In Chief Counsel Advice 202352018, dated December 29, 2023, the IRS issued guidance explicitly stating that it no longer upholds the stance outlined in Private Letter Ruling (PLR) 201647001. The focal issue is the determination of gift (and possible subsequent estate) tax consequences arising from the modification of an intentionally defective grantor trust. This modification entails adding a provision that permits the trust to reimburse the grantor for taxes paid on the trust’s income.

Intentionally Defective Grantor Trust

An Intentionally Defective Grantor Trust (IDGT) is a strategic tool frequently employed in estate planning. Its purpose is to transfer assets out of the grantor’s estate, while the grantor remains responsible for paying income tax on the trust’s earnings. Notably, these tax payments are not considered additional gifts by the grantor. This approach leverages the income tax grantor trust rules (outlined in IRC §§671-679), treating the assets as though they are owned by the grantor for income tax purposes. This is achieved through various powers retained by the grantor, yet structured in a way that does not impede the completion of the gift for estate tax purposes.

However, there are instances where grantors may reconsider this arrangement, particularly when faced with income tax obligations exceeding their comfort level. In response to these concerns, some advisers have recommended modifying the trust. Such modifications could include granting the independent trustee discretion to distribute assets to the grantor for income tax payments. This suggestion was previously underpinned by the IRS’s conclusions in Private Letter Ruling 201647001, which indicated that these modifications would not trigger gift or income tax consequences.

The Issue Addressed in the Chief Counsel Advice

The specific issue addressed in Chief Counsel Advice (CCA) 202352018 is as follows:

What are the gift tax consequences to the beneficiaries when the trustee of an irrevocable trust, with respect to which the grantor is treated as the owner under subpart E, part I, subchapter J, chapter 1 (subpart E) of the Internal Revenue Code (Code), modifies the trust, with the beneficiaries’ consent, to add a tax reimbursement clause that provides the trustee the discretionary power to make distributions of income or principal from the trust in an amount sufficient to reimburse the grantor for the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income? [CCA 202352018]

The illustrative facts forming the basis of the ruling are as follows:

In Year 1, A establishes and funds Trust, an irrevocable inter vivos trust, for the benefit of A’s Child and Child’s descendants. Trustee is the current trustee of Trust and satisfies the governing instrument requirement that a trustee of Trust must be a person not related or subordinate to A within the meaning of §672(c) of the Code. Under the governing instrument of Trust, a trustee of Trust may distribute income and principal to or for the benefit of Child in the trustee’s absolute discretion. Upon Child’s death, Trust’s remainder is to be distributed to Child’s issue, per stirpes.

Under the governing instrument of Trust, A retains a power that causes A to be the deemed owner of Trust under §671 of the Code, and, accordingly, all items of income, deductions, and credits attributable to Trust are included in A’s taxable income.

Neither State law nor the governing instrument of Trust requires or provides authority to a trustee of Trust 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, Trustee petitions State Court to modify the terms of Trust. Pursuant to State Statute, Child and Child’s issue consent to the modification. Later that year, State Court grants the petition and issues an Order modifying Trust to provide a trustee of Trust the discretionary power to reimburse A for any income taxes A pays as a result of the inclusion of Trust’s income in A’s taxable income. [CCA 202352018]

Analysis of the Case

Revenue Ruling 2004-64 offers guidance for scenarios where a reimbursement clause is included from the inception of the trust. The Chief Counsel Advice (CCA) summarizes this ruling as follows:

In Rev. Rul. 2004-64, 2004-2 C.B. 7, 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 subpart E of the Code. 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. 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 of these situations, when the trustee of the trust reimburses the grantor for the income tax paid by the grantor, the ruling 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 discretionary authority granted under the terms of the governing instrument. [CCA 202352018]

In Private Letter Ruling (PLR) 201647001, the IRS previously determined that adding a reimbursement clause to an intentionally defective grantor trust (IDGT) after its initial formation did not result in a transfer tax issue. However, the IRS has since revised its stance, no longer considering this interpretation as the correct application of law to the given facts. The IRS’s current analysis is outlined as follows:

Under the governing instrument of Trust, Child and Child’s issue each have an interest in the trust property. As a result of the Year 2 modification of Trust, A acquires a beneficial interest in the trust property in that A becomes entitled to discretionary distributions of income or principal from Trust in an amount sufficient to reimburse A for any taxes A pays as a result of 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. This is distinguishable from the situations in Rev. Rul. 2004-64 where the original governing instrument provided for a mandatory or discretionary right to reimbursement for the grantor’s payment of the income tax. Thus, as a result of the Year 2 modification, Child and Child’s issue each have made a gift of a portion of their respective interest in income and/or principal.1 See §25.2511-1(e) and §25.2511-2(b). See also Robinette v. Helvering, 318 U.S. 184 (1943). 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 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 accordance with the regulations under §2512 and any other relevant valuation principles under subtitle B of the Code. [CCA 202352018]

Within this Chief Counsel Advice, there are two footnotes of significance. The first footnote acknowledges the Office of the Chief Counsel’s shift in position, specifically refuting the analysis previously presented in Private Letter Ruling (PLR) 201647001.

PLR 201647001 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. These conclusions no longer reflect the position of this office. [CCA 202352018, Note 1]

The second footnote concedes that significant practical challenges arise in valuing the gift, as concluded by the Chief Counsel Advice (CCA).

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. See Smith v. Shaughnessy, 318 U.S. 176, 180 (1943) (“The language of the gift tax statute, ’property . . . real or personal, tangible or intangible,’ is broad enough to include property, however conceptual or contingent.”) [CCA 202352018, Note 2]