How Does Revenue Ruling 2004-64 Affect Grantor Trusts?

An intentionally defective grantor trust (IDGT) is a type of irrevocable trust where the creator, or grantor, is treated as the owner for income tax purposes but not for estate tax purposes. This structure allows the trust’s assets to grow without being depleted by income taxes, as the grantor pays them, while keeping those assets outside the grantor’s taxable estate. This article analyzes Revenue Ruling 2004-64, which clarifies the estate and gift tax consequences when a trust agreement allows the trustee to reimburse the grantor for the income taxes paid on the trust’s behalf.

The Grantor Trust Tax Reimbursement Principle

The foundational concept of a grantor trust is that the grantor retains certain powers, causing the IRS to view them as the same entity for income tax purposes. This means all income generated by the trust’s assets is reported on the grantor’s personal income tax return, and the grantor is legally obligated to pay the resulting tax. This arrangement creates a financial issue, as the grantor’s personal estate is reduced by taxes paid on assets held for others.

To address this, estate planners developed the “tax reimbursement provision,” a clause included in the trust document. This provision gives the trustee the authority to use trust funds to pay the grantor back for the income taxes attributable to the trust’s earnings. The central question that prompted IRS guidance was whether this power would be seen as the grantor retaining an interest in the trust, thereby pulling the trust’s assets back into the grantor’s estate.

Scenarios and Rulings on Estate Tax Inclusion

Revenue Ruling 2004-64 outlines three distinct scenarios to clarify when a tax reimbursement provision will or will not cause trust assets to be included in the grantor’s gross estate. The ruling focuses on whether the grantor has retained an enforceable right to the trust’s assets.

The first situation involves a trust where the governing instrument provides the trustee with the discretion to reimburse the grantor for income taxes paid. As long as there is no understanding or pre-existing arrangement about the reimbursement, this discretionary power alone does not cause the trust assets to be included in the grantor’s estate. The grantor has not retained a legally enforceable right to the funds.

The second situation presents a different outcome where the trust document or an applicable state law mandates that the trustee must reimburse the grantor. If the language used is obligatory, such as “shall” or “must,” the grantor has effectively retained an enforceable right to receive payments. Consequently, the full value of the trust’s assets at the time of the grantor’s death is includible in their gross estate.

The third scenario addresses a situation where the trustee has discretion, but the grantor’s creditors can attach the trust assets. If the trust’s terms or the relevant state law allows creditors to make claims against the trust to satisfy the grantor’s debts, it is equivalent to the grantor having retained a right to the property. This access by creditors also triggers estate inclusion.

Gift Tax Consequences of Tax Payments and Reimbursements

Beyond the estate tax implications, Revenue Ruling 2004-64 also provides important clarifications regarding federal gift tax. First, the ruling confirms that when a grantor pays the income tax liability generated by a grantor trust, this payment is not considered an additional gift to the trust’s beneficiaries. The reasoning is that the grantor is simply satisfying their own legal tax obligation.

Second, the ruling examines the gift tax consequences when a trustee makes a reimbursement payment to the grantor. If a trustee makes a reimbursement pursuant to a discretionary power granted in the original trust document, this payment is not considered a gift from the trust beneficiaries to the grantor. The payment is seen as a fulfillment of the trust’s provisions.

A distinction was clarified by the IRS in a late 2023 Chief Counsel Advice memorandum. It addressed what happens when a tax reimbursement provision is added to an irrevocable trust that did not originally have one. The memorandum concluded that if the trust beneficiaries consent to a modification that grants the trustee discretionary power to reimburse the grantor, this modification is considered a taxable gift from the beneficiaries to the grantor. The reasoning is that the beneficiaries have effectively relinquished a portion of their interest in the trust assets by allowing them to be used for the grantor’s benefit.

Practical Applications for Trust Administration and Drafting

For Trust Drafters

The guidance from Revenue Ruling 2004-64 directly impacts how trust documents are written. To avoid inadvertent estate tax inclusion, the language in a tax reimbursement clause must grant the trustee discretion rather than imposing a requirement. Using permissive terms like “may” is advisable, while mandatory words like “shall” or “must” should be avoided.

Drafters must also consider the interplay between the trust document and applicable state law. Some jurisdictions may have statutes that could be interpreted as giving a grantor’s creditors rights to trust assets. A well-drafted trust should include specific provisions that negate any implication of a retained right and ensure the power cannot be compelled by the grantor or their creditors.

For Trustees

Trustees of a grantor trust that contains a discretionary reimbursement provision hold significant fiduciary responsibilities. A trustee must act in the best interests of the trust and its beneficiaries, which requires a careful balancing of several factors. They should consider the grantor’s financial situation, the liquidity of the trust’s assets, and the potential impact of the reimbursement on the beneficiaries’ interests.

To protect themselves from potential claims of breach of fiduciary duty, trustees should meticulously document their decision-making process. If they decide to make a reimbursement, the documentation should justify the payment based on the relevant factors. If they decline a request, the reasoning should be equally well-documented to show the decision was made prudently.

For Grantors

Individuals who create grantor trusts with discretionary reimbursement provisions need to have clear expectations. Including such a clause provides a layer of flexibility, offering a safety net if the tax burden becomes unmanageable. It allows an independent trustee to provide relief without jeopardizing the primary estate planning goals of the trust.

However, the grantor must understand that reimbursement is not guaranteed. The power rests solely with the trustee, who must exercise their independent judgment. The grantor cannot force a reimbursement, and any attempt to create a side agreement that compels the trustee to make payments would undermine the structure and likely lead to negative estate tax consequences.