Grantor trusts are a powerful tool in estate planning in part because they facilitate depletion of the grantor’s estate by the grantor’s payment of income taxes attributable to the trust. There may be circumstances, however, when the grantor is no longer in a position to bear some part or all of the trust’s tax burden, yet grantor trust status remains desirable for other reasons. In those circumstances, an issue arises as to whether the trustee may reimburse the grantor for income taxes paid by the grantor and attributable to the trust.
When trust agreements are silent on the issue of reimbursement of the grantor, the trustee may be in a difficult position. In addition, while Rev. Rul. 2004-64 approved of discretionary reimbursement of grantors, it also noted that estate tax inclusion arises unless state law prevents creditors from reaching the trust assets as a result of such reimbursement. Colorado recently followed the trend of other states and addressed these issues by a new statute, C.R.S. § 15-16-502, which became effective on August 8, 2013.
Specifically, C.R.S. § 15-16-502 provides that an independent trustee of a trust may, in the trustee’s discretion, reimburse the grantor for an amount equal to any income taxes on the trust’s taxable income for which the grantor is liable. The statute clarifies that the reimbursement does not allow the grantor’s creditors to reach the trust assets, thus addressing the concern highlighted by Rev. Rul. 2004-64. The trustee does not have the discretion to reimburse the grantor, however, if the trust instrument expressly prohibits it. In addition, the statute provides that reimbursement of the grantor is not permitted if the exercise of such discretion would be inconsistent with qualifying the trust for the marital deduction, and it sets out certain exceptions with regard to trusts for tax-exempt beneficiaries.
C.R.S. § 15-16-502 is intended to apply to trusts created before and after the effective date of the statute unless expressly prohibited by the trust instrument. However, many irrevocable trusts contain a provision under which the grantor expressly relinquishes all rights in the trust, which raises the issue whether the trustee is implicitly prohibited from reimbursing the grantor despite the statutory authorization. Therefore, a trustee who is considering reimbursing the grantor for income taxes attributable to the trust must not only ensure that he complies with the express parameters of the statute, but he must also analyze whether the trust includes any provisions that may, by implication, preclude the exercise of the authority otherwise available under the statute.