A recent Chief Counsel Advice issued by the IRS has been described by one team of estate planning experts as “the most important IRS ruling in a decade,” and it directly contradicts the prior IRS position on the issue. Should we be concerned?
In the waning days of 2023, the IRS issued Chief Counsel Advice 2023-52-018 (the “CCA”), concluding that a modification to an irrevocable grantor trust to allow an independent trustee to reimburse the grantor for income taxes paid results in a taxable gift by the beneficiary to the grantor because the beneficiary consented to the modification.
Many states, including Ohio, Kentucky, and Florida, permit certain parties (namely the trustee and beneficiaries, or a court) to modify an irrevocable trust if the modification furthers the grantor’s purpose in creating the trust, advances a tax objective, or is otherwise in the beneficiaries’ best interests, among other considerations. It is fairly common at some point in the life of an irrevocable trust that a modification is considered or desirable for one reason or another, and often, the trust beneficiaries are required to be parties to or consent to the modification. At KMK, we work on irrevocable trust modifications on a near-daily basis, which is to say that private settlement agreements or court actions modifying an irrevocable trust are not particularly rare.
In many irrevocable grantor trusts we draft, the trust agreement itself authorizes (but does not require) an independent trustee to reimburse the grantor for income taxes paid, a relatively standard provision and an important planning tool when considering a SLAT, gift trust, or other irrevocable vehicle. However, in the trust at issue in the CCA, the original trust did not contain such a provision and the trustee petitioned the probate court to modify the trust to add it. The sole beneficiary of the trust, being the grantor’s child, consented to the modification on behalf of himself and his unborn descendants, and the court modified the trust accordingly. The IRS, through the CCA, held that such a modification was a gift by the child; after all, his failure to object resulted in trust funds that otherwise would have been available to him to be available to the grantor, albeit for tax reimbursement purposes only and at the sole discretion of an independent trustee. The IRS conceded that determining the value of the gift would be very difficult, particularly if the trustee never distributed income or principal to the grantor for this purpose.
Although this decision contradicts the IRS position outlined in Chief Counsel Advice 2016-47-011, where the IRS ruled that a similar modification was an “administrative change” only and not a taxable gift by the beneficiaries, the full scope of the CCA’s effect is not yet known. But the CCA does offer a cautionary tale for beneficiaries when it comes to modifying irrevocable trusts, and it may be wise to pump the brakes on any similar trust modification until the IRS offers additional guidance. Will a decanting, where the beneficiaries receive notice but have no legal right to consent or object, be viewed similarly, or differently? Will language in the modification agreement (or court order) noting that the change is valid only insofar as there is no adverse tax consequence to the beneficiaries insulate the beneficiaries from this type of ruling? Or is this just an outlier that will have no effect on long-standing planning techniques and interpretations?
Regardless, it is prudent to talk to the attorney drafting an irrevocable trust or a trust modification about the CCA to be sure its interpretation and potential effects are thoroughly considered.
