The IRS recently ruled that trust beneficiaries made a taxable gift when they consented to the modification of a grantor trust to permit reimbursement to the grantor for income tax attributable to the trust (Chief Counsel Advice (“CCA”) Memorandum 202352018). Neither state law nor the trust permitted such reimbursement. The IRS ruled that the modification of the trust to add such a provision was effectively a taxable gift by the beneficiaries because it decreased the value of their interest in the trust by adding a discretionary power to distribute income and principal to the grantor.

This ruling is surprising for a few reasons:

1.     It is contrary to prior IRS guidance which held that the insertion of such a provision was an administrative, and not a substantive, modification (see PLR 201647001, which the CCA notes is no longer the IRS’s position).

2.     The presence of a reimbursement provision is not generally viewed as vesting in the grantor a discretionary interest in the trust’s income or principal, but instead is seen as a more limited right that is distinguishable from discretionary beneficial interests in trusts.

3.     The IRS does not treat the grantor’s payment of the taxes on the trust’s income as an additional gift to the trust, so it is surprising to treat the reverse as a gift.

Beneficiaries (and their advisors) should be mindful of potential gifts any time they are asked to consent to trust modifications, even if such modifications on their face appear to be administrative in nature. If a grantor is considering whether to include a tax reimbursement clause (or other seemingly administrative provisions) in a trust, it is simpler to include one from inception (relying on the guidance of Rev. Rul. 2004-64) than it is to modify the trust in the future to include one.

Thank you David Goldstein for this week’s Tax Tracker!