For the full PDF, click here: Risks and Opportunities when Irrevocable Grantor Trusts Own Pass-Through Entities that Pay State Income Tax for Their Grantors
The vast majority of states have now passed legislation to provide new mechanisms
whereby pass-through entities (PTEs) may pay state income tax that would previously
have been the tax burden of their owners. This generates an exclusion or a credit for
the individual taxpayer to use to offset their state income tax. Thus, it usually does not
increase the overall state income tax but allows more of it to be deductible without
being limited by the $10,000 cap on itemizable state and local income tax (SALT)
deductions. The IRS has signaled in Notice 2020-75 that it will issue proposed
regulations to permit this and provide further guidance.
When an irrevocable grantor trust (IGT) owns PTEs, however, the benefit from such
PTE tax payments does not inure to the trust at all. It is the grantor who benefits – not
the trust and its beneficiaries. Moreover, the grantor often retains control over
whether the PTE pays the grantor’s state tax bill or whether they pay it themselves.
This dynamic may cause several serious transfer tax problems that were neither
blessed nor even discussed in IRS Notice 2020-75.
While the IRS may ultimately decide to overlook the gift, estate and generation
skipping transfer (GST) tax implications of this optional state tax structure, such
payments probably do not come within the current protections of Rev. Rul. 2004-64,
and few states have clear laws that protect such payments from causing the IGT to be
susceptible to a grantor’s creditors. The optional nature of who pays this state tax
burden may also create serious implications for GRATs, intervivos marital trusts, or
other split-interest trusts such as grantor charitable lead trusts.
It may not be enough to tell clients to simply not make such PTE tax elections, as this
may be outside of the client’s control, or it may simply be too late. This newsletter
outlines the dangers and proposes a solution for states to consider in clarifying their
state law regarding application of the rule against self-settled trusts vis a vis such
payments, suggestions for the IRS to consider in their proposed regulations and
clauses for practitioners to consider to avoid the various financial, asset protection,
litigation and transfer tax risks discussed herein.