Tax Planning Technique Works TOO Well…Be Careful What You Wish For!!!
As discussed in a prior blog, a grantor of a trust, which is a “grantor trust” for INCOME tax purposes, pays income taxes on the income earned in the trust. The grantor’s payment of the income taxes benefits the beneficiaries of such trust as the income taxes do not deplete the trust assets.
For example, Billy, transfers stock worth 5 million to an irrevocable trust for the benefit of his children, Bob and Sue. The trust is drafted as a “grantor” trust. Thus, Billy pays income taxes on the income earned in the trust. The income tax payments are not considered additional gifts to Bob and Sue subject to a gift tax because the liability is Billy’s and not the trust. Thus, the trust can grow income tax free provided the trust remains a grantor trust and Billy continues to pay the income taxes.
What happens if Billy can not pay the income taxes? Can he “undo” the grantor trust provisions? Ideally, in drafting the trust, a trustee or trust protector could have the power (but not a requirement) to reimburse Billy for those income taxes. If the trust REQUIRES a trustee or trust protector to reimburse Billy for the income taxes, then the irrevocable trust will be taxed in Billy’s estate. However, what if the irrevocable trust is silent on the reimbursement of income taxes?
In a recent Ohio case, Millstein v. Millstein, Norman is the grantor of an irrevocable trust (the “Trust”). Norman’s son, Kevin, is a beneficiary and trustee of the Trust. Unfortunately, as the Trust became more successful, the income taxes became burdensome for Norman. Norman asked his son, Kevin, to reimburse him. Kevin said no because the Trust no longer had liquid assets available to pay those income tax liabilities.
Norman argued that, under Ohio law, he could bring an action to modify the trust to achieve his tax objectives. Unfortunately, under Ohio law, only a trustee or beneficiary can bring a proceeding to approve this type of modification. Thus, Kevin argued that Norman had no standing and the requested relief was “unavailable to him without the cooperation of a trustee or beneficiary”.
Norman also requested an “equitable reimbursement of income taxes”. Kevin argued that an equitable reimbursement to Norman for tax liability incurred under the terms of a trust Norman created, was not available.
The lower court dismissed Norman’s petition for failure to state a claim and the appellate court agreed.
The Ohio statute is similar to the Florida statute which permits a modification of a trust to achieve the grantor’s tax objectives. The Florida statute provides that an “interested person” can bring an action for this type of modification. Interested person is defined under Florida law as “any person who may reasonably be expected to be affected by the outcome of the particular proceeding…”
Would Norman be an “interested person” under the Florida statute such that he would have standing to bring an action to modify the Trust to provide for income tax reimbursement.? This author thinks such an argument could be made.
However, if, in this case, Norman had that capability, would this cause the Trust to be included in Norman’s estate for estate tax purposes, i.e., Norman has the power to REQUIRE the trustee to reimburse him for income taxes through a modification of the Trust? The answer is not clear as this author knows of no case that specifically addresses this situation.
ADVICE: When drafting a “grantor” trust, confirm that language in the trust includes language that a trust protector MAY reimburse the grantor for income taxes or includes provisions to “turn off” grantor trust status. If a current irrevocable grantor trust does not have “savings” language, then consider decanting or a modifying the trust if the appropriate individuals will consent. Also analyze the Florida statute to determine if the statute would help. However, carefully consider the possible adverse estate tax issues.
WORD OF THE WEEK: Locus standi or “standing” is the capacity of a party to bring suit in court. Generally, a state statute determines what constitutes standing. Generally, the plaintiff must show that he or she has sustained or will sustain direct injury or harm and that this harm can be addressed by the court.
GENEROSITY IS A KEY TO HAPPINESS…REACH OUT AND HELP SOMEONE TODAY! 😎