The IRS recently issued a favorable revenue ruling concerning the gift tax consequences when a grantor of a "grantor trust" pays income tax on the trust's income. Essentially, a grantor trust is a trust that treats the grantor as the owner of the trust for income tax purposes and, as a result, the grantor must include the trust's income in his or her taxable income. A grantor will be treated as the owner of a trust if the grantor retains certain powers (e.g., the power, in a nonfiduciary capacity, to replace trust assets with assets of equivalent value). Revenue Ruling 2004-64 states that the grantor's payments of income taxes attributable to the trust's income are generally not additional gifts to the trust. This ruling is significant because it allows the grantor to make what are in effect additional gifts to the trust beneficiaries without having to pay gift tax, or utilize additional gift exemptions.
The revenue ruling cautions that trust agreements created after October 4, 2004, that require the trustee to reimburse the grantor for any income taxes paid on the trust's income, will cause the full value of the trust's assets to be included in the grantor's estate. Similarly, the full value of the trust's assets will be included in the grantor's estate if applicable state law requires (unless the trust agreement says otherwise) that the trustee reimburse the grantor for income taxes paid. Conversely, a provision that gives the trustee discretion to reimburse the grantor for taxes paid will not by itself cause the trust's assets to be included in the grantor's estate. However, the assets of the trust may be included in the grantor's estate if this discretion is combined with other factors such as: (1) a pre-existing arrangement between the grantor and the trustee that the trustee will use its discretion to reimburse the grantor; (2) the grantor's ability to remove the trustee and name himself or herself trustee; or (3) applicable state law subjecting the trust's assets to the claims of the grantor's creditors.
