, an additional gift would result when the grantors paid the tax attributable to the undistributed income.

Taxpayers questioned the ruling’s correctness to such an extent that the IRS reissued the ruling in PLR 9543049 (August 3, 1995). The revised ruling deleted the discussion of the gift tax consequences of the grantors’ tax payments but retained the requirement that the trustees reimburse the grantors for the tax liability on the undistributed income. This ruling left in doubt the gift tax consequences where there was no reimbursement provision and the estate tax consequences where such a reimbursement existed.

Reimbursement and Liability

In Revenue Ruling 2004-64, a U.S. citizen established and funded an irrevocable trust for descendants. The trust instrument required the trustee to be independent. The grantor could not cause an incomplete gift or inclusion in the grantor’s estate, but did have sufficient powers to cause grantor trust treatment. In the first year, the trust had income that is included in the grantor’s taxable income and increased the grantor’s tax liability. In the third year, the grantor died. The ruling posited three scenarios: 1) neither state law nor the trust instrument requires or permits reimbursement for the increased tax liability; 2) the trust instrument requires reimbursement and the trustee reimburses; 3) the trust instrument gives the trustee discretion to reimburse.

The ruling concluded that in all of the scenarios the grantor’s payment of the tax is not a gift to the trust beneficiaries, because the grantor is liable for it. The subsequent reimbursement of the payment, whether mandatory or discretionary, is, likewise, not a gift from the beneficiaries to the grantor, because the reimbursement is pursuant to the trust instrument.

The ruling also concluded that a mandatory reimbursement provision, whether through the trust instrument or through state law, would bring the full value of the trust owned by the grantor into the grantor’s estate under IRC section 2036(a)(1) and Treasury Regulations section 20.2036-1(b)(2), because the discharge of the grantor’s legal liability is a retained use of the trust property. The ruling noted, however, that the discretionary reimbursement by an independent trustee would not cause inclusion in the grantor’s estate without the presence of other factors. Other factors might include an understanding or arrangement between the grantor and the trustee requiring reimbursement, the ability of the grantor to remove the trustee and name the grantor as a successor trustee, or the right of the grantor’s creditors to reach trust assets pursuant to local law. The ruling further stated that its adverse estate tax holding on mandatory reimbursements will not apply to trusts existing before October 4, 2004.

Revenue Ruling 2004-64 may present a problem for grantor trusts because of state laws. Where states give a trustee discretion to reimburse for income taxes paid and also permit creditors to reach trust assets used for the grantor’s benefit, it is unclear whether the IRS will consider this sufficient to include the trust in the grantor’s estate. Absent further clarification, planners should suggest adding clauses to new trusts specifically negating any discretionary tax reimbursement.

The ruling specifically exempts pre–October 4, 2004, trusts from the adverse estate tax consequences of a mandatory reimbursement provision. Although it is not stated, it is unlikely that pre–October 4, 2004, discretionary reimbursement trusts drafted in reliance on prior letter rulings will not be grandfathered. To avoid tainting the grandfathering of pre–October 4, 2004, trusts, additions to these types of trusts should be avoided.