On the last workday of the year, December 29, 2023, the IRS issued a Chief Counsel Memorandum adding a wrinkle to one of the most frequently used estate planning techniques — to give assets away for estate tax purposes but not income tax purposes.

This includes intentionally defective grantor trusts (IDGT) and spousal lifetime access trusts (SLAT), as well as all their variations.

By placing assets into a Trust for estate tax purposes, the grantor can ‘freeze’ the value of their assets for estate tax purposes, and lock in the current elevated estate tax exemption. However, Trust tax brackets are compressed, and so a Trust would typically pay higher income tax than an individual. Thanks to differences in the tax code, many trusts are taxed to the individual grantor, which typically results in lower income tax obligations. This also has the added benefit that any income tax payments are made by the taxable estate, further reducing any potential future estate tax.

However, it may not always be desirable for the individual to pay the income tax, especially if the individual’s assets may eventually run out, and a common question is whether or not the trust can reimburse the individual for the income tax payments.

Back in 2004, the IRS issued revenue ruling 2004-64, which explained the tax treatment of such a reimbursement provision. It outlined three situations, and the tax treatment thereof:

  • The Trust is obligated to reimburse the individual for income tax payments. In this situation, the transfer to the Trust is not a completed gift for estate tax purposes, and the assets will be subject to the estate tax.
  • The Trust is prohibited from (or does not mention) reimbursing the individual. In this situation, the Trust assets are not subject to the estate tax.
  • The Trustee may reimburse the individual for income tax payments. This is the ‘best of both worlds’ situation — the assets are out of the estate, and the individual can get reimbursed, no issues. (unless the Grantor becomes the Trustee, but that’s a much longer story). For most trusts, this is the right answer.

There is a fourth situation, which was not addressed at the time, and has now received an answer. What if the Trust prohibits or does not mention reimbursement, but someone can modify the Trust to allow reimbursement? According to the IRS, adding such a provision is a taxable gift from the beneficiaries to the grantor.

Over the past few decades, a trend in Trusts is to provide more and more powers to a third-party, ranging from directed trusts to trust protectors. In general, this is a good idea, as it provides a lot more flexibility and allows a Trust to be modified or adjusted after the fact. However, such third-party powers should not be too broad to avoid adverse tax consequences.