A private letter ruling that you may have missed (PLR 201417002 (released April 25, 2014) could mean trouble for clients who want to modify an irrevocable trust into a generation-skipping transfer (GST) trust so that it applies to future generations. Such a modification could result in loss of the GST tax exemption.
Assume a client asks you to modify an irrevocable trust. The trust’s beneficiaries are the client’s children and the client’s grandchildren, per stirpes. The trust was allocated GST tax exemption to cause an inclusion ratio of zero.
Your client informs you that he wants to modify the GST trust so that it applies to future generations, rather than outright to the grandchildren.
Rules on Trust Modification
Treasury Regulations Section 26.2601-1(b)(4 provides:1
(4) Retention of trust's exempt status in the case of modifications, etc.—
This language implies that modification of a GST tax exempt trust may cause a loss of the trust’s GST exempt status, if the modification(s) aren’t qualified under the Treasury regulations. A trust can be modified in four ways. The first three aren’t relevant to our client’s requested modification. These three are:
1. Change in the discretionary powers.
2. Settlement. A court-approved settlement of a bona fide issue regarding the administration of the trust or the construction of terms of the governing instrument won’t cause an exempt trust to be subject to the provisions of chapter 13
3. Judicial construction. A judicial construction of a governing instrument to resolve an ambiguity in the terms of the instrument or to correct a scrivener's error won’t cause an exempt trust to be subject to the provisions of chapter
The fourth way to modify the trust, specified in Treasury Regulations Section 26.2601-1(b)(4) (D), may apply to our client, as it’s explained in PLR 201417002.
In the PLR, the grantors had created three irrevocable trusts, one for each of their children, all of which are substantially the same.
The grantors desired to modify the trusts to: (1) empower the trustees to grant the trustees expanded powers to appoint successor trustees, and (2) grant the trustee an increased power to make discretionary distributions to one child.
The IRS’ analysis follows:
You have requested the following rulings:
(3) The modifications of Trusts will not cause Trusts, as modified, to lose exempt status for purposes of the GST tax of chapter 13 . . .
Section 26.2601-1(b)(4)(i)(D) provides that a modification of the governing instrument of an exempt trust (including a trustee distribution, settlement, or construction that does not satisfy paragraph (b)(4)(i)(A), (B), or (C) of this section) by judicial reformation, or nonjudicial reformation that is valid under applicable state law, will not cause the exempt trust to be subject to the provisions of chapter 13, if the modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation (as defined in Sec. 2651) than the person or persons who held the beneficial interest prior to the modification, and the modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust. (Emphasis added)
The PLR makes two holdings: (1) the modification must not replace the grandchildren with great grandchildren or other subsequent generations, and (2) extend any beneficial interest beyond the rule against perpetuities (RAP) provided for in the original trust.
Some practitioners believe that modifying the trust so that it extends within the applicable RAP will keep the GST tax exemption safe, even if the trust adds junior generations as beneficiaries. But the PLR requires that, both: (1) avoiding junior generation addition and not extending the RAP must both be achieved for the modifications to avoid a loss of GST tax exemption.
You must inform the client that converting the trust will cause a loss of its GST tax exempt status, because it will add grandchildren and subsequent generations to occupy a beneficiary status, when not provided in the original trust.
1. The discussion is subject to space limitations and complete requirements under Treasury Regulations Section 26.2601-1(b)(4)(A), (B), (C) aren’t covered, and individual research is necessary.