Trusts, like everyone else, pay taxes when they earn income or sell capital assets for a profit. The tax liability, however, can be shifted to – or more properly retained by – the Grantor (the person creating the trust) if the Grantor retains certain powers identified in IRC Sections 671 – 679. Trusts are frequently drafted as Grantor Trusts to secure a step-up in basis upon the Grantor’s death. There are other reasons for creating grantor trusts, but in the Elder Law world, that seems to be the most common reason. Within the last year, the IRS has issued guidance on grantor trusts that has the estate planning world spinning.
CCA 202352018
Sometimes the IRS’s Chief Counsel will offer opinions regarding tax law and that was done in CCA 202352018 (November 23, 2023). In CCA 202352018, the IRS Chief Counsel examined a fact pattern regarding an irrevocable trust where the grantor retained no interest in the trust. The Chief Counsel’s Office concluded that if an irrevocable trust is originally drafted as a grantor trust and does not allow the trustee to pay the grantor’s taxes attributable to income earned by the trust, and if the trust is later modified with the beneficiary’s consent (or non-objection) to allow for payment of the grantor’s tax obligations, then a trust modification that permits the trustee to pay the grantor’s taxes constitutes a taxable gift by the beneficiaries. One commentator describes the implications of CCA 202352018 as far reaching, calling “into question any trust modification that indirectly shifts an interest from one beneficiary to another beneficiary, or that shifts a trust benefit from a beneficiary back to the grantor.” Another suggested that decanting a trust could have potential gift tax consequences.
Most Medicaid Asset Protection Trusts will not be affected by this guidance. The reason is that if the trust is an irrevocable income only trust, then the the grantor already gets the income. And if the trust was drafted to permit payment of the grantor’s taxes from trust principal, then the trust would fail Medicaid’s “any circumstance” test. Failing that test would mean that the trust protects nothing if you go to a nursing home.
Many third party special needs trusts (usually called Supplemental Needs Trusts) are structured as grantor trusts. However, they are usually drafted so the beneficiary is the sole beneficiary. It is unlikely one of these trusts would be modified to benefit someone other than the special needs beneficiary, but it could happen. Still, it appears like CCA 202352018 would not apply because a special needs trust beneficiary never has dominion or control over the disposition of trust assets so as to avoid causing the trust to be countable. See POMS SI 01120.200.D.2.
In other situations, it appears as though CCA 202352018 can be avoided by having the grantor retain a limited power of appointment over the trust remainder. This is addressed in the section discussing IRC section 25.2511-2(b). It could also be addressed by including flexibility in the original trust agreement.
RR 2023-2
In IRS Revenue Ruling 2023-2 (which we discussed on ezelderlaw) the IRS took on basis adjustments for capital gains tax purposes. There, the fact pattern assumed the trust was an irrevocable grantor trust. It also assumed the trust held capital assets that appreciated in value. The trust appears to have been drafted to “freeze” the value of assets because it was a grantor trust for income tax purposes, but was drafted to excluse the trust assets from the grantor’s estate.
IRC section 1014(a)(1) provides that the basis of property acquired from a decedent is “the fair market value of the property at the date of the decedent’s death.” Section 1014(b)(1) provides that property is acquired from or passed from a decent if property is “acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent.” Using Black’s Law Dictionary, the IRS concluded that passing property to beneficiaries using an irrevocable trust does not qualify for the stepped up basis because it is not “bequeathed,” “devised,” or “inherited.”
Most Medicaid Asset Protection Trusts will not be impacted by R.R. 2023-2 because most are drafted to cause estate tax inclusion for the specific purpose of securing an adjusted tax basis and lower capital gains tax liability following the grantor’s death. For example, an Irrevocbale Income Only Trust would qualify for the basis adjustment under section 1014(b)(2). A revocable living trust would qualify for the adjusted basis under section 1014(b)(3). The same subsection would apply if the grantor retained a testamentary power of appointment to make changes in the beneficiaries.
Conclusion
Don’t assume your trust will get specific tax treatment. In fact, don’t assume anything. Ask a professional. At the Elder Law Practice, we will work with your tax advisor to get your questions answered. If you want to talk about trusts, give us a call at (706) 428-0888.
