Reimbursement of Grantor for Income Tax Paid on a Grantor Trust’s Income

The IRS rules, questionably, that trust beneficiaries have made a taxable gift by consenting to add to the terms of a grantor trust a discretionary power in the independent trustee to reimburse the grantor for income tax the grantor pays on the trust’s income.

FACTS IN THE CCA

Chief Counsel Advice 202352018 (issued Nov. 28, 2023; released Dec. 29, 2023) deals with an irrevocable trust that authorizes the independent (not “related or subordinate” to the grantor within the meaning of section 672(c)) trustee to distribute trust principal or income to the grantor’s child “in the trustee’s absolute discretion” and directs that at the child’s death the trust remainder is to be distributed to the child’s issue, per stirpes.

The grantor retained a power with respect to the trust that causes the grantor to be taxed on all the trust income under section 671 but would not cause the value of the trust assets to be subject to estate tax at the grantor’s death – in other words, making the trust a “grantor trust,” often referred to as a “defective grantor trust.” The CCA does not reveal what power the grantor held, but an example would be a power to reacquire trust assets by substituting property of equivalent value, under section 675(4)(C). Neither the governing state law nor the trust instrument required or authorized the trustee to reimburse the grantor for income tax the grantor pays on the trust’s income.

At a time when the grantor’s child had living children but no grandchildren or more remote descendants, the trustee petitioned a state court to modify the terms of the trust to give the trustee the discretionary power to reimburse the grantor for the income tax the grantor pays on the trust’s income. Pursuant to a state statute, the grantor’s child and that child’s children consented to the modification. The court granted the petition and issued an order modifying the trust to allow such reimbursements in the trustee’s discretion.

THE CCA’S CONCLUSION

The Chief Counsel’s Office concluded that, as a result of the modification to which they had consented, the beneficiaries “each have made a gift of a portion of their respective interest in income and/or principal” of the trust. Ominously, it added without elaboration 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 their right to object.”

APPLICATION OF REV. RUL. 2004-64

Rev. Rul. 2004-64, 2004-2 C.B. 7, has been the guide regarding the payment of income tax on the income of a grantor trust for 19½ years. The 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 section 671. It also clarified that if the terms of the trust require the trust 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 obligation” that would cause the full value of the trust assets to be included in the grantor’s gross estate under section 2036(a)(1). In contrast, it held that if that 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 or not 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 retained 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.” (emphasis added)

Rev. Rul. 2004-64 also held that 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.

With regard to the reimbursement discretion, CCA 202352018 distinguishes Rev. Rul. 2004-64 on the ground that the discretionary authority in the Revenue Ruling was granted under the terms of the original governing instrument, not under a modification consented to by the beneficiaries as in the CCA.

REVERSAL OF A PREVIOUS POSITION

The CCA

The CCA acknowledges in a footnote that Letter Ruling 201647001 (issued Aug. 8, 2016; released Nov. 18, 2016) “concludes 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.” But the CCA adds that “these conclusions no longer reflect the position of this office.” Like the CCA, the 2016 ruling did not offer much insight into the actual context, other than the statement (not mirrored by the CCA) that “due to unforeseen and unanticipated circumstances, payment by the Grantors of the income taxes on Trust’s income has become unduly burdensome.”

Precedent

A similar IRS reversal of position, allowing neither a charitable deduction nor a marital deduction for a charitable remainder unitrust interest that the trustee may “sprinkle” between the grantor’s spouse and charity, was seen in Chief Counsel Advice 202233014 (issued July 12, 2022; released Aug. 19, 2022), which was Number Nine in “The Top Ten Estate Planning and Estate Tax Developments of 2022” (Capital Letter Number 58). CCA 202233014 acknowledged in a footnote that four previous PLRs had allowed an estate tax or gift tax marital deduction for a unitrust interest that could be distributed between charity and the decedent’s or grantor’s spouse in the trustee’s discretion, but (like CCA 202352018) stated in its footnote that “the position in these earlier rulings no longer reflects the position of this office.”

Effect

Significantly, the issuance of a Chief Counsel Advice repudiating a position taken in a letter ruling does not revoke the ruling, in the absence of further action specific to the recipient of that letter ruling. Under section 11.04 of Rev. Proc. 2024-1, 2024-1 I.R.B. 1, 64, automatic revocation of a letter ruling is limited to the enactment of legislation, the ratification of a tax treaty, a decision of the United States Supreme Court, the issuance of temporary or final regulations, or the issuance of a revenue ruling, revenue procedure, notice, or other statement published in the Internal Revenue Bulletin. That does not include a Chief Counsel Advice.

VALUATION

The CCA’s Ominous Avoidance of Valuation

The CCA does not say how to value the purported gifts, stating in another footnote that “although 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.”

Earlier, in the section titled “Law,” the CCA includes this paragraph:

“Section 25.2511-2(a) [of the Gift Tax Regulations] provides that the gift tax is not imposed upon the receipt of the property by the donee, nor is it necessarily determined by the measure of enrichment resulting to the donee from the transfer. Rather, it is a tax upon the donor’s act of making the transfer. The measure of the gift is the value of the interest passing from the donor with respect to which they have relinquished their rights without full and adequate consideration in money or money’s worth.”

Like most CCAs and letter rulings, the CCA makes no immediate or specific application of that paragraph and therefore offers little help with valuation – basically just redundantly reciting that the value “is the value.”

Still earlier in the “Law” section, the CCA ominously quotes Reg. §25.2511-1(e) for the proposition 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.” Again, though, there is no elaboration, and thus the statement is not very helpful. The context of Reg. §25.2511-1(e) is a transfer by gift of “less than [the donor’s] entire interest in property,” which is awkward to apply to a case in which the purported gift is actually a purported transfer by the donees back to the donor. In any event, taxing the beneficiaries on the entire value of the trust property in the case of this CCA is an outcome that seems simply too extreme to be entertained, even under the surprising aggressiveness of this CCA.

Sections 2701 and 2702

There are provisions of the Internal Revenue Code, such as sections 2701 and 2702, that are intended and presumably designed to target gifts of less than the transferor’s entire interest in the property, but they may not offer much help. For one thing, section 2701 applies to gifts to “a member of the transferor’s family,” which seems quite inclusive, except that under section 2701(e)(1) it is limited to the transferor’s spouse, descendants of the transferor or the transferor’s spouse, and spouses of such descendants. It would not apply to the purported transfer here by the child and grandchildren of the grantor to their parent or grandparent.

Section 2702 does apply to transfers to ancestors, under section 2704(c)(2)(B) (incorporated by section 2702(e)), but its focus under section 2702(a)(1) on the retention of interests only by the transferor and “applicable family members” (the transferor’s spouse and their ancestors or ancestors’ spouses, under section 2701(e)(2)) reflects the focus on transfers to younger generations with interests retained by older generations.

That is confirmed by the fact that every example in the section 2702 regulations that identifies a transferee mentions only children, or in a couple instances the spouse, of the transferor. See Reg. §§25.2702-2(d), 25.2702-3(e), 25.2702-4(d), 25.2702-5(d), and 25.2702-6(c). To be fair, those examples may simply reflect the types of transfers that are most common. But they are consistent with the traditional focus on transfers to younger generations illustrated, for example, in Rev. Rul. 81-264, 1981-2 C.B. 185, which held that the running of a state statute of limitations on recovery of a demand loan and accrued interest resulted in a taxable gift by “D” (the lender) to “A” (D’s child). The ruling showed its preoccupation with transfers to lower generations by reasoning (emphasis added):

“Here, as in all such familial transactions, there is a presumption that the transfer of wealth from D to A without consideration is not entirely free of donative intent. … A had the resources to pay the debt, and, as D’s child, was the natural object of D’s bounty. On these facts, D’s failing to enforce the debt obligation and permitting it to be barred by the statute has not been shown to be free of donative intent.”

Moreover, except under section 2702(a)(3)(ii) and (b) where an interest in a personal residence or an annuity or unitrust interest is involved (which don’t appear to be applicable to the reimbursement of income tax paid), the result under section 2702(a)(2)(A) is apparently that the beneficiaries could be treated as making taxable gifts equal to the entire value of the trust assets (an outcome, as stated above, that seems simply too extreme to be entertained), or perhaps only the value of their particular interests at the time (which seems very difficult to determine).

A Radical Alternative: Section 2519

Section 2519 is another Code section that in effect could impose gift tax on the entire value of the assets in a trust – in this case a QTIP trust if the surviving spouse disposes of only the spouse’s life interest, which is only a part of the trust. In fact, section 2519 would treat even the “disposition of … part of a qualifying income interest for life” as a disposition of the entire interest in the trust apart from that income interest.

The potential mischief of such a rule is illustrated in Chief Counsel Advice 202118008 (issued Feb. 1, 2021; released May 7, 2021), in which the IRS ruled that the agreement of the surviving spouse and the deceased spouse’s children (as remainder beneficiaries and as virtual representatives of the contingent and unborn beneficiaries) to distribute all the assets of a QTIP trust to the spouse (in what the CCA called a “commutation”) resulted in both (1) a disposition of the surviving spouse’s qualifying income interest under section 2519(a), and thus, the surviving spouse’s gift of all of the interests in the trust other than the qualifying income interest, and (2) a gift by the remainder beneficiaries of their remainder back to the spouse.

By not permitting any offset of those two opposite or circular gifts, CCA 202118008 attracted considerable attention from estate planners, as imposing unnecessary double taxation. Indeed, on the same day as the commutation, the spouse transferred assets, some by gift and some (including assets received from the QTIP trust in the commutation) in exchange for promissory notes, to irrevocable dynasty trusts that the spouse had created for the benefit of the children and their descendants. Those transfers, plus the observation that other assets received in the commutation and retained by the spouse would be subject to estate tax at the spouse’s death, escalated some of the reactions to a perception of triple taxation.

Nevertheless, the Chief Counsel’s Office seemed to have no problem concluding in CCA 202118008 that “the QTIP statutory scheme and legislative history support the view that … the separate transfers by Spouse and Children cannot be offset by consideration for tax purposes.” There is no similar “statutory scheme” applicable in CCA 202352018, which cites nothing but generally applicable gift tax regulations.

The Challenge of Gift Tax Valuation

One way to deal with the valuation challenge might be to treat any reimbursement pursuant to the modified trust terms as a gift by the beneficiaries when that reimbursement is made. But that is just not the way the gift tax works. It depends on projections, maybe actuarial factors, and math – “complex calculations,” as the footnote in the CCA puts it. Perhaps appraisals, although an appraisal would undoubtedly raise issues of extraordinary assumptions, hypothetical conditions, and limiting conditions (imposed by the CCA itself) that at a minimum would require disclosure in any appraisal report under the Uniform Standards of Professional Appraisal Practice (USPAP), and, together with the absence of any “comparable sale” data, might also discourage a qualified appraiser from undertaking the engagement in the first place.

The Challenge of Allocating the Gift Among Potential Donors

And even if the creation of the discretionary reimbursement authority can be credibly viewed as a gift and credibly valued for gift tax purposes, the allocation of that value among the current, future, contingent, and even unborn beneficiaries would pose still another challenge – not to mention how an unborn beneficiary could be required to file a gift tax return or be liable for gift tax. Ironically, the CCA itself seems to envision gift tax liability for unborn beneficiaries by asserting in its footnote that “Child and Child’s issue cannot escape gift tax on the basis that the value of the gift is difficult to calculate,” when in the facts of the CCA “Child’s issue” currently include only Child’s children.

In fairness, the CCA does not explicitly state any intention to treat unborn contingent beneficiaries as donors, and the use of “issue” may be just an inclusive drafting convention that estate planners often use as well. Besides, unborn beneficiaries could never personally give their consent anyway. But does that mean that no loss of value attributable to the reimbursement authority is attributed to unborn beneficiaries? Or that the loss of value attributed to unborn beneficiaries is deemed to be part of the gift by their parent or other ancestor? Or that the loss of value attributed to unborn beneficiaries is just not treated as a gift. (Of course, if no value is attributed to unborn beneficiaries – taking a more or less “qualified beneficiary” approach – valuation might be a bit simpler, because it could bypass very speculative steps such as estimates of fertility.)

REFLECTIONS AND COMMENTS

The Role and Backstory of a CCA

A Chief Counsel Advice typically arises from a specific audit or audits of a specific case or cases that are probably headed to litigation if they are not settled. For that reason, it is always possible that there is a backstory, not revealed in the CCA itself, that would explain the IRS’s seemingly aggressive reaction. It is also reasonable to assume that a CCA is written to support the strongest possible litigation position, either to reinforce the litigation itself or to encourage the taxpayer to avoid litigation by agreeing to a settlement that is favorable to the IRS, which in this case might be an agreed higher value for the beneficiaries’ purported gifts.

The unique backstory of CCA 202352018 also includes that fact that it is addressed to two IRS Associate Area Counsels – Janice B. Geier in Portland, Oregon, and Sheila R. Pattison in Austin, Texas – who have been among the IRS counsel of record in a number of Tax Court cases, including cases well-known to estate planners. Ms. Pattison was counsel in the Texas cases of Estate of Strangi v. Commissioner,115 T.C. 478 (2000), aff’d in part, and rev’d and rem’d in part, 293 F.3d 279 (5th Cir. 2000), involving the includability in a decedent’s gross estate of the value of property that the decedent had transferred to a limited partnership, and Nelson v. Commissioner, T.C. Memo. 2020-81, aff’d, 17 F.4th 556 (5th Cir. 2021), involving a defined value clause limited to appraisals obtained shortly after the dates of the transactions. Ms. Geier was counsel in the Strangi case on remand, T.C. Memo. 2003-145, aff’d, 417 F.3d 468 (5th Cir. 2005), and in the Oregon case of Estate of Jones v. Commissioner, T.C. Memo. 2019-101, involving “tax-affecting” in the valuation of interests in timber businesses. Thus, it is hard to view the CCA as a request by inexperienced lawyers for education from the National Office, and perhaps more likely that it should be viewed as a more strategic step in the context of anticipated litigation.

The Frustrating Dilemma of the CCA

Even so, CCA 202352018 will seem troubling to many. And rightly so. There does not appear to be any reason for the IRS to be concerned about the potential for placing more money in the hands of a grandparent where it could be subject to transfer tax in the near future, rather than continuing to accumulate it free of transfer tax to pass to the grandchildren or potentially even great-grandchildren. The CCA does not say a word to indicate why the IRS would or should be concerned about that.

As noted above, Rev. Rul. 2004-64 confirmed that the grantor’s payment of income tax on the income of a grantor trust 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 section 671. In other words, when the trust was created as a grantor trust, the grantor gave the beneficiaries the value transferred to the trust, which was a taxable gift, and also gave the beneficiaries a framework within which the grantor would in effect pay the future income tax on their income, but that was not a taxable gift. If the benefit of the arrangement to pay that income tax is not a transfer to the beneficiaries for gift tax purposes, how, it might be asked, can what amounts to the return of that benefit to the grantor, in whole or in part, be a transfer for gift tax purposes?

What About Simply Relinquishing the Grantor Trust Feature?

Or suppose the grantor’s retained power or other feature of the trust that makes it a grantor trust can be relinquished or renounced by the grantor. Whether, when, and how it can be relinquished or renounced might be difficult to determine and might vary widely, depending on the particular grantor trust power or feature involved, the other specific terms of the trust, the applicable state law, and sometimes the experience and perspective of the observer. The CCA does not clarify whether relinquishment or renunciation was an option in the case or cases it addresses.

Of course, such relinquishment or renunciation could not possibly be a gift by the grantor – it leaves the grantor theoretically better off, not worse off. But neither can it be a gift by the beneficiaries – even though they are left theoretically worse off, they didn’t do anything. So what if the beneficiaries consent to giving the trustee a discretionary reimbursement authority in order to dissuade the grantor from taking the more decisive action of relinquishment or renunciation? How could that be a gift by the beneficiaries, when they theoretically gain, not lose, from avoiding the grantor’s more decisive action of relinquishment or renunciation?

Often (although not necessarily always), the grantor’s consideration of relinquishment or renunciation of grantor trust status may be prompted by the anticipation of an extraordinary gain, perhaps from the sale of an asset that has been the trust’s sole or principal asset and has performed very well, but in the view of the trustee has reached the point where it would be prudent to replace it with other assets, possibly more diversified, that the trustee believes have better income and/or appreciation potential for the future. It would probably be quite aggressive and risky to suppose that under the terms of the trust the grantor could suspend the grantor trust feature for only one taxable year. (But watch for it – we might now start seeing trusts drafted that way – although I do not recommend it!) The presence of a discretionary reimbursement authority that would permit reimbursement, perhaps even partial reimbursement, only for the taxable year of that transaction (in the trustee’s discretion if the trustee finds that to be in the best interests of the beneficiaries to whom the trustee owes a fiduciary duty), would both meet the grantor’s concerns and serve the beneficiaries’ interests, and would leave in place the beneficiaries’ right to expect the grantor, again, to effectively pay the income tax on those beneficiaries’ income in the future.

In fact, wouldn’t the strong principle of fiduciary duty that governs all the trustee’s actions always govern any discretionary reimbursement by the trustee of the grantor pursuant to the type of discretion added to the terms of the trust in the facts of CCA 202352018? If so, shouldn’t that lead to the conclusion that in fact the beneficiaries are not hurt but benefited – that is, they will not lose and they may gain – by the presence of such a power? So how can the creation of such a power be a gift by beneficiaries? Again, the CCA does not say a word to indicate that the IRS has considered such obvious facts of life.

SO WHAT’S NEXT?

As noted above, CCA 202352018 is probably a step in the audit of an actual case or cases headed to settlement or to litigation. If settled, there will be no public release of any kind, as there was of the CCA itself, which did not identify names or dates. Sometimes persons involved in such settlements receive permission from the taxpayers to discuss the cases publicly, but that is rather rare.

If the case or cases go to litigation, there will probably be unredacted public documents that shed more light on the case, including possibly a court opinion or, alternatively, a stipulated decision to reflect a settlement reached after the litigation is commenced. And we might learn more about the “backstory” from such an opinion. More interestingly, if the outcome is anything but a complete taxpayer victory, we could learn more about how such an outcome could possibly be explained and justified.

The Example of CCA 201939002

This waiting game recalls the case of Chief Counsel Advice 201939002 (issued May 28, 2019; released Sept. 27, 2019), which concluded that stock on a listed exchange transferred to a GRAT by the co-founder and chairman of the board of the corporation had to be valued for gift tax purposes by taking into consideration an anticipated merger of the underlying company that was expected to increase the value of the stock. The CCA failed to even mention that because the donor was the chairman of the board of the publicly traded corporation, federal securities laws may have prohibited him from disclosing confidential information regarding the merger. Because securities laws prohibited what the CCA appeared to require, the estate planning community generally regarded the CCA as unreasonable.

The case addressed by the CCA turned out to be Baty v. Commissioner (Tax Court Docket No. 12216-21, petition filed June 23, 2021). On June 15, 2022, after the petitioner had filed a motion for summary judgment and a memorandum in support (arguing, among other things, the application of the restrictive securities laws) and 12 days before the IRS’s response was due, the IRS conceded, and the parties filed a proposed stipulated decision. On June 17, 2022, the court entered the stipulated decision and denied the motion for summary judgment as moot.

The Example of CCA 202152018: Section 2702 Reprised

Chief Counsel Advice 202152018 (issued Oct. 4, 2021; released Dec. 30, 2021) also involved the valuation of shares of a company transferred to a GRAT, in this case by the founder of what the CCA described as a “very successful company.” In this case, the IRS’s concerns may have seemed more justified than in CCA 201939002, because they appeared to be based on the donor’s choice to rely on an appraisal obtained about seven months earlier to report the value of a nonqualified deferred compensation plan under section 409A, rather than to obtain an appraisal for purposes of the GRAT as of the date of funding of the GRAT that presumably would have taken account of merger negotiations and offers in the previous few weeks.

Surprisingly, however, the conclusion of CCA 202152018 was not just that the IRS disagreed with the value. The CCA reasoned that what it described as “intentionally basing” the annuity payments “on an outdated and misleading appraisal” was an “operational failure,” and “because of this operational failure, Donor did not retain a qualified annuity interest under § 2702.” It did not seem to matter whether the GRAT document included a formula, specifically authorized by Reg. §25.2702-3(b)(1)(ii)(B), to adjust the annuity payments to a specified percentage of the initial fair market value of assets contributed to the GRAT, “as finally determined for federal tax purposes.” Not accepting the retained annuity interest as a “qualified interest” meant that it would be valued at zero under section 2702(a)(2)(A), and the entire value determined to be transferred to the GRAT would be the taxable gift, even though at least a large portion of the value was expected to be returned to the grantor as annuity payments.

Thus, possibly worse facts for the taxpayer, but a much worse result proposed by the CCA. Nothing public has appeared yet.

Application to CCA 202352018

So, in the case of CCA 202352018, we might hear rumors about a settlement at the IRS. Or we might see some court documents that suggest that litigation had commenced but the case was settled and a stipulated decision entered. Or we might be treated to a full-blown court opinion, in which, as stated above, it would be very interesting to see how anything but a complete taxpayer victory is justified. Or we might hear nothing more.

Meanwhile, and regardless of the outcome, the CCA has created a lot of turmoil.

Ronald D. Aucutt

© Copyright 2024 by Ronald D. Aucutt. All rights reserved.