Recent CCA raises concerns for irrevocable grantor trust modifications

Editor: Theodore J. Sarenski, CPA/PFS

In Chief Counsel Advice memo (CCA) 202352018, released Dec. 29, 2023, the IRS determined that the addition of a discretionary reimbursement clause to an irrevocable grantor trust under Secs. 671– 679 resulted in a gift made by the trust’s beneficiaries to the grantor. The CCA generally resulted in more questions than answers with respect to potential gift tax implications caused by trust modifications. This column explores some of the issues and uncertainties the CCA raises and provides practical suggestions for tax practitioners.

Facts of the CCA

An irrevocable grantor trust (IGT) was established by the grantor in year 1 for the benefit of the grantor’s child and the child’s issue. Pursuant to the trust’s terms, the independent trustee had absolute discretion to distribute income and principal for the benefit of the child. In year 2, the trustee petitioned a state court to add a discretionary power to reimburse the grantor for income taxes paid as a result of inclusion of the trust’s income in the grantor’s taxable income (“reimbursement clause”). A state statute required that the beneficiaries of the trust approve the addition of the power, and the grantor’s child consented to the modification, also doing so on behalf of their issue.

The IRS distinguished the CCA from Rev. Rul. 2004-64, in which it had ruled that actual reimbursement by a trustee to a grantor for income taxes paid by the grantor on behalf of a grantor trust, pursuant to the original terms of the trust agreement, would not be a gift from the trust beneficiaries to the grantor. Thus, the IRS took the position in the CCA that the beneficiary’s consent to the addition of a reimbursement clause that did not previously exist constitutes an act by the beneficiary that rises to the level of a gift under Sec. 2511.

The CCA represents a reversal of the IRS’s position in Letter Ruling 201647001, in which the Service ruled that the addition of a similar reimbursement clause by an independent trustee by court approval was not a gift from the beneficiaries to the grantor. While the CCA is not authoritative to other taxpayers, it provides taxpayers with an indication of the IRS’s current thinking on the matter and therefore raises questions on the tax implications of modifications to the terms of an IGT.

Questions raised by the CCA

Result of modifications generally

The most obvious question posed by the CCA is whether the IRS’s position would extend to any modification of an IGT other than a strictly administrative change (e.g., a change from one independent trustee to another). As noted above, the CCA reversed the IRS’s position in Letter Ruling 201647001, which ruled that a modification to an IGT providing the trustee a discretionary power to reimburse was “administrative in nature” and did not “result in a change in the beneficial interests in Trust.” Letter Ruling 201647001 did not elaborate on its reasoning in arriving at that conclusion. The IRS’s current position appears to be that the addition of a reimbursement provision may not always be strictly administrative in nature. In the absence of clear guidance of what constitutes a strictly administrative provision for estate and gift tax purposes, practitioners may wish to exercise heightened caution and scrutiny when advising clients about the tax implications of a potential modification to an irrevocable trust.

If the CCA is upheld, the question becomes, what is a tax preparer to do if a modification is made? Presumably, a modification that is purely administrative in nature and does not change the beneficial interests in a trust would not cause a completed gift by either the grantor or the beneficiaries, but this is far from clear. For instance, it is unclear whether the modification proposed in the CCA changed the beneficial interests in the trust, as the reimbursement provision was wholly discretionary and might never be exercised.

Furthermore, could the beneficiaries argue that the addition of a reimbursement clause actually enhances their interest? For example, if the grantor were to revoke grantor status (assuming the grantor had the power to do so under the trust agreement), the trust (and, by extension, its beneficiaries) would be left bearing its own share of the tax in perpetuity. In contrast, if the reimbursement provision was never or rarely exercised, the beneficiaries’ interests might ultimately increase from the modification, as the grantor would bear the trust’s share of the tax except when an actual reimbursement was made. A modification in exchange for the grantor’s written agreement to leave grantor status in place might also be viewed as a sale or exchange for equal value. In any situation where a modification occurs, the beneficiaries might consider including a nongift disclosure meeting the requirements of Regs. Sec. 301.6501(c)-1(f)(4) on their Forms 709, United States Gift (and Generation- Skipping Transfer) Tax Return, in the year the modification occurs.

The CCA may result in differing gift tax outcomes across trusts with similar economic profiles, depending upon when the discretionary reimbursement power is added to the trust agreement. The trust in the CCA after the proposed modification appears to have a similar income tax profile as that of Situation 3 of Rev. Rul. 2004-64, in that they are both IGTs in which the trustee has a discretionary reimbursement power. However, in Rev. Rul. 2004-64, the discretionary reimbursement power apparently existed from the time of creation, as opposed to being added in a subsequent year, as in the CCA. The beneficiaries of the trusts in either case might end up in similar economic positions, but, according to the IRS, those in the CCA would have made a taxable gift to the grantor, while those in Rev. Rul. 2004-64, Situation 3, would not have. This is the case even though the trustee actually reimbursed the grantor in the revenue ruling.

Role of beneficiary consent

The beneficiaries’ consent to the modification described in the CCA raises a number of questions around whether unborn or minor beneficiaries can make a gift as a result of a consent to a legal act on their behalf when they are legally incompetent. In the CCA, the IRS indicated that “Child and Child’s issue” had made a gift to the grantor, without clarifying the meaning of the word “issue.” In using the term “Child’s issue,” the CCA provides no indication of exactly which beneficiaries had made a gift. While it does not explicitly state that beneficiaries who had not yet been born at the time of the modification had made gifts, neither does it foreclose the possibility.

The CCA also states, “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.” The IRS’s position appears consistent with the result in Rev. Rul. 84-105, in which a beneficiary’s failure to protect an interest in trust resulted in a taxable gift by that beneficiary, though this revenue ruling is not referenced in the CCA. Following the logic of the CCA, it appears a beneficiary could not make a taxable gift to a trust’s grantor on account of the addition of a reimbursement clause in a state where beneficiary consent to such a modification is neither required nor allowed. This could result in inconsistencies in the gift tax result of otherwise similar modifications across states.

Valuation

The CCA provides limited guidance on how the interest should be valued for gift tax purposes and leaves practitioners with more questions than answers. It states that the interest should be valued in accordance with the general rule for valuing property interests found in the regulations under Sec. 2512, then broadly adds, “and any other relevant valuation principles under subtitle B of the Code.” If the interest is not capable of being valued, the CCA cites Regs. Sec. 25.2511-1(e) in suggesting the value of the gift could be the value of the entire trust. However, it seems illogical that the beneficiaries could make a gift greater than the property interest they previously held in a trust.

It may seem impossible to determine the value of a discretionary right to reimbursement; however, the authority cited supports the position that complex interests in trust can have values subject to gift and estate taxation. The CCA cites a 1943 Supreme Court case, Smith v. Shaughnessy, 318 U.S. 176 (1943), in which a remainder interest in trust would revert to the grantor if he outlived his wife; otherwise, it would pass to his wife’s heirs. The Court held that the grantor’s contingent reversionary remainder interest was subject to gift tax despite the taxpayer’s argument that no realistic Value could be placed on such an interest. It was determined that because the grantor relinquished control over the trust property unless he outlived his wife, a completed gift was made, except for the value of the contingent reversionary interest. The Courtfs opinion states:

We cannot accept any suggestion that the complexity of a property interest created by a trust can serve to defeat a tax. For many years Congress has sought vigorously to close tax loopholes against ingenious trust instruments. Even though these concepts of property and value may be slippery and elusive they can not escape taxation so long as they are used in the world of business.

One can distinguish the interest in Shaughnessy from the one in the CCA, as the former is susceptible of valuation using actuarial principles, while the latter is purely discretionary and may never occur. However, Rev. Rul. 67-370 concluded that where there was a reasonable probability that an estate would receive assets in the future, the mere possibility that it may not occur does not warrant the assignment of a nominal value. Presumably, the valuation of a discretionary interest in a trust would require a valuation professional to make a series of assumptions about the probability of relevant future actions of the trustee (e.g., the likelihood that the trustee will actually reimburse the grantor) in order to arrive at a value. Assuming the beneficiaries could not make a gift greater than the value of their interests in the trust before a potential gift, both the beneficiaries’ interests before the addition of the reimbursement clause and the grantor’s interest after the addition of the reimbursement clause would need to be valued in order to measure the actuarial value of the beneficiaries’ presumed gift.

Other questions

There are other unanswered questions as well, such as:

• Do differences in state property law vesting affect whether a beneficiary is deemed to have an interest in a trust?
• If the position of the IRS is that the essence of a gift by trust is the abandonment of control over the property, how is a value assigned across beneficiaries when the beneficiary’s own right is merely discretionary?
• Under the CCA’s logic, are subsequent reimbursements to the grantor pursuant to the reimbursement clause precluded from being considered gifts, since the beneficiaries’ gift was completed upon their consenting or not objecting to the modification?

Recommendations

Due to the lack of clarity and the draconian potential effects of executing a modification that could cause a taxable gift by beneficiaries to the grantor, practitioners should consider apprising their clients of the tax risks posed by modifications.

Collaboration with a clientfs attorneys may also result in a more holistic approach, as tax advisers may be particularly attuned to the tax consequences of legal actions. A clientfs tax preparer and attorney may together explore alternatives to modifications and advise on the potential tax consequences. For example, tax practitioners can suggest that clients ask their legal counsel whether a judicial reformation, retroactively effective to the trustfs creation date, or turning off grantor status altogether, could provide the client a better result. Alternatively, a tax preparer may ask such incisive questions as whether, in the governing state of the clientfs trust, beneficiaries must consent or legally may object to a modification or whether exercise of a modification by a trust protector might relieve beneficiaries of the ability to object to a modification. Tax practitioners can also provide helpful commentary on whether a proposed trust agreement provides adequate flexibility to account for prospective changes to a grantorfs economic situation.

The IRSfs position in the CCA is farreaching, with limited guidance on how to value a discretionary interest. Given the complexity and subjective nature of valuations and determining the actuarial interest held by a beneficiary, practitioners should be mindful of uncertainty. Tax preparers might consider whether a nongift disclosure meeting the requirements of Regs. Sec. 301.6501(c)-1(f)(4) would be appropriate to include with a clientfs Form 709 in the year a modification or decanting occurs. Such a disclosure would start the statute of limitation with respect to the transaction. To that end, tax preparers may wish to add a question to their client intake questionnaires asking whether any modifications, amendments, or other changes were executed with respect to trusts with respect to which clients were grantors or beneficiaries during the year.

Regardless of the form modifications to irrevocable trusts may take, understanding their tax consequences is critical to achieving a client’s intended result. Tax practitioners should ask proactive questions of their clients and work collaboratively with them and their attorneys toward this end.

Contributors

Trisha McGrenera, CPA (Illinois), MSA, is senior manager in the Estate, Gift, Trust and Charitable group of Deloitte Tax LLP in Chicago. Laura Hinson, CPA (North Carolina), MAC, is a managing director with Deloitte Tax LLP in Raleigh, N.C. Tandilyn Cain, CPA (Maryland and Oregon), MST, CFP, is vice president of tax and estate planning with Schnitzer Properties in Portland, Ore. Theodore J. Sarenski, CPA/PFS, CFP, is a wealth manager at SageView Advisory Group in Syracuse, N.Y. For more information about this column, contact thetaxadviser@aicpa.org.