By James Mulhern

Grantor Trust Basics

The “grantor” trust is an important tool for estate planning practitioners. Where a trust is classified as a grantor trust, the trust’s settlor, rather than the trust itself, is responsible for paying the income tax generated by the trust assets.

Originally, lawmakers established intricate grantor trust rules to address the problem of taxpayers moving income-generating assets to trusts to manipulate marginal tax brackets, while still retaining ultimate control over and enjoyment of these assets. The resulting rules, codified in Internal Revenue Code Sections 672–679, specify the set of powers that, if retained by the trust’s settlor, will shift the trust’s income tax back to the settlor.

In current practice, however, grantor trust status, rather than serving as a pitfall to avoid, is commonly a central objective of clients establishing certain types of trust arrangements. Take the example of a settlor who sets up an irrevocable trust for the settlor’s descendants and then makes a sizeable gift to the trust. The purpose of such a trust is generally to move assets out of the settlor’s ownership to minimize transfer taxes (estate, gift, and generation-skipping). But if the trust is a properly drafted grantor trust, the settlor can retain just enough power over the trust’s corpus that the settlor continues to be deemed the owner of the corpus for income tax purposes, but not for transfer tax purposes. The settlor has thus given away the assets for transfer tax purposes but is still treated as the owner of the assets for income tax purposes.

The settlor’s ongoing payment of the income tax in the example above serves as additional tax-free gifting to the trust beneficiaries — the trust corpus, which is now outside of the settlor’s taxable estate, can grow tax free, and the settlor’s taxable estate is further reduced by the amount of the income tax payments.

Because these techniques diminish the tax revenue raised by transfer taxes, they have been the target of proposed federal legislative changes as recently as last year. But, for now, they remain a mainstay of modern trust design.

“Toggling Off” Grantor Trust Status

Although it is tax efficient for the settlor to shoulder the trust’s income tax burden, this burden sometimes becomes too heavy. If this happens, the settlor may wish to redirect the tax payments back to the trust.

Accordingly, well-drafted grantor trusts are typically structured with a provision for terminating grantor trust status — a so-called “toggle-off” feature. The settlor’s decision to toggle off grantor trust status (and thereby force the trust to pay its own income taxes) is, however, irreversible. The settlor’s exercise of a toggle-off therefore results in a permanent loss of the benefits of grantor trust status, even if the need to spare the settlor from the trust’s income tax is only temporary.

A Different Approach: Reimbursement

One way to avoid the need to toggle off grantor trust status is to allow for the trustee to reimburse the settlor for the income tax paid on behalf of the trust. Reimbursement may meet a short-term need of a settlor for tax relief without the permanence of the toggle-off.

New Hampshire is among a small but growing group of states that have augmented their trust laws to permit explicitly a trustee to reimburse the settlor even where the trust instrument is silent on the subject. The New Hampshire Trust Code, RSA 564-B:8-816(c) provides that “[e]xcept as otherwise provided under the terms of the trust, a trustee shall have the discretionary power to reimburse the settlor for the portion of the settlor’s income tax liability attributable to the trust . . . .” Whereas practitioners today often expressly authorize reimbursement in the trust instrument, this statute is particularly useful for trusts that lack express terms relating to trustee reimbursement.

Transfer Tax Warning

New Hampshire law provides clear support for trustee reimbursement, but caution is nonetheless warranted. It is crucial that allowing for reimbursement not undermine the fundamental goal of many trusts: keeping the trust corpus out of the settlor’s taxable estate. In other words, settlors must still “give away” the assets as regards estate, gift, and generation-skipping taxes.

In Revenue Ruling 2004-64, the IRS provided guidance that trustee reimbursement of income taxes will not result in inclusion of the trust corpus in the settlor’s estate so long as certain requirements are met. Fundamentally, the IRS demands that reimbursement not be expressly or implicitly mandatory — the trustee must possess real discretion to reimburse the settlor (or not). All parties, and their advisors, should keep the IRS requirements carefully in mind in both drafting and administering grantor trusts.

Summary

In keeping with our state’s overall embrace of trust law modernization, New Hampshire has been in the vanguard in its approach to trustee reimbursement for income taxes from grantor trusts. Appropriate use of trustee reimbursement can lead to improved tax outcomes for grantor trusts. Attorneys who draft grantor trusts or advise settlors and trustees should be alert to the risk of undesirable transfer tax consequences and take step to avoid them.

James Mulhern is an attorney at Mulhern and Scott PLLC in Portsmouth, New Hampshire, who concentrates on trusts and estates, tax and appellate litigation. He can be reached at 603-436-1211 or james@mulhernlaw.com.