This is the second and final installment of the 2020 legislative update. Part 1 focused on non-tax changes to our probate and trust codes. This post focuses on CS/HB 1089, a single-purpose bill introducing new F.S. 736.08145, a tax-planning measure involving irrevocable “grantor trusts”.

What’s a “grantor trust” and why should I care?

According to the IRS: All “revocable trusts” are by definition grantor trusts. An “irrevocable trust” can be treated as a grantor trust if any of the grantor trust definitions contained in Internal Code §§ 671, 673, 674, 675, 676, or 677 are met. If a trust is a grantor trust, then the grantor is treated as the owner of the assets, the trust is disregarded as a separate tax entity, and all income is taxed to the grantor.

Most of the sophisticated tax planning involving grantor trusts is limited to irrevocable trusts sometimes referred to as “intentionally defective grantor trusts” or “IDGTs”. This kind of tax planning looms large in modern estate planning for the wealthy, as explained in Where Are All The Grantor Trust Reimbursement Statutes?

While originally intended essentially to punish settlors who tried to evade income taxes by transferring assets to trusts, grantor trust planning has become an essential tool in estate planning.

With grantor trust status, a trust can accelerate growth without the tax drag. Also, the trust can utilize the grantor’s Social Security number as its taxpayer ID number and avoid tax preparation hassles and fees. It can engage in desirable transactions with the grantor, like renting residential real estate, buying assets in an installment sale at low interest rates, and swapping out low basis assets for higher basis assets.

Paying someone else’s income taxes is great estate planning … until it’s not:

A central feature of estate planning with grantor trusts is that the settlor (referred to as the “grantor” by the IRS) pays the trust’s annual income taxes, even if the settlor’s not a beneficiary of the trust. As in, the settlor creates an irrevocable grantor trust for her children, but continues to pay the trust’s income taxes. If done right, this essentially generates a nontaxable gift to the beneficiaries, thereby reducing the settlor’s gross estate without incurring estate or gift taxes.

While paying someone else’s income taxes may be a great way to transfer wealth tax free, sometimes it can be a problem to pay taxes on earnings you’ve never received. Ideally, you’d want the trust to pay its own taxes every once in a while without blowing all of the trust’s tax savings benefits. Estate planners have grappled with this dilemma for years. Fortunately for them (and their clients), states, like Florida, who aggressively compete for a share of the billions in fees that come with catering to large multigenerational trusts, routinely pass taxpayer-friendly changes to their trust codes specifically designed to solve tax-planning dilemmas just like this one.

Enter new F.S. 736.08145, a 2020 change to Florida’s Trust Code specifically designed to make it easier for settlors to get reimbursed for income taxes they pay on behalf of grantor trusts. Here’s how the statute’s Legislative Analysis explains how this new addition to Florida’s Trust Code is supposed to work.

[F.S. 736.08145] modernizes Florida’s trust code by allowing, but not requiring, an independent trustee of a grantor trust to reimburse the grantor for all or part of the income tax paid by the grantor and attributable to trust income or to pay such taxes directly on the grantor’s behalf, provided the trust instrument does not explicitly prohibit such tax reimbursements or payments. The bill applies to all trusts, regardless of when they were created, unless:

  • The trustee provides written notice to the grantor and any person who can remove and replace the trustee that he or she intends to irrevocably elect out of the tax reimbursement and payment provisions at least 60 days before the election takes effect.
  • Applying the tax reimbursement and payment provisions would prevent a contribution to a trust from qualifying for, or would reduce, a federal tax benefit which was originally claimed, or could have been claimed, for the contribution.

Further, the bill provides that, if a trust’s terms require the trustee to act at the direction or with the consent of a trust advisor, a protector, or any other person, or that tax reimbursement or payment decisions be made directly by such a person, the powers granted by the bill to the trustee must instead or also be granted to such person if he or she meets the independence criteria established for trustees. Finally, the bill provides that a person may not be considered a grantor trust beneficiary due solely to implementation of the tax reimbursement or payment provision, including for purposes of determining the elective estate. In other words, a grantor would not become a grantor trust beneficiary simply by receiving tax reimbursement or payment assistance from the trust.

Sounds great, but does it work?

While Florida may be all in on tax breaks for Florida trusts, the IRS isn’t such a big fan. Which means anytime our legislature tries to shape our state laws in a way that makes it easier to lower federal taxes, you need to proceed with caution.

In this case we can take some comfort from the the fact that Florida isn’t the first to pass this kind of grantor-trust tax friendly legislation. As reported in the Legislative Analysis, Colorado, Delaware, New Hampshire, and New York, all beat us to the punch (they’re competing for the same trust business).

But you’ll also want to confirm the tax analysis yourself. For that you’ll want to read a White Paper submitted by an outfit calling itself the Florida Coalition for Modern Laws (“FCML”), which apparently was influential in the drafting and passage of CS/HB 1089. Here’s what FCML’s White Paper had to say about the tax analysis that went into the planning and design of the new statute:

[F.S. 736.08145] has been drafted to fit squarely within the principles of Revenue Ruling 2004-64. First, the reimbursement authority granted to trustees would be purely discretionary, not mandatory, which is consistent with the Revenue Ruling’s holding that a discretionary reimbursement power will not, by itself, cause estate tax inclusion. Second, the “other facts” identified by the Revenue Ruling as having the potential to cause estate tax inclusion if combined with a discretionary reimbursement power are addressed either by existing Florida law or by the proposed statute itself:

  • [F.S. 736.0505(1)(c)] already provides that the trustee’s power to reimburse the grantor for income taxes paid in respect of trust income will not cause the trust assets to be subject to the claims of the grantor’s creditors.
  • The proposed legislation vests the tax reimbursement authority only in disinterested fiduciaries, which ensures that the tax reimbursement authority will not be held by or imputed to the grantor even if he or she has the power to remove the trustee and name himself or herself as successor trustee.

The proposed legislation also incorporates additional safeguards intended to prevent any adverse federal gift or estate tax consequences under current law or as a result of changes in law. These additional tax safeguards are modeled on the most sophisticated statutes recently enacted in other jurisdictions. For example:

  • The proposed legislation provides that insurance policies on the grantor’s life cannot be used to satisfy the grantor’s tax liability; and
  • The reimbursement power cannot be exercised in a manner inconsistent with the marital or charitable deductions or the annual exclusion, or in a manner that would cause the inclusion of such trust’s assets in the grantor’s gross taxable estate for federal estate tax purposes.

Furthermore, if the parties to any trust do not wish to take advantage of the proposed legislation, or are concerned about the financial or tax impact, the trust document can “opt out” of the law or the independent fiduciaries may simply elect out of the application of the proposed legislation.