In McDougall v. Commissioner[1], the Tax Court applied the “change in economic position” analysis present in IRS Chief Counsel Advice memorandum 202352018. The court’s analysis suggests that the Chief Counsel’s reasoning was sound, albeit incomplete. Advisors should judiciously consider whether some modifications to irrevocable trusts make sense now that the IRS has additional authority to attack those modifications.

Introduction

In Chief Counsel Advice Memorandum 202352018 (the “CCA Memo”), the IRS Chief Counsel reviewed a trust modification where the local court, at the trustee’s request and with the beneficiaries’ consent, granted the trustee the power to reimburse the grantor for income taxes attributable to the trust assets. The Chief Counsel concluded that, by consenting to the trustee’s petition, the beneficiaries had made a taxable gift to the grantor. Moreover, the Chief Counsel wrote that “[t]he result would be the same if the modification was pursuant to a state statute that provides beneficiaries with a right to notice and a right to object to the modification and a beneficiary fails to exercise their right to object.”[2]

Many commentators questioned aspects of the CCA Memo. By its own admission, the Chief Counsel did not explain how it proposed to value the alleged gift. The Chief Counsel also failed to consider potential counterarguments from the taxpayer. But, in the author’s opinion, while some critiques had merit, the Chief Counsel’s basic conclusion was sound.[3]

The Tax Court has now implicitly affirmed the Chief Counsel’s reasoning. In McDougall v. Commissioner, the court concluded that the beneficiaries’ consent to terminate a QTIP marital trust constituted a taxable gift from the remainder beneficiaries to the surviving spouse. Though the court did not cite the CCA Memo, it tracked the Chief Counsel’s analysis. Accordingly, advisors should grant greater deference to the CCA Memo.[4]

A Brief Review of CCA 202352018 and Its Aftermath

The CCA Memo centered on a trust created for the grantor’s child and grandchildren. The trust was a grantor trust. As such, the grantor was liable for tax on the trust’s income. Advisors often view grantor trust status as a positive (hence the term “intentionally defective grantor trusts”).

However, at some point after this trust was created, grantor trust status became undesirable. Perhaps the grantor’s cash flow was reduced, or the trust was expected to have a large income tax event. To address such risks, grantor trusts will sometimes authorize an “independent trustee” to reimburse the grantor for income taxes attributable to the trust assets. This power is known as a tax reimbursement clause.[5]

The trust in the CCA Memo did not initially contain a tax reimbursement clause. However, the trustee petitioned the state court to add one. The trust’s beneficiaries consented to that petition. The court agreed and entered an order modifying the trust.

The Chief Counsel argued in the CCA Memo that this modification shifted a beneficial interest in the trust from the beneficiaries to the grantor. As the Chief Counsel noted, the modified terms of the trust now allowed the trustee to pay trust assets to the grantor, reducing what was available for the beneficiaries. Thus, the beneficiaries voluntarily changed their economic position, they became somewhat worse off, and the grantor became somewhat better off.

The IRS has ruled that tax reimbursement clauses, if properly drafted and included in the original terms of the trust, do not create negative tax issues for the grantor.[6]  But, because the tax reimbursement clause was added after the irrevocable trust was created and funded, with the beneficiaries’ consent, the Chief Counsel concluded that the beneficiaries had made a taxable gift to the grantor.

Perhaps most concerningly, the Chief Counsel wrote that “[t]he result would be the same if the modification was pursuant to a state statute that provides beneficiaries with a right to notice and a right to object to the modification and a beneficiary fails to exercise their right to object.”[7]  Thus, non-judicial settlement agreements and potentially other forms of trust modification appeared to be threatened.[8]

Many in the estate planning community responded to the CCA Memo with concern. Most of those commentators viewed the analysis as incomplete. Indeed, the CCA Memo ignored important questions, such as how to value the purported taxable gift. But some highly respected commentators questioned the Chief Counsel’s basic conclusion that a taxable gift had occurred at all.

Nine months after the release of the CCA Memo, the Tax Court issued its opinion in McDougall. Although the facts are slightly different than those in the CCA Memo, the court adopted the Chief Counsel’s “change in economic position” analysis. Thus, it appears the court would have agreed with the Chief Counsel’s conclusion in the CCA Memo.

McDougall v. Commissioner

Clotilde McDougall died in 2011. Her revocable trust created a QTIP marital trust for her husband, Bruce. Bruce was entitled to the net income from the trust. The trustee was also authorized to distribute principal for Bruce’s health, maintenance, and support in his accustomed manner of living. At Bruce’s death, he had the power to appoint the remaining trust assets among Clotilde’s descendants in any shares and upon any terms. The remaining, unappointed assets would be distributed to Clotilde’s descendants who survived Bruce per stirpes.

By 2016, the trust had grown to over $100 million. Bruce and Clotilde’s two children, Linda and Peter, signed a non-judicial settlement agreement that year to terminate the trust and distribute all the trust assets to Bruce. Following the termination of the trust, Bruce sold a portion of the assets he received from the trust to Linda and Peter in exchange for promissory notes. The IRS audited Bruce, Linda and Peter’s respective gift tax returns and issued deficiency notices to each of them.

The Tax Court’s decision was a mixed bag for the family. Following its decision in Estate of Anenberg,[9] the court ruled that Bruce had not made a taxable gift to Peter and Linda.

However, the court agreed with the IRS that Peter and Linda had made taxable gifts to Bruce. In particular, the court cited the change in the family members’ economic positions. Under the terms of the trust, Peter and Linda had an expectation that they would receive the remaining assets at Bruce’s death (albeit subject to Bruce’s power of appointment, which he could have used to leave the assets to Clotilde’s grandchildren, thus leaving Peter and Linda with nothing).  Once the trust terminated, Bruce owned the assets outright and could use them however he desired.[10]  By agreeing to terminate the trust, Peter and Linda voluntarily reduced their economic position to Bruce’s benefit. Therefore, the court determined that they had made a gift to him.

McDougall Requires More Deference to CCA 202352018

The Tax Court’s “change in economic position” reasoning essentially adopts the Chief Counsel’s analysis in the CCA Memo. As the court wrote, “[b]efore the [termination of the trust], Bruce did not own the assets of the Residuary Trust outright and could not do with them what he wished. After the [termination of the trust], he did and could. On the other hand, before the [trust terminated], Linda and Peter had remainder rights with respect to the Residuary Trust. After, they did not.”

The Chief Counsel applied the same logic in the CCA Memo. Recall that in the CCA Memo, the beneficiaries voluntarily reduced their economic position, and improved the grantor’s economic position, by consenting to the insertion of a tax reimbursement clause. While the action was slightly different than in McDougall, a trust modification rather than a trust termination, the IRS would likely cite the McDougall court’s analysis in future litigation involving trust modifications.[11]  Therefore, advisors should treat the CCA Memo with greater deference.

Another lesson from the CCA Memo and affirmed by McDougall is to consider including an “independent trustee” who is not subject to an ascertainable standard. If the trustee in McDougall had been given discretion to distribute principal for Bruce’s general welfare or best interests, perhaps the trust could have been terminated without Peter and Linda’s consent. The Chief Counsel’s analysis in the CCA Memo was expressly premised on the beneficiaries’ consenting or otherwise failing to object to the trust modification. If Peter and Linda could not prevent the termination of the trust, then they logically should not be charged with a taxable gift. This argument might have been strained in McDougall, where the independent trustee would have had to defend a $100 million outright distribution as within its discretion. In less extreme cases, though, it is persuasive.

Finally, trustees seeking to modify an irrevocable trust should consider techniques that do not require the beneficiaries’ consent. The parties in the CCA Memo and McDougall relied on a consent petition and a non-judicial settlement agreement, respectively. Those techniques require the consent of all interested parties. By contrast, trust decanting typically does not require the beneficiaries’ consent. Note, though, that the beneficiaries usually have a right to object if the trustee oversteps its authority; under the CCA Memo’s reasoning, such right could be fatal.[12]

Conclusion

The CCA Memo created a flurry of discussion upon its release. Commentators, including the author, agreed that the Chief Counsel’s analysis was incomplete. However, they were split on whether the conclusion was correct.

The Tax Court’s decision in McDougall implicitly affirmed the Chief Counsel’s analysis in the CCA Memo. Specifically, the court cited the voluntary change in the parties’ economic positions to establish that Peter and Linda’s agreement to terminate the trust constituted a taxable gift to Bruce. The principles are strikingly similar to those in the CCA Memo. After the result in McDougall, the IRS may feel emboldened to challenge trust modifications where one party agrees to shift a beneficial interest to another. Advisors should review the CCA Memo again with greater credence and carefully consider the potential tax ramifications of trust modifications.

The author thanks his colleague Helen Lewis Kemp, Esq. and Micah Talabiska, University of Richmond School of Law (J.D. expected May 2026) for their valuable contributions to this article.

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[1] McDougall v. Commissioner, 163 T.C. No. 5, (September 17, 2024).

[2] CCA Memorandum 202352018 (Dec. 2023).

[3] For an in-depth discussion of the CCA Memo, see Scott W. Masselli, Repairing the Broken Trust: Irrevocable Trust Modifications after CCA 20235201, 44 J. Est. & Tax Planning (July 2024).

[4] McDougall v. Commissioner, 163 T.C. No. 5, (September 17, 2024).

[5] The author has rarely used tax reimbursement clauses in his practice. The power to reimburse the grantor, if exercised inappropriately, could trigger estate tax inclusion. See Rev. Rul. 2004-64 (situation 3). A less risky option would be to terminate grantor trust status entirely or to structure the trust as a non-grantor trust from the outset. If the client expects to request a tax reimbursement, then a grantor trust may not be an appropriate technique for them.

[6] See Rev. Rul. 2004-64 (but note that adverse tax consequences, such as estate tax inclusion under I.R.C. § 2036, could occur if the repayment were pursuant to a pre-existing agreement among the parties).

[7] CCA Memorandum 202352018 (Dec. 2023).

[8] See Masselli, supra, for a discussion of various trust modification mechanisms and the CCA Memo’s implication for each of them.

[9] Estate of Anenberg,162 T.C. No. 9 (May 20, 2024).

[10] Coincidentally, the court’s opinion did not determine the amount of the taxable gifts. It specifically did not determine how Bruce’s limited power of appointment would affect that valuation. See id. at n.10. One of the most common frustrations with the CCA Memo was that advisors were understandably unsure how the IRS would value the alleged taxable gifts.

[11] Assuming the new IRS leadership does not change its legal conclusion.

[12] For an in-depth discussion of modifying trusts after the CCA Memo, see Masselli, supra.