What Is a Tax Reimbursement Clause?
Tax reimbursement clauses are a common provision found in many trusts. Understanding their purpose and implications is important for anyone involved in estate planning.
Understanding Grantor Trusts
To comprehend tax reimbursement clauses, you must first understand grantor trusts. In a grantor trust, the person creating it – known as the trustor or grantor – is responsible for paying income taxes on income generated by the trust.
Historical Context
Tax reimbursement clauses emerged during an era when marginal income tax rates were significantly higher than current levels. Taxpayers sought to reduce their tax burden by transferring income to trusts that paid lower rates. Congress responded by implementing rules that taxed certain trust incomes to the grantor instead.
However, tax professionals discovered how to leverage these new regulations for estate planning advantages. Starting in 1986, grantor trusts became valuable tools for estate tax planning when non-grantor trusts faced harsher taxation.
The Purpose and Benefits
The primary objective of transferring assets into a trust is protecting them while allowing rapid growth. As trust assets increase, the taxable estate value decreases, and fewer assets remain vulnerable to creditors.
A key advantage: by paying income tax on trust income, the trust grows faster since its value compounds on a tax-free basis. This tax-free compounding represents one of the most powerful wealth-building methods available.
The tax reimbursement clause itself serves to provide funds to the grantor to cover income taxes owed on trust income. If tax obligations become burdensome or you prefer not to continue paying them, the trust can reimburse you for these taxes – potentially addressing cash flow challenges.
Important Considerations
Estate planning professionals hold differing opinions on this provision. Some believe it should be included in every grantor trust, while others avoid using them altogether.
The primary concern: including a tax reimbursement clause might be viewed as a retained right or beneficiary interest in the trust, potentially causing all trust assets to be included in your taxable estate – defeating the planning purpose.
The decision to include this clause depends on your specific circumstances and state law. Improper use can trigger unintended estate inclusion, so careful planning is essential. Conversely, omitting the clause may also be appropriate given documented cases of misuse.
Key Takeaway
Each trust contains its own unique language, and any tax reimbursement clause must comply with specific trust terms. Consult your estate planning attorney about whether this provision is appropriate and commonly used in your jurisdiction.
If you or a loved one needs assistance with elder law, probate or estate planning issues, do not hesitate to contact us to schedule a consultation. We are here to help.
