Since passage of the Uniform Trust Code in New Jersey in 2016, planners now have an established procedure to modify or terminate an irrevocable trust, and it is undoubtedly a valuable tool. Clients frequently have trusts that could be made better if one or two changes were made. However, while attractive, the modification or termination of an irrevocable trust so that the trust will accommodate circumstances unforeseen when the trust was created, can have unintended gift tax consequences.
It was just such a situation that a recent Memorandum issued by the Chief Counsel for the IRS, CCA 202352018 (hereafter the CCA or Memorandum), addresses. In that Memorandum the grantor of the trust established an irrevocable trust for her child for the child’s life. The trustee had the power to distribute income and principal to the child, in the trustee’s discretion, and on the child’s death the trustee was directed to distribute the proceeds to the child’s descendants. The grantor had no right to income or principal from the trust and essentially had relinquished all control over the assets in the trust. As such, the grantor appeared to have successfully removed the assets in the trust from her taxable estate.
The trust included a provision that made the trust income taxable to the grantor under section 671 of the Internal Revenue Code. Using such a provision in a trust is actually very popular. Because the trust will not pay any income taxes, the trust can grow more quickly. In effect, it is as if the grantor is making a tax-free gift to the trust each year in the amount of the tax the trust would otherwise have paid. Sometime after the trust in the CCA was operational, however, the grantor no longer wished to pay those income taxes and instead sought to have the trust reimburse her for those tax payments.
Pursuant to the law in her state the grantor brought an action to modify this otherwise irrevocable trust to permit the trustee to reimburse the grantor for the income taxes. The beneficiary consented to the request and an Order was entered by the court allowing the modification. Unfortunately, while the parties had legal authority to take the steps they did, the CCA held that there were gift tax consequences to this modification. Specifically, the CCA found that the beneficiary, the grantor’s child (there were as yet no grandchildren), had made a gift back to the grantor of that portion of the trust which could be now used to reimburse the grantor for those income taxes!
As a result, the parties not only had to recognize a gift from the child to the grantor, which was never intended, but they also had to determine how to value that gift. While the Memorandum recognizes that such a gift is very hard to value, it gives no standard of measurement and worse, posits that where “a donor’s retained interest is not susceptible of measurement on the basis of generally accepted valuation principles the tax is applicable to the entire value of the property subject to the gift” (emphasis added). This language holds that the beneficiaries have in effect made a gift to the grantor in an amount equal to the total value of all the assets in the trust.
One way to solve this immediate problem is to create flexibility in the initial trust agreement. There should be a power in the trust that allows the trustee, in the trustee’s discretion, to reimburse the grantor for income taxes. Alternatively, a broader provision could be included in the trust which allows a grantor to turn off or revoke the “Grantor Trust” status by releasing the power in the trust that “triggered” section 671 in the first place.
The more far-reaching impact of this Memorandum, however, is to call into question any trust modification that indirectly shifts an interest from one beneficiary to another beneficiary, or that shifts a trust benefit from a beneficiary back to the grantor. For example, what are the gift tax consequences when a family decides that a credit shelter trust created by the first parent to die for the benefit of the surviving parent is no longer needed? Frequently we see that with the current high federal estate tax exemption, even if the surviving spouse owned the trust assets herself her estate would not have to pay any federal estate taxes. Further, those assets if owned by the surviving spouse would receive a step-up in basis, which is unavailable if the assets are owned by a credit shelter trust. In such a case it seems that a termination of the trust whereby all of the assets are given to the surviving parent would be a win-win situation. However, the parties must recognize that the children, the remainder beneficiaries, are actually making a gift back to Mom of their remainder interests. Conversely, Mom might feel she no longer needs the income and would like to relinquish her remaining life estate so that the trust assets pass to the remainder beneficiaries now. These kinds of gifts can be valued using IRS tables which calculate the value of life estate and remainder interests, but not all modifications are so clear-cut.
CCA 202352018 is a powerful reminder that any attempt to modify or terminate an irrevocable trust must be analyzed for potential gift tax consequences.