When Beneficiaries Want to Modify Trustees’ Duties

When Beneficiaries Want to Modify Trustees’ Duties

What are the GST, gift and income tax consequences of such an action?

Between 1985 and 2000, a settlor created an irrevocable trust for the benefit of his two children and for any other child born or adopted after the trust’s creation.  At some point after the trust’s creation, a third child was born and became the third beneficiary. 

 

The Trust’s Original Terms

Under the terms of the trust, each beneficiary was to have equal shares of the trust estate.  Net income from each share was to be paid at least annually to each beneficiary during his lifetime.  The trustees had the discretion to apply the trust corpus of each share to provide for the maintenance, education and support of each beneficiary.  Each beneficiary had a testamentary limited power of appointment to increase or decrease the share provided to his issue; to alter the terms of distribution of assets to such issue; and to redirect the disposition of remaining trust assets at the trust’s termination among his issue and his issues’ spouses. 

The trust provided that on the death of a beneficiary, his trust share would terminate, and any remaining trust estate would be delivered to such decedent beneficiary’s then-living issue by right of representation.  If there weren’t any such living issue, then that share would go to the grantor’s then-living beneficiary children and the then-living issue of any deceased child by right of representation. 

 

The Trust Modification Agreement

The three beneficiaries, individually and on behalf of their minor children, entered into an agreement to modify the duties and authorities of the trustees regarding the requirement for current annual distributions of net income.  The modification provided that the trustees would have no duty to distribute net income annually, and instead, would have the discretion to apply net income in the same manner as provided for the distribution of the trust corpus.  Any net income not distributed would be retained and set aside as accumulated net income and that income, along with any earnings, if not paid to any beneficiary while alive, would be paid to the estate of the deceased child beneficiary.

The Internal Revenue Service ruled on three issues:

 

1.     Does the modification of the income distribution provision adversely affect the trust’s generation-skipping transfer (GST) tax exemption?

2.     Does the modification of the income distribution provision cause any trust beneficiary to have made a gift that’s subject to gift tax under Internal Revenue Code Section 2501?

3.     Does the modification of the income distribution provision cause the trust or any trust beneficiary to recognize gain or loss from the sale or disposition of property under IRC Section 61 or IRC Section 1001?

In Private Letter Ruling 201320004 (May 17, 2013), the IRS answered all three questions in the negative. 

 

GST Tax

The IRS noted that the settlor allocated sufficient GST exemption to the trust transfers to cause the trust to have an inclusion ration of zero, and there were no distributions of trust corpus since the date of the trust’s creation.  Moreover, since the date of the trust’s creation, any net income from each beneficiary’s share that was required to be distributed was, in fact, distributed to each beneficiary.

IRC Section 2601 imposes a tax on every GST.  IRC Section 2642(a)(1)(A) provides that an inclusion ratio for any property transferred in a GST is the excess of “1” over the applicable fraction determined for the trust from which such transfer is made.  At the time relevant to the trust creation, IRC Section 2631 allowed a GST tax exemption of $1 million, which could be allocated by an individual to any property with respect to which such individual was the transferor.  In this case, the parties represented that the settlor allocated sufficient GST tax exemption to all transfers in the trust to cause it to have an inclusion ration of zero.  

Treasury Regulations Section 26.2601-1(b)(4)(i)(D)(1) provides that a modification won’t cause a trust to lose its tax-exempt status if the modification doesn’t shift a beneficial interest in the trust to any beneficiary who occupies a lower generation than the person who held the beneficial interest prior to the modification, and the modification doesn’t extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust. 

In this instance, the accumulated income would be included in the beneficiary’s gross estate for estate tax purposes, and the beneficiary would be treated as the transferor of the accumulated income for GST tax purposes.  The modification, however, didn’t shift a beneficial interest in the trust to any beneficiary who occupied a lower generation than the individual who held the beneficial interest prior to the modification. The IRS thus concluded that the modification wouldn’t cause the trust, as modified, to lose its GST tax-exempt status as a result of allocating the settlor’s GST tax exemption to the trust.

 

Gift Tax

IRC Section 2510 imposes a tax on a transfer of property deemed to be a gift.  The gift tax applies whether a gift is indirect or direct; whether the transfer is in trust or not; and whether the property is real, personal, tangible or intangible. 

The modification gave the trustees discretion to distribute income to the beneficiaries or to accumulate such income.  The accumulated income would be included in each beneficiary’s estate on his death.  Thus, at the time of the modification, no income interest was gratuitously transferred from one beneficiary to any other beneficiary.  The IRS therefore concluded that the modification wouldn’t cause any beneficiary to have made a gift subject to gift tax under Section 2501.

 

Income Tax

IRC Section 61(a)(3) includes in gross income any gain derived from dealings in property.  IRC Section 1001(c) provides that the entire amount of gain or loss must be recognized.

In this case, the modification didn’t confer any new rights to the beneficiaries or result in any relative shifting of interests among the beneficiaries.  Thus, the modification wouldn’t result in the realization of gain or loss to either the trust or any beneficiary. 

 

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