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Grantor Trusts and Tax Reimbursement: A Big No-No?

Grantor Trusts and Tax Reimbursement: A Big No-No?

Analyzing Rev. Rul. 2004-64 and CCA 202352018

Griffin Bridgers's avatar
Griffin Bridgers
Feb 13, 2025
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State of Estates
State of Estates
Grantor Trusts and Tax Reimbursement: A Big No-No?
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Table of Contents

  1. Phantom Income – a Foundational Concept

  2. Income Tax Versus Transfer Tax

  3. Tax Reimbursement under Rev. Rul. 2004-64

  4. The October 4, 2004 Carve-Out, and Decanting

  5. Gifts Through Tax Payment and Reimbursement

  6. State Law Implications of Creditors’ Rights

  7. Key Practice Pointers

Phantom Income – a Foundational Concept

Grantor trusts are often labeled as “disregarded entities,” or as “pass-through entities.” This, however, is not accurate. Typically, only a single-member LLC can be awarded disregarded entity status. Likewise, “pass-through entity” is a blanket term typically used for entities that are taxed as partnerships or S corporations for income tax purposes – with partnerships having at least two partners who are distinct taxpayers, and S corporations having anywhere between 1 and 100 shareholders all of whom must be eligible shareholders.

There are a couple of foundational reasons why these labels cannot be properly applied to a grantor trust. For one, grantor trusts do not present an all-or-nothing approach to income taxation – it is still possible for the grantor to be taxed on some income, while the trust is taxed on the remaining income, which would not be the case for a disregarded entity or pass-through (at least for federal income tax purposes). Second, unlike disregarded entities and pass-through entities, the ability to make distributions for purposes of paying or reimbursing a grantor’s income tax is limited. It is important to note, however, that this limitation is not a product of the grantor trust income tax rules themselves. Instead, it is a product of the estate, gift, and GST tax effects of the trust.

This article discusses some of these issues in the context of the guidance of Revenue Ruling 2004-64, but to preface it is important to introduce the concept of “phantom income.” This term typically applies to income that must be included on a person’s income tax return, but for which they may not have an immediate right to receive such taxable income in cash. This economic dynamic is present in disregarded entities and pass-throughs, under which the actual cash representing taxable income may be retained in the entity for business purposes – creating a tension between an immediate return to equity holders versus growth in the value of the business and underlying equity through reinvestment.

To ease this tension, many entities make distributions of cash to satisfy equity owner’s increased income tax burden owing to phantom income. This mechanism of tax distributions recognizes that equity owners are often getting taxed on the growth in the value of an entity in real-time, while delaying economic realization of that growth. This tax distribution is usually estimated to be the incremental increase in an equity owner’s income tax owing to the pass-through of tax items.

Phantom income can be an issue in grantor trusts as well, but the tension highlighted above is not necessarily present for the grantor themselves (as opposed to a beneficiary). There is a corollary when we consider the tension between providing income to current beneficiaries, as opposed to growth for future distribution to remainder (or current) beneficiaries. But, unlike with a disregarded entity or pass-through, it is not the current beneficiaries who are getting taxed on growth for the remainder beneficiaries at their own expense unless those beneficiaries are treated as deemed owners under the grantor trust rules – particularly IRC Section 678(a). Instead, the grantor is usually shouldering the income tax burden of all beneficiaries in most grantor trusts. Which raises the question – since this is a problem that is self-imposed by the grantor, should they be entitled to economic relief in the form of tax reimbursement?

Before exploring rules for the grantor, it is important to note a few things. Beneficiaries who are deemed owners usually do not run into the issues presented above, as they are naturally entitled to receive distributions (including tax distributions) so long as the terms of the trust allow such distributions. And, when we speak of tax reimbursement to a grantor, we are speaking again only to the amount necessary to cover the incremental increase in the grantor’s personal income tax liability owing to the taxable income generated by the grantor trust.

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Income Tax Versus Transfer Tax

Before exploring this question of tax reimbursement further, recall that the framework of grantor trust treatment involves the retention of certain powers by the grantor over assets that have been gratuitously transferred to a trust. However, there is a second set of retained interests that can create issues for estate tax purposes under IRC Sections 2035-2038, and 2042. While these two sets of retained interests – income tax versus estate tax – have some differences, there is some crossover between them.

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