Irrevocable Grantor Trusts—Discretionary Reimbursement of Tax Liability
Effective January 1, 2023, changes to the California Probate Code confirm that a trustee of an irrevocable grantor trust can have the discretion to reimburse a trust settlor for payment of the trust’s income taxes without subjecting the trust to claims of the settlor’s creditors (and possibly triggering inclusion of the trust in the settlor’s estate). As a result, California grantor trusts can now include discretionary income tax reimbursement powers, potentially making them more attractive for estate planning.
Grantor Trust Benefits and Considerations. A grantor trust is a trust in which the settlor retains certain powers or interests as specified under the Internal Revenue Code. The settlor is then treated as the owner of the trust assets for income tax purposes and must pay the trust’s income tax liability. With proper structuring, the settlor will not be treated as the owner of an irrevocable grantor trust’s assets for estate tax purposes at death, so any property gifted or transferred to the trust (and any appreciation) will be removed from the settlor’s taxable estate.
This divergent tax treatment offers benefits for estate and wealth transfer planning. The settlor’s payment of the income taxes on the trust assets reduces the value of the settlor’s estate while simultaneously allowing the trust to grow without any income tax burden. These income tax payments also are not treated or taxed as gifts, even though they could be viewed as constructive additions to the trust. The trade-off is that the settlor remains obligated to make these tax payments for as long as the trust is a grantor trust, which may become a significant burden for the settlor over time.
Reimbursement of Settlor’s Tax Payments. To help address this potential concern, the trust agreement can grant the trustee a discretionary power to reimburse the settlor for payment of the trust income taxes. Under IRS Revenue Ruling 2004-64, this discretionary reimbursement power will not cause the trust assets to be included in the settlor’s estate so long as (1) there is no preexisting arrangement regarding the trustee’s exercise of discretion, (2) the settlor cannot remove and replace the trustee with himself or herself and (3) the state law applicable to the trust does not subject the trust assets to claims of the settlor’s creditors (since assets reachable by a settlor’s creditors generally are includable in a settlor’s taxable estate at death).
Prior Law—Potential Creditor Exposure From Tax Reimbursement. Until now, the last requirement of Revenue Ruling 2004-64 was problematic for grantor trusts subject to California law. Long-standing provisions of the California Probate Code allow a creditor to access trust property to satisfy the debts of a trust settlor who has a beneficial interest in the trust. It had been unclear under these laws whether a discretionary tax reimbursement power would constitute a beneficial interest of the settlor in the trust that would be subject to claims of the settlor’s creditors, thereby causing inclusion of the trust in the settlor’s estate.
New Law—No Creditor Exposure From Discretionary Tax Reimbursement. As of January 1, 2023, new California Probate Code Section 15304(c) clarifies that a trustee’s discretionary power to reimburse the settlor for any income taxes paid with respect to a grantor trust is not a beneficial interest of the settlor, and the settlor’s creditors cannot access the trust property solely due to this discretionary tax reimbursement power. Now California grantor trusts can provide trustees with discretionary reimbursement powers for the trust income taxes paid by the settlor. With such a provision, if the payment of the trust’s income tax liability becomes too burdensome, the settlor can request reimbursement for such payments, rather than possibly seeking to terminate grantor trust status (and thereby ending its associated planning benefits).
Revocable Trusts—Remainder Beneficiaries’ New Rights to Trust Information Upon Incapacity of Person Holding Revocation Power
Effective Jan. 1, 2022, the California Probate Code gives remainder beneficiaries of revocable trusts certain rights to trust information upon the incapacity of all persons who hold a power to revoke the trust, subject to the settlor’s ability to modify or eliminate these rights under the trust agreement.
Under prior law, California Probate Code Section 15800 made it clear that unless a trust provided otherwise, all rights under a trust and all duties of a trustee were owed to the person(s) holding the power to revoke the trust (typically the settlor). Similarly, California Probate Code Section 16069 provided that the trustee had no duty to account or to provide information to a beneficiary during the time when the trust could be revoked. As of January 1, 2022, however, new obligations are imposed on the trustee of a revocable trust if the settlor and any other person having the power to revoke the trust becomes incompetent (determined as provided in the trust agreement or by a judicial determination of incompetency).
Based on this change, within 60 days of receiving information establishing the incompetency of the last person having the revocation power, the trustee must provide a true and complete copy of the trust to each beneficiary who is required or eligible to receive a distribution at the settlor’s death. The trustee also will be required to provide information and regular trust accountings to these beneficiaries. (Similar duties to account and report apply to trustees of irrevocable trusts under California law, as summarized in the newsletter here.
This change in the law is intended to ensure that the trustee continues to be accountable during the incapacity of the settlor. However, many individuals prefer to keep the terms of their trusts and the trusts’ financial information private during their lifetimes, even in the event of their incapacity. Fortunately, the law permits a settlor to override these rules in the terms of the trust agreement.