What Is a Tax Reimbursement Clause?
What Is a Tax Reimbursement Clause? To understand a tax reimbursement clause, you must first understand what a grantor trust is, and how it works. A grantor trust means the person creating the trust, also called a trustor or grantor, is responsible to pay the income tax on income earned by the trust.
According to the article “Tax Reimbursement Clauses: What They Are And Why You Need To Know” from Forbes, these clauses were established when marginal income tax rates were much higher than they are today and taxpayers tried to save taxes by shifting income to a trust which paid a much lower income tax. Congress reacted by creating rules to cause the income of some trusts to be taxed to the grantor. However, tax experts reimagined the new laws and found a way to use the clause to benefit estate plans.
In 1986, when non-grantor trusts were taxed in a harsher way, grantor trusts were used for estate tax planning purposes. When assets were shifted into a trust, the goal is to have them grow rapidly and be protected by the trust. An increase in value of assets in the trust means less value in your taxable estate and outside the reach of creditors.
If you pay the income tax on the income earned by the trust, it grows faster because the value of the trust is compounding on a tax-free basis. Tax free compounding growth is considered one of the most powerful ways to build wealth.
As you pay income taxes on trust income, the trust grows faster and the assets in and value of the remaining estate is reduced. This also reduces the assets subject to the estate tax.
The purpose of the clause is to provide funds to the grantor to pay the income tax on the income earned by the grantor trust. What if the grantor trust tax becomes too much of a good thing, or if you don’t want to keep paying the income tax on the trust’s income?
If the trust can reimburse you for the income tax, it may help with cash flow concerns.
Talk with your estate planning attorney about the pros and cons of including a tax reimbursement clause in your trust. Some estate planning attorneys insist that a tax reimbursement clause must be included in every grantor trust, while others never use them. They are concerned that they may increase the risk of all trust assets being included in your estate as a result of the tax reimbursement clause being viewed as a retained right in the trust, or you as a beneficiary of the trust.
The decision depends upon your situation and your state laws. The improper use of a tax reimbursement clause might cause estate inclusion, in which case great care needs to be used before including this provision. However, there have been so many cases of taxpayers misusing tax reimbursement clauses that not including them may also make sense.
Every trust has its own language and the exercise of any tax reimbursement clause must comply with the terms of the trust.
Talk with your estate planning attorney about understanding what a tax reimbursement clause is and if it is appropriate for you. If you would like to learn more about taxes and estate planning, please visit our previous posts.
Reference: Forbes (Jan. 8, 2023) “Tax Reimbursement Clauses: What They Are And Why You Need To Know”