On the other hand, if the GRAT instrument allows (but does not require) the trustee to reimburse the grantor for income taxes, and there is no implicit or explicit agreement between the grantor and the trustee that the GRAT assets will always be available to reimburse the grantor, the reimbursement provision should not, by itself, have any estate tax consequences. This suggests that a tax reimbursement provision should always be fully discretionary and should not require the trustees to reimburse the grantor for income taxes.
However, even a discretionary income tax reimbursement provision could create estate tax problems if under state law such a provision would allow the grantor’s creditors to reach the assets held in the GRAT. If the grantor’s creditors can reach the assets, then the IRS says that they should be included in the grantor’s taxable estate.
But what is the estate tax treatment absent any kind of reimbursement provision? It turns out that it is virtually identical, meaning that there is little practical reason not to include an income tax reimbursement provision in a GRAT.
Here is why: The regulations under Internal Revenue Code section 2036 require the grantor to include in his estate property sufficient to produce the remaining GRAT annuity payments from only trust income, assuming there is an income rate equal to the then-7520 rate. This requirement makes it almost certain that all the remaining GRAT property will be taxed in the grantor’s estate if he dies during the GRAT term, regardless of whether the GRAT instrument includes an income tax reimbursement provision.
Consider the following example: A client creates a two-year GRAT in October 2013 (when the statutory rate is 2.4%), funds the GRAT with $1 million and dies during the initial term. Under the section 2036 regulations, in order for any part of the GRAT assets to escape estate tax on the grantor’s death, the GRAT would have to be worth over $21 million. Needless to say, very few GRATs will ever be this successful.
All of this means that, in most cases, including an income tax reimbursement provision in a GRAT does not create any additional estate tax exposure.
When To Include A Reimbursement Provision
Advisors should evaluate whether to include an income tax reimbursement provision in a GRAT based on several factors. If, for example, a client has sufficient other assets to pay any income tax liability that could be generated by the assets held inside a GRAT, a reimbursement provision may be unnecessary.
But if a client prefers the flexibility of including an income tax reimbursement provision, then be sure to make that reimbursement provision fully discretionary. This way, if the GRAT is wildly successful and the section 2036 regulations would not otherwise require the grantor to include the entire GRAT property in his estate, the estate will have an argument that the discretionary reimbursement provision should not have the effect of including the balance.
Finally, advisors should keep in mind that using assets held inside the GRAT to pay the donor’s income tax liability undermines the effectiveness of the GRAT technique. Assets held in a successful GRAT could pass to the next generation without any gift tax cost.
If instead some of the GRAT assets were used to pay income taxes, there would be less appreciation to benefit the remainder beneficiaries of the GRAT.
The bottom line is that, while a client may choose not to include an income tax reimbursement provision because he has sufficient assets outside the GRAT to pay any such tax liability, the risk of potential estate tax inclusion should not drive the decision.