For many years, the IRS has taken a fairly permissive view of irrevocable trust modifications.  However, Chief Counsel Advice 202352018 suggests that position is changing.  Advisors should understand the potential shift in the IRS’s position, the circumstances where a modification could create concerns under the CCA’s analysis, and how to draft irrevocable trusts that are flexible enough to address unexpected changes.

Introduction

Client goals and family circumstances inevitably change.  An irrevocable trust created decades or even years ago might not reflect the current situation of the grantor or the beneficiaries.  The trust might lack administrative flexibility, or its dispositive provisions might be inappropriate following changes in tax laws or the beneficiaries’ lives.  Advisors have several tools to repair these “broken” trusts: court modifications, non-judicial settlement agreements (“NJSAs”), trust advisor amendments, decanting, and exercises of powers of appointment.  These tools have proliferated mostly with approval from the Internal Revenue Service (the “IRS”).  That permissive stance may be changing, though.

In IRS Chief Counsel Advice Memorandum 202352018 (released December 29, 2023) (the “CCA Memo”), the IRS Chief Counsel concluded that a court order modifying an irrevocable trust resulted in a taxable gift by the beneficiaries.  Notably, the CCA Memo directly contravened a 2016 private letter ruling.[1]

This article begins with background on Chief Counsel Advice memoranda and grantor trusts.  The article then evaluates the IRS’s argument in the CCA Memo.  Next, the article analyzes whether, under the CCA Memo’s logic, the trustee could have modified the trust without causing a taxable gift.[2]  Finally, the article identifies several lessons for modifying existing irrevocable trusts and drafting new ones.

Background of the CCA Memo and Grantor Trusts

Before discussing the CCA Memo itself, advisors should understand IRS Chief Counsel Advice Memoranda. Chief Counsel Advice Memoranda are not official IRS positions, nor are they precedential.  They are essentially legal analysis from the IRS Chief Counsel’s office to a field office.  These memoranda are sometimes issued in the context of an audit.  Therefore, advisors might expect the IRS to take an aggressive posture in these memoranda.  Nonetheless, they illuminate the IRS’s approach to developing tax issues.

The CCA Memo involved a trust created for the grantor’s child and grandchildren.  The trust was a grantor trust.  As such, the grantor was liable for taxes on the trust’s income.  Grantor trust status greatly advantages the beneficiaries because the trust grows unhindered by income taxes.  Grantor trust status can become a burden for the grantor, though, if his or her cash flow decreases.  To reduce that risk, some trusts give an independent trustee discretion to reimburse the grantor for income taxes attributable to the trust (herein, a “tax reimbursement clause”).[3]

The trust agreement in the CCA Memo did not initially contain a tax reimbursement clause.  After the trust was established, circumstances evidently changed and additional flexibility was desired.  The trustee petitioned the state court to add a tax reimbursement clause.  The beneficiaries consented to this request.  The court entered an order modifying the trust under state law.

The IRS Chief Counsel’s office argued in the CCA Memo that this modification shifted a beneficial interest in the trust from the beneficiaries to the grantor.  Because the beneficiaries consented to the modification, the IRS Chief Counsel’s office advised the field agent that the beneficiaries should be deemed to have made a taxable gift to the grantor.

Analyzing the CCA Memo’s Conclusion

The CCA Memo’s basic argument has some appeal.  The gift tax applies to “any transaction in which an interest in property is gratuitously passed or conferred upon another, regardless of the means or device employed.”[4]

The trust modification conferred some interest in the trust principal onto the grantor.  The CCA Memo states that neither the trust instrument nor applicable state law authorized tax reimbursements.  Thus, before the modification, the grantor could not benefit from the trust.  After the modification, though, the grantor could benefit from the trust principal.  Specifically, the trustee could use trust assets to reimburse the grantor for income taxes attributable to the trust.

The beneficiaries conferred this benefit onto the grantor.  Although the trustee petitioned the court, the beneficiaries consented to the petition.  In fact, although the CCA Memo did not disclose the applicable state law, the beneficiaries’ consent might even have been necessary to obtain court approval for the trust modification.

However, the CCA Memo contains ample shortcomings.  First, it failed to consider that the trustee might never reimburse the grantor.  Even if a trust authorizes tax reimbursements, the trustee’s fiduciary duties are to the beneficiaries, not to the grantor.  The trustee might conclude that reimbursing the grantor is not in the beneficiaries’ best interest.  If the trustee will never exercise the reimbursement power, the grantor’s interest in the trust is effectively zero.  Therefore, the beneficiaries should not be deemed to have made a taxable gift to the grantor.[5]

The beneficiaries might also argue that the transfer was not “gratuitous.”  Perhaps the grantor gave them a choice: consent to the trust modification or I will terminate the grantor trust status of the trust.[6]  Given those choices, a purely self-interested beneficiary might prefer the former.[7]  In that scenario, the beneficiaries benefitted from the trust modification.  It is hard to describe a transaction as “gratuitous” where the alleged donor acted in his or her own pecuniary self-interest.  However, this argument could create larger concerns for the family: the negotiation might betray an implicit agreement about tax reimbursement decisions.  Such an agreement might cause the trust assets to be included in the grantor’s estate.[8]

The CCA Memo also failed to address several important questions.  Primarily, how could an appraiser value this purported taxable gift?  As noted above, the trustee might never reimburse the grantor.  Moreover, the grantor might terminate grantor trust status in the future, rendering the tax reimbursement clause moot.  The CCA Memo did not attempt to provide a framework for appraisers under these circumstances.  The CCA Memo merely conceded that the valuation of the alleged taxable gift would be “complex.”

The CCA Memo also did not explain how it would apportion the gift among the current and future beneficiaries.  The CCA Memo states that the gift was made by the grantor’s child and the child’s “issue”.  It is possible the trust would benefit individuals who have not been born yet.  As two commentators asked, would the IRS impose gift tax on those unborn children?[9]

Despite these shortcomings, however, the CCA Memo provides an important window into the IRS’s internal deliberations.  It appears the IRS’s view on the tax effects of trust modifications is changing.  Advisors should be mindful and watch closely for additional guidance.

Effect on Other Trust Modification Tools

The most concerning facet of the CCA Memo, though, is that it extends beyond the designated facts.  That is, the CCA Memo argues that a taxable gift would also occur if the trust had been modified through other means that gave the beneficiaries a right to object.[10]

In evaluating whether a trust modification by “other means” constitutes a taxable gift, the CCA Memo seems to advocate for a two-step analysis.  First, does the modification shift a beneficial interest?  Second, may the beneficiaries object to the modification?

Administrative modifications, such as a waiver of the prudent investor rule, do not shift beneficial interests in the trust.  Therefore, NJSAs should be viable for such modifications even if the IRS adopts the CCA Memo’s position in official guidance.

However, an NJSA that does shift a beneficial interest might constitute a taxable gift under the CCA Memo’s analysis.  An NJSA is not effective unless it is signed by all of the interested persons.[11]  A beneficiary may “object” simply by refusing to sign the NJSA.  Therefore, an NJSA that shifts a beneficial interest might constitute a taxable gift under the CCA Memo’s analysis.  While NJSA may still be viable if the modification resolves a genuine dispute,[12]  a trustee seeking to modify the trust’s dispositive provisions might consider a different tool, at least until the IRS issues additional guidance.

One alternative to an NJSA is a trust advisor amendment.  Many trust instruments authorize a trust advisor (or another third party) to amend the trust terms for limited purposes.  The trust advisor usually may act without any person’s approval or consent.  As noted, the CCA Memo argues that the trust modification might constitute a taxable gift if the beneficiaries have a right to object.  Because the beneficiaries cannot object to the amendment, the amendment should not constitute a taxable gift under the CCA Memo’s analysis.

Trust advisors do not have unlimited discretion, though.  Suppose the trust advisor adds a tax reimbursement clause despite a clear prohibition under the provisions of the trust instrument.  In that case, the beneficiaries would have a right to object to the amendment and any tax reimbursement payments made pursuant to the amendment.  If the beneficiaries acquiesce to the trust advisor’s ultra vires actions, the IRS might argue the beneficiaries made a taxable gift under the CCA Memo’s analysis or even under other, long-standing IRS guidance.[13]

Another option may be to decant the trust.  The analysis is similar to trust advisor amendments.  The trustee, not the beneficiaries, undertakes the decanting.  Many decanting statutes allow the trustee to decant without the beneficiaries’ consent.[14]  Thus, a valid trust decanting should not result in gift tax under the CCA Memo’s framework.

Like the trust advisor amendment, though, the trust decanting must be valid.  At least one state supreme court has invalidated a decanting as an abuse of discretion.[15]  Therefore, the trustees should consider the purposes of the trust and document their reasoning.  The trustees should also ensure they have the requisite authority to decant.  The trustees of a fully discretionary trust usually have broad decanting powers.  Trustees subject to an ascertainable standard, however, often may decant only to change administrative terms of the trust instrument.[16]  If the trustees abuse their discretion or exceed their authority, the beneficiaries might have a right to object.  Again, a failure to raise that objection could constitute a taxable gift.

Even if trust decanting and trust advisor amendments are theoretically viable under the CCA Memo’s analysis, they could become problematic in practice.  Fiduciaries often ask beneficiaries to consent to trust modifications by an advance written agreement.  If the decanting is conditioned on the beneficiaries’ consent, the IRS might argue the beneficiaries directed the decanting.  That argument might stretch a court’s credulity.  Perhaps the agreement could be drafted to demonstrate that the trustees still exercised their own judgment.[17]  Until the IRS issues additional guidance, fiduciaries desiring protection from liability for modifying a trust might want to seek court approval.

Finally, the fiduciary should consider factors beyond the CCA Memo.  For example, if the trust is a GST-grandfathered trust, the trust modification should not shift a beneficial interest to a lower generation or extend the time for vesting.  Otherwise, the trust could lose its GST exempt status.

Lessons for Practitioners

The CCA Memo is neither a regulation nor a court decision; it is only internal advice to a field office.  Nonetheless, it provides several lessons for repairing broken trusts.

First, court modifications and NJSAs are valuable tools to modify administrative trust terms.  However, until a court opinion or official IRS guidance provides clarity, advisors may be wise to avoid NJSAs that shift beneficial interests.

Second, decanting and trust advisor amendments should be viable under the CCA Memo’s analysis even if the modification shifts a beneficial interest.   These tools are not cure-alls, though.  The fiduciaries must act within their authority.  Under the CCA Memo’s analysis, if the fiduciaries exceed their authority, the beneficiaries would be forced to act or risk being deemed to have made a gift tax.[18]

Finally, estate planners should carefully draft new trusts to be flexible.  The trust might grant an independent trustee broad distributive powers – and, thus, broad decanting powers.  The trust might also grant a beneficiary (particularly the grantor’s spouse) a power of appointment.  The trust could also authorize a trust advisor to make limited amendments.  Of course, the trust should not be so malleable that someone can defeat the grantor’s intent.  But when the future is uncertain, flexibility is a virtue.

Conclusion

Families change.  The scheduled sunset of the Tax Cuts and Jobs Act is a reminder that tax laws change, too.  The terms of an irrevocable trust designed and funded in 2012 might not make sense in 2024.  Modern trust law provides advisors with numerous tools to repair these broken trusts.  The CCA Memo is neither a court opinion nor a binding statement of the IRS’s position.  Nevertheless, it should remind advisors repairing broken trusts to carefully select the best tool for the job.  It should also encourage estate planners to draft trusts with built-in flexibility for an uncertain world.

Scott W. Masselli is an attorney at Virginia Estate & Trust Law, PLC, in Richmond, Virginia.  He advises clients on estate planning, tax planning, and estate and trust administration.  He has significant experience advising fiduciaries on trust modifications to resolve ambiguities, achieve tax savings and promote family harmony, while preserving the grantor’s intent.  Scott lives in Richmond, Virginia with his wife and son.

The author thanks his colleagues Sarah E. Brownlow and Katherine E. Ramsey for their thoughtful input on this article. 

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[1] See I.R.S. P.L.R. 201647001.  Private Letter Rulings are not precedential.

[2] The CCA Memo does not appear to implicate the analysis of powers of appointment.  Therefore, they are not addressed.

[3] Another, often superior, option is simply to terminate grantor trust status.  Tax reimbursement clauses open the door, if only slightly, for estate tax inclusion.  See Rev. Rul. 2004-64 (noting that drafting or administration issues that may cause estate tax inclusion).  Moreover, reimbursing the grantor transfers assets back into her taxable estate.  Note also that a state statute might permit the trustee to reimburse the grantor.  See, e.g., Va. Code § 64.2-1065(C).

[4] Treas. Reg. § 25.2511-1(c)(1).

[5] On the other hand, if the trustee in the CCA never intends to reimburse the trustee, why would it incur the cost of a court proceeding?

[6] See Ronald D. Aucutt, Capital Letter No. 61, Reimbursement of Grantor for Income Tax Paid on a Grantor Trust’s Income.

[7] If the trust remains a grantor trust, the trustee might reimburse the grantor for some, but probably not all, of the income tax payments each year.  If the trust becomes a non-grantor trust, the beneficiaries will bear the tax liability, directly or indirectly.  The beneficiary’s preference would ultimately depend on several variables, including the amount of trust income, the amount distributed to the beneficiaries, the grantor and beneficiaries’ marginal tax rates, and the amount of the reimbursements.

[8] See Rev. Rul. 2004-64 (situation 3).

[9] See Jennifer Schooley and Sydney Albrecht, What Trust and Estate Practitioners Need to Know about CCA 202352018: Practical Impacts and Planning Considerations, Virginia State Bar Trusts & Estates Newsletter (Spring 2024).

[10] Technically, the CCA refers to a right to notice and a right to object.  Those two prongs are condensed for brevity.

[11] See Unif. Trust Code § 111.

[12] For a general discussion of the tax implications of NJSAs and other trust modifications, see Melissa J. Willms, Decanting Trusts: Irrevocable, Not Unchangeable, 6 Est. Plan. & Cmty. Prop. L. J. 35, 67-79 (2013).

[13] See Rev. Rul. 84-105 (holding that a beneficiary made a taxable gift when she failed to object to the underfunding of her pecuniary bequest).

[14] See, e.g., Unif. Trust Decanting Act § 7.

[15] See Hodges v. Johnson, 170 N.H. 470 (2017).

[16] Compare Unif. Trust Decanting Act §§ 11 and 12.

[17] For example, the agreement might state that the trustee may exercise the decanting power in a certain manner, and, if the trustee does so, the beneficiaries consent to that decision.

[18] For this reason, the beneficiaries might retain separate counsel from the fiduciary.