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Even before the Internal Revenue Code concluded that a settlor of a grantor trust won’t be treated as having made a gift of the amount of the tax to the trust beneficiaries,1 most practitioners have long understood the many benefits of grantor trusts.2
Grantor trusts enhance the value of the original transfer by shifting the tax burden from the trust to the settlor,3 allowing the trust to grow free of income tax and the estate of the settlor to shrink. Further, because the grantor trust is disregarded for income tax purposes, transactions that would ordinarily result in an income tax between the grantor and the trust, such as selling assets to the trust, are also disregarded for income tax purposes.4
Unfortunately, settlors sometimes lose their excitement for paying income taxes on income they didn’t actually receive but which went into the trust for their beneficiaries. What options might mollify growing “grantor trust angst” from continuing to bear the tax on trust income?
The practitioner might try to identify the underlying reasons creating the angst for the client since the initial reaction of evaluating how to turn off grantor trust status might not be the best approach. It may not even address the actual concerns the client has.
Financial Analysis
When originally discussing the estate plan with a client, a practitioner might have prepared a cash flow analysis to project the impact of the trust plan, including income taxes paid for client’s life expectancy. That analysis may be helpful to review when a client frets over paying income taxes.
Practitioners may create current financial forecasts, or update the original ones, to get a better understanding of the source of the client’s grantor trust angst. Such projections should be based on a realistic budget and quantify the real tax exposure to the settlor.
Updated financial forecasts may help to determine whether angst about continued payment by the grantor of the taxes on the income earned by the grantor trust stems from real or perceived financial hardship and whether any such hardship is likely to be temporary or permanent. From this starting point, the practitioner should then evaluate whether the client’s grantor trust angst may also be driven by non-financial, personal concerns. For example, if the hardship of tax payments is short lived, it may be inadvisable to consider turning off grantor trust status as an option.
Personal Feelings/Family Dynamics
Also consider personal feelings and family dynamics. Perhaps there hasn’t been a material change in the financial picture, but the client just doesn’t want to be as generous to their children by paying the taxes on the income earned by the grantor trust.
It’s important to identify the actual cause of the client’s grantor trust angst before crafting solutions. The solution may not be restructuring a trust or estate plan, but rather reassessing how the client will interact with adult children and other beneficiaries. For example, it may be possible that a spouse or other individual holds a power of appointment over trust assets that might redirect trust assets to modify the beneficiary’s rights, reduce the beneficiary’s ultimate benefit or, if appropriate, cut the beneficiary out entirely.
In some cases, the beneficiaries might feel like they have no real control over the assets in the trust or financial autonomy because grantor trust status pulls the grantor back into the activities of the trust on an annual basis. Turning off grantor trust status could help to separate the financial fortunes of the beneficiaries from their parent. While it might not make much sense from a tax or planning perspective, it could be just the thing that helps to heal family divisions.
Finally, a practitioner may need to consider whether a completely different course of action is preferable. Depending on the allocation of family wealth between trust and non-trust assets, the client might simply revise their dispositive plan for non-trust assets by revising beneficiary designations for retirement plans or changing distributions under a will. Such decisions could reduce the economic benefit to the errant heir without disrupting the trust. The benefit of this approach is that it doesn’t require any tinkering with the trust plan, and perhaps quite importantly, it can be more easily done, and in the future undone, if the client’s feelings change again.
By understanding the root cause, the practitioner may be better positioned to understand whether the tax angst is caused by a temporary or permanent problem. Turning off grantor trust status is generally a permanent solution and may be too dramatic if the problem is temporary and can be solved by gentler means.
Tax Reimbursement Clause
One of the first steps in addressing a client’s grantor trust angst is to determine whether the original trust instrument included a tax reimbursement clause, which may offer a simple solution.
When there’s a tax reimbursement clause, the practitioner should explain its uses and limitations. A practitioner should caution the client about how frequently and to what degree a tax reimbursement clause may be used. If a trustee uses a tax reimbursement clause regularly to provide funds to the grantor to pay taxes on an annual or quarterly basis, such a pattern could be evidence of an implicit agreement between the client and the trustee, particularly when the trustee is an individual who has a close personal relationship with the client and the family. The implicit agreement might form the basis of a claim by the Internal Revenue Service or a creditor that the client retained an interest in the trust that could cause estate tax inclusion.
In evaluating a request for tax reimbursement, the trustee owes a fiduciary obligation to act in the best interests of the trust beneficiaries and may deny requests for reimbursement in fulfillment of fiduciary obligations to the beneficiaries. The practitioner should communicate all of this to the client, preferably in writing, and make clear that a tax reimbursement mechanism may not be a complete remedy for grantor trust angst.
Grantor Trust Powers
Grantor trusts may offer sufficient flexibility to deal with grantor trust angst without turning off grantor trust status. The practitioner may wish to consider the following, non-exhaustive list of transactions between the grantor and the trust to shift cash from the trust to the grantor without triggering an income tax consequence:5
- The trust can make a principal payment to pay down the note owed to the grantor.
- A grantor can sell illiquid assets to the grantor trust in exchange for cash or marketable securities.
- If the trust has liquidity but the grantor doesn’t, the settlor may substitute assets in the trust for personal assets of equivalent value.6
- The trustee may be able to loan cash to the grantor, under either the general loan powers or a special grantor trust power requiring the trust to lend to the settlor without adequate security.7
Turning Off Grantor Trust Status
Practitioners should evaluate and advise the client in writing about the effects of turning off grantor trust status. Practitioners should exercise caution and avoid proceeding in a way that might undermine the original plan and inadvertently cause an adverse tax event. In a recent malpractice case, the client sued the attorney claiming they didn’t understand the consequences of relinquishing grantor trust powers.8
To the extent that the liabilities in the trust exceed the basis of assets in the trust, turning off grantor trust status could create an income recognition event (that is, a deemed sale).9 The practitioner should collaborate with the CPA to limit adverse income tax consequences of turning off grantor trust status if that path is chosen.
Only certain types of trusts may own S corporation (S corp) shares. Prior to turning off the grantor trust status of a trust that owns S corp stock, the trustee should consider whether the trust needs to make an election to qualify as an S corp shareholder.10
The trust agreement may include a provision that allows for grantor trust status to be toggled off automatically on a date certain or before the occurrence of a specific event. Alternatively, an individual acting in a non-fiduciary capacity may be given authority to turn off grantor trust status in the trust instrument.
When a trust owns a life insurance policy on the life of the grantor, such policy may need to be transferred out of the trust before grantor trust status can be turned off. When the grantor’s spouse is a primary beneficiary of a trust, turning off grantor trust status may be challenging as distributions to a spouse would have to be approved by a nonadverse party. It may be feasible to add that mechanism to the trust via a decanting or non-judicial modification.
Endnotes
1. See Revenue Ruling 2004-64.
2. Note that the General Explanations of the Administration’s Fiscal Year 2024 Revenue Proposals (Green Book) proposes eliminating this rule and making the grantor’s payment of income taxes on trust income a gift after date of enactment.
3. Under Internal Revenue Code Sections 671-677, if certain powers are retained, the grantor is taxed on the income of the trust.
4. See Rev. Rul. 85-13. Note that the Green Book has also proposed eliminating this tax treatment from the date of enactment.
5. See ibid.
6. See Rev. Rul. 2008-22. The trustee has a fiduciary obligation to the trust beneficiaries to ensure that the assets swapped have equivalent value.
7. Under the Green Book proposal, a loan would carry out distributable net income the same as a distribution.
8. SeeScott v. Rosen, et al., Broward County, Docket No. CACE20000868.
9. See Treasury Regulations Section 1.1001-2(c), Example 5.
10. An electing small business trust or qualified subchapter S election under IRC Section 1361(e) or Section 1361(d), respectively.