By Michael Rosen-Prinz
Loeb & Loeb LLP
Headnote: Grantor Trusts – Creditor Access – Discretionary Reimbursement of Tax Liability
Summary: Effective January 1, 2023, new Probate Code section 15304, subdivision (c), clarifies that a trustee’s discretionary power to reimburse the settlor of a “grantor trust” for income taxes paid on behalf of the trust does not create a beneficial interest that would allow the settlor’s creditors to access trust assets to satisfy the settlor’s debts.
Longstanding provisions of Probate Code section 15304 allow a creditor to access trust property to satisfy the debts of the trust’s settlor when the settlor has retained a beneficial interest in the trust. This section exemplifies California’s policy against self-settled asset protection trusts, by providing that any beneficial interest in a trust held by the settlor will be accessible to creditors, and that a creditor can even access trust property subject to a discretionary interest up to the maximum potential exercise of that discretion.
Under the “grantor trust” rules of Internal Revenue Code (“IRC”) sections 671-678, the settlor of a trust can be deemed the owner of all or a portion of a trust for income tax purposes based on the powers and interests the settlor holds in the trust. Carefully drafted irrevocable grantor trusts will be characterized by conflicting treatment under income tax law and transfer tax (i.e., gift, estate, and generation-skipping transfer tax) law so that any gift to the trust is removed from the settlor’s taxable estate as a completed gift; however, the trust assets, and the corresponding income and principal, are deemed owned by the settlor under income tax law and the settlor is subject to “phantom” income tax on the trust’s income. This structure is often beneficial for estate planning and wealth transfer, because it allows the irrevocable trust to receive income and recognize gains without any tax burden, while the settlor is able to reduce an otherwise taxable estate by paying the income tax on behalf of the trust.
These rules, as well as those under IRC section 2036 governing the inclusion of assets in a settlor’s taxable estate, intersect when a trust settlor grants a trustee the power to reimburse the settlor for income taxes paid on behalf of the trust. IRS Revenue Ruling 2004-64 states that a trustee may have a discretionary power to reimburse a settlor for taxes paid without causing the trust assets to be included in the settlor’s estate provided certain requirements are met: (1) there must not be a preexisting arrangement regarding the trustee’s exercise of discretion, (2) the settlor must not be able to remove and replace the trustee with him-or-herself, and (3) applicable state law must not subject the trust assets to the settlor’s creditors. Until now, it has been unclear whether California law would treat this discretionary tax reimbursement power as a beneficial interest subject to creditor claims. However, Probate Code section 15304, subdivision (c), effective January 1, 2023, clarifies that a trustee’s discretionary power to reimburse the settlor for any income tax liability incurred because of the income of a grantor trust is not a beneficial interest and that a creditor of the settlor cannot access the trust property solely due to this discretionary tax reimbursement power, fulfilling the third requirement of the Revenue Ruling.
This subdivision was enacted under AB 1866 (Phillip Chen), a bill originated as a TEXCOM legislative proposal. It passed both houses of the legislature without any opposition or amendments.