IRS Chief Counsel Advice (CCA) 202352018, released on December 29, 2023, addresses the gift tax consequences of modifying a grantor trust on beneficiary consent to add a tax reimbursement clause. The CCA concludes that such a modification to add a tax reimbursement clause will constitute a taxable gift by the trust beneficiaries because the addition of a discretionary power to distribute income and principal to the grantor is a relinquishment of a portion of the beneficiaries’ interest in the trust.

Before we unpack this, it is important to note that a CCA is not a revenue ruling or its functional equivalent. Rather, it is advice from the IRS national office to an IRS auditor who has posed a question for its review in the context of an audit, and essentially constitutes the IRS’s litigation position akin to a brief that would be filed with a court.

Relevant Facts

In its recitation of facts, the CCA notes that in “Year 1,” the grantor “A” establishes and funds an irrevocable inter vivos trust (the “Trust”) for the benefit of A’s “Child” and Child’s descendants. Under the governing instrument of the Trust, the “Trustee” [who is not related or subordinate to the grantor within the meaning of IRC Section 672(c)] may distribute income or principal to or for the benefit of Child in the Trustee’s absolute discretion. Upon Child’s death, the Trust’s remainder is to be distributed to Child’s issue per stirpes.

Under the governing instrument of the Trust, A retains a power that causes A to be the deemed owner of the Trust under the grantor trust rules; accordingly, all items of income, deductions, and credits attributable to the Trust are included in A’s taxable income. Neither applicable state law nor the governing instrument of the Trust requires or provides authority to the Trustee to distribute to A amounts sufficient to satisfy A’s income tax liability attributable to the inclusion of Trust’s income in A’s taxable income.

In Year 2, when Child has no living grandchildren or more remote descendants, the Trustee petitions the state court to modify the terms of the Trust. Pursuant to the applicable state statute, Child and Child’s issue consent to the modification.

Later that year, the state court grants the petition and issues a court order modifying the Trust to provide the Trustee with the discretionary power to reimburse the grantor A for any income taxes A pays as a result of the inclusion of Trust’s income in A’s taxable income.

The CCA’s Analysis

In developing its analysis, the CCA observed that Treas. Reg. § 25.2511-1(c)(1) of the gift tax regulations provides that the gift tax applies to gifts indirectly made. Further, any transaction in which an interest in property is gratuitously passed or conferred upon another, regardless of the means or device employed, constitutes a gift subject to gift tax.

In addition, Treas. Reg. § 25.2511-1(e) provides that if a donor transfers by gift less than their entire interest in property, the gift tax is applicable to the transferred interest.  Further, 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.

Under Treas. Reg. § 25.2511-2(a), the measure of the gift is the value of the interest passing from the donor with respect to which the donor has relinquished its rights without full and adequate consideration in money or money’s worth.

Importantly, the CCA’s analysis also addressed Treas. Reg. § 25.2511-2(b), which provides that as to any property, or part thereof or interest therein, of which the donor has so parted with dominion and control as to leave in him no power to change its disposition, whether for their own benefit or for the benefit of another, the gift is complete. If, however, a donor transfers property to another in trust to pay the income to the donor or accumulate it in the discretion of the trustee, and the donor, for example, retains a testamentary power to appoint the remainder among the donor’s descendants, then no portion of the transfer is a completed gift—that is to say, it is instead an incomplete gift for federal gift tax purposes.

The CCA also referred to Rev. Rul. 2004-64 (which it distinguished). In that ruling, a grantor created an irrevocable inter vivos trust for the benefit of the grantor’s descendants and retained sufficient powers with respect to the trust so that the grantor is treated as the owner of the trust under the grantor trust rules. In relevant part, the ruling considers two situations in which the trustee reimburses the grantor for taxes paid by the grantor that are attributable to the inclusion of all or part of the trust’s income in the grantor’s income.

• In Situation 2 of Rev. Rul. 2004-64, the distribution reimbursing the grantor is mandated under the terms of the governing instrument [which is something generally to avoid as it will cause estate tax inclusion under IRC Section 2036(a)(1)].
• In Situation 3 of Rev. Rul. 2004-64, the governing instrument provides the trustee with the discretionary authority to make a reimbursing distribution.

In both situations, when the trustee of the trust reimburses the grantor for income tax paid by the grantor, Rev. Rul. 2004-64 concludes that the payment does not constitute a gift by the trust beneficiaries because the distribution was either mandated by the terms of the governing instrument or made pursuant to the exercise of the trustee’s authority granted under the terms of the governing instrument.

The CCA’s Conclusion

The CCA concludes by recapitulating that under the governing instrument of the Trust, Child and Child’s issue each have an interest in the trust property. As a result of the Year 2 modification of the Trust, grantor A acquires a beneficial interest in the trust property in that A becomes entitled to discretionary distributions of income or principal from the Trust in an amount sufficient to reimburse grantor A for any taxes A pays as a result of the inclusion of Trust’s income in A’s gross taxable income. In substance, the modification constitutes a transfer by Child and Child’s issue for the benefit of A. 

According to the CCA, this is distinguishable from the situations in Rev. Rul. 2004-64 where the original governing instrument provides for a mandatory or discretionary right to reimbursement for the grantor’s payment of income tax. Thus, as a result of the Year 2 modification, Child and Child’s issue have made a gift of a portion of their respective interests in income and/or principal. 

The CCA acknowledged that the IRS’s national office was reversing its prior position that it articulated in Private Letter Ruling 201647001, which had concluded 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 CCA summarily dismissed this prior ruling, noting that “these conclusions no longer reflect the position of this office.”

In a statement that has generated a good deal of attention due to its potential application to trust decantings and other trust modifications that may not require beneficiary consent, the CCA then adds that “the result would be the same if the modification was pursuant to a state statute that provides beneficiaries with a right to notice and a right to object to the modification and a beneficiary fails to exercise the right to object.”

The CCA further observed that the gift from Child and Child’s issue of a portion of their interests in trust should be valued in accordance with the general rule for valuing interests in property for gift tax purposes. In a footnote, the CCA adds that “[a]though 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.”

Some Further Thoughts

The CCA is very daunting on its face, and potentially could apply to any trust modification to which a beneficiary fails to object, such as a trust decanting. But is its analysis complete, or is there another aspect of the gift tax regulations that should also be considered?

Taking a step back, let’s consider what’s happening as a result of the beneficiary’s consent to this trust modification. In effect, a discretionary beneficiary of a trust is consenting to add another beneficiary (the grantor) while continuing in his status as a trust beneficiary. Under many states’ laws [including that of New York under NY EPTL § 7-3.1(a)], this constitutes a “self-settled trust” because the beneficiary is effectively making a transfer to a trust of which he is a discretionary beneficiary; such transfer would be considered void against the transferor’s creditors. If the transfer is void against the transferor’s creditors, that means that the transferor has retained the “string” of being able to deny other beneficiaries from obtaining access to the trust property by being able to relegate his creditors to the trust property instead.     

The transfer tax consequences of self-settled trust treatment can be very significant. Under Rev. Rul. 76-103, a transfer to a self-settled trust to which the transferor’s creditors can be relegated causes the gift to be considered incomplete for federal gift tax purposes because the transferor has retained the ability to divert the trust property from the other beneficiaries in favor of his creditors. The gift generally would not become complete for federal gift tax purposes until the trust property is distributed out of the trust to the beneficiary (should that ever occur), and then only in the amount of such distribution.

As a corollary to incomplete gift treatment, the death of the beneficiary who is a deemed transferor to a self-settled trust may create exposure to estate tax under IRC Section 2036(a)(1). Note, however, that there is an exception to estate tax inclusion under Section 2036 [including for Section 2036(a)(1)] where there is a bona fide sale for full and adequate consideration in money or money’s worth. Query whether this circumstance—particularly where an independent trustee has instituted the trust modification—could potentially invoke the “bona fide sale exception” to Section 2036.

This Issue Is Entirely Avoidable in the Context of Grantor Trusts

Finally, it should be noted that, with careful planning, this issue can be entirely avoided in the context of grantor trusts.

First, this issue can be avoided by giving the trustee the discretionary power to reimburse the grantor for income taxes attributable to grantor trust status. In certain states [such as New York under NY EPTL § 7-1.11(a)], this reimbursement power exists under default principles of state law without having to be expressly conferred in the trust instrument—in the case of New York pursuant to NY EPTL § 7-3.1(d), without creating self-settled trust concerns for purposes of IRC Section 2036(a)(1) with respect to the trust’s grantor. 

In addition, this issue can be avoided by having the trustee loan funds to the grantor in an amount sufficient to help defray the grantor’s income tax liability that is attributable to grantor trust status. This has the additional benefit of creating a liability (as a result of the loan) to reduce the net value of the grantor’s taxable estate for federal estate tax purposes.