Understanding a tax reimbursement clause requires first comprehending what a grantor trust is and how it functions. In a grantor trust, the person creating it, also known as the trustor or grantor, is responsible for paying the income tax on income generated by the trust.
According to a Forbes article titled “Tax Reimbursement Clauses: What They Are And Why You Need To Know,” tax reimbursement clauses were established during a time when marginal income tax rates were much higher than they are today. Taxpayers attempted to reduce taxes by shifting income to a trust that paid a lower income tax rate. Congress responded by creating rules that caused some trust incomes to be taxed to the grantor. However, tax experts found a way to utilize the new laws and the clause to benefit estate planning.
Grantor trusts were used for estate tax planning purposes in 1986 when non-grantor trusts were taxed more harshly. The objective of transferring assets into a trust is to protect them and allow them to grow rapidly. An increase in trust assets means less taxable estate value and fewer assets available to creditors.
By paying income tax on trust income, the trust grows faster since its value compounds on a tax-free basis. Tax-free compounding growth is one of the most powerful methods to create wealth.
As you pay income taxes on trust income, the trust grows faster, and the remaining estate’s assets and value are reduced. This also lowers the estate tax subject to the assets.
The purpose of a tax reimbursement clause is to provide funds to the grantor to pay the income tax on the income earned by the grantor trust. However, if the grantor trust tax becomes too much, or if you don’t want to keep paying the trust’s income tax, the trust can reimburse you for the income tax, which may assist with cash flow concerns.
It’s important to speak with your estate planning attorney about the pros and cons of including a tax reimbursement clause in your trust. Some estate planning attorneys believe it should be included in every grantor trust, while others never use them. They’re concerned that the tax reimbursement clause may be seen as a retained right in the trust or you as a beneficiary of the trust, causing all trust assets to be included in your estate.
The decision about whether to include a tax reimbursement clause in your trust depends on your situation and your state’s laws. The improper use of a tax reimbursement clause may cause estate inclusion, so great care must be taken before including this provision. However, not including them may also make sense, given the number of cases of misuse.
It’s essential to note that 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 whether a tax reimbursement clause is used in your state and if it is appropriate for you.
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Reference: Forbes (Jan. 8, 2023) “Tax Reimbursement Clauses: What They Are And Why You Need To Know”