The IRS, with its release of Revenue Ruling 2004-64, has given its approval to the use of grantor trusts as an income and estate planning strategy and it has removed any confusion as to whether the trust must contain a provision for the reimbursement of income taxes paid by the grantor.

Many estate planning attorneys have been using the concept of an intentionally defective grantor trust, or “IDGT” (pronounced id-jet), for many years. At various times in the past the IRS has expressed hostility toward certain aspects of this planning strategy. For example, the IRS has refused to rule on the tax consequences of creation of a grantor retained annuity trust unless the trust included a provision requiring reimbursement to the grantor for income taxes. It also hinted that the payment of the income tax by the grantor of a trust might in some circumstances be treated as a constructive gift to the beneficiaries of the trust. In Rev. Rul. 2004-64, 2004-27 IRB 7, the IRS has laid to rest many of the concerns surrounding the use of IDGTs in advanced estate planning. The Ruling specifically answers questions regarding the gift and estate tax implications of a taxpayer’s payment of income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income.

Before we get into the details of the Revenue Ruling, you may be wondering why an estate planning attorney uses a trust that is “defective.” The term refers to a disconnect between the income tax rules and the gift and estate tax rules. This disconnect allows a knowledgeable estate planning attorney to create a trust that is defective for income tax purposes (meaning the income is taxable to the trust creator or grantor), yet not included in the estate of the grantor for estate tax purposes.

Use of an IDGT allows the grantor-taxpayer to shift income taxes and to leverage his lifetime gift tax exemption amount. If a grantor creates a trust that is not an IDGT, then either the trust or the beneficiaries of the trust will pay the income tax on the trust’s income. Essentially, the tax the trust or beneficiaries pay reduces the value of the assets transferred to the trust and works against the grantor’s objective to reduce his taxable estate. If, on the other hand, the trust is an IDGT (meaning that it includes powers which cause the trust’s income to be taxed to the grantor), the trust assets are preserved and the payment of the income tax by the grantor further reduces the grantor’s estate. Thereby, the grantor has shifted the trust’s income tax liability to himself. He has also leveraged his $1,000,000 lifetime gift tax exemption amount by getting both the value of the trust assets as well as the current and future income taxes out of his estate, but only at a cost of using gift tax exemption equal to the value of the assets transferred to the IDGT.

An IDGT also allows the grantor to “freeze” the value of his estate through use of a strategy known as a Sale to an IDGT. The freeze results in all future appreciation on the assets sold to the trust accruing to the beneficiaries of the IDGT and escaping estate taxation in the grantor’s estate, as illustrated in the following table:

These savings can be further increased by combining the grantor trust concept with “estate squeezing” techniques such as Family Limited Partnerships, Family Limited Liability Companies, Restricted Management Accounts, and Qualified Personal Residence Trusts.

The powers used to create an IDGT are found at IRC §§ 673 – 677 and 679. The powers at IRC § 678 pertain to a trust designed to be taxed to the beneficiary rather than the grantor.

What Rev. Rul. 2004-64 says:
The Service has finally laid many of the outstanding questions regarding grantor trusts to rest in a very helpful ruling. Rev. Ruling 2004-64 sets out three different situations. In all three, the grantor, a U.S. citizen, establishes an IDGT that presumably would not otherwise be included in the grantor’s estate for estate tax purposes. The ruling also assumes that the trustee is not related or subordinate to the grantor within the meaning of IRC § 672(c).

1. Where neither the trust itself nor governing state law includes any provision either requiring or permitting the trust to reimburse the grantor for income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, the IRS concedes that the payment by the grantor of the income tax liability does not constitute a gift to the trust’s beneficiaries and has no estate tax implications. Why not? Because under the grantor trust rules the grantor is legally liable for the taxes.
   
   
2. Where the trust actually REQUIRES the trustee to reimburse the grantor for the income tax paid by the grantor on the trust’s income, the IRS has taken the position that the trust WILL be includible in the grantor’s gross estate under IRC § 2036(a)(1). The reason is that the grantor has retained the right to have the trust discharge the grantor’s legal obligation to pay the income tax. The IRS in earlier pronouncements had actually encouraged the inclusion of this tax reimbursement provision in IDGTs. Because of this, the estate tax inclusion holding of Rev. Rul. 2004-64 will only be applied to trusts created on or after October 4, 2004.
   
   
3. Where the trust gives the trustee discretion to reimburse the grantor for income tax, but does not require such reimbursement, the IRS has ruled that the reimbursement will not be considered a gift by the trust beneficiaries, and failure to reimburse the grantor will not be a gift by the grantor to the beneficiaries. Furthermore, the mere discretion to reimburse the grantor will not cause estate tax inclusion unless there is an understanding, expressed or implied, between the grantor and the trustee regarding the trustee’s exercise of this discretion. The IRS also ruled that, unless an understanding is found, there will be no estate tax inclusion in the event the trustee actually reimburses the grantor for the income tax. A note of caution here: the IRS also stated that it would also look to other facts, such as the power retained by the grantor to remove the trustee and name himself as successor trustee, or applicable local laws subjecting the trust assets to the claims of the grantor’s creditors, to find inclusion of the trust assets in the estate of the grantor for federal estate tax purposes.

Note: Although the IRS assumes in Rev. Rul. 2004-64 that the trustee is neither related nor subordinate to the grantor in the three situations it outlines, the result should be the same even if the initial trustee were related or subordinate to the grantor. However, if the grantor retained the power to replace the initial trustee with someone related or subordinate to the grantor, this would cause inclusion in the estate of the grantor.

Our law firm is familiar with the use of grantor trusts, as well as other estate squeezing and freezing techniques to reduce estate and income taxes. These techniques are especially appropriate for business owners and taxpayers with large investment portfolios and real estate holdings. Schedule an appointment to discuss your client’s estate planning needs with one of our estate planning attorneys.