In Private Letter Ruling 201507008 (released Feb. 13, 2015), the Internal Revenue Service addressed whether: 1) a trustor’s contribution to an irrevocable trust was a completed gift subject to federal gift tax; 2) a distribution of income to a beneficiary was a completed gift; and 3) the fair market value (FMV) of the trust property was includible in the trustor’s gross estate. The IRS concluded that a trustor’s contribution wasn’t a completed gift subject to federal gift tax. The IRS did determine, however, that a distribution of income or principal by a distribution adviser to a beneficiary (other than the trustor) was a completed gift and, on the trustor’s death, the FMV of the property in the trust would be includible in the trustor’s gross estate for federal estate tax purposes.
Trust Distribution Terms
The trustor created an irrevocable trust for her benefit and her issue’s benefit. She designated a distribution adviser who had the sole discretion to direct an independent trustee to distribute income and principal to the trustor. The distribution adviser also had the sole discretion to direct the trustee to distribute income and principal to any living issue of the trustor, but only with the trustor’s written consent. If there weren’t any issue alive during the trustor’s lifetime, then the issue of the trustor’s father could be substituted to get distributions. Net income not distributed by the trustee would be added to the trust principal.
The trustor retained a consent power: With written consent of the trust protector, she could appoint during life (that is, a lifetime limited power of appointment (POA)) or in her will (that is, a testamentary limited POA), any part of accumulated net income and principal to a certain foundation and to any issue of her father. The trustor couldn’t appoint this accumulated net income and principal to herself, her creditors, her estate and the creditors of her estate.
Division of Shares Into Family Trusts
On the trustor’s death, the accumulated and unappointed net income and principal would be divided into equal shares for the trustor’s living children. If any of the trustor’s children were deceased, the property would go to the issue of such deceased children. Each share would be distributed to a separate family trust for the benefit of each living child and the issue of each deceased child. If the trustor didn’t have any living issue, an “alternative mechanism” would kick in: The shares would be equally divided and distributed to a separate family trust for the benefit of the living children of the trustor’s father and the issue of each deceased child of the trustor’s father. If there weren’t any issue of the trustor’s father alive on the trustor’s death, the accumulated and unappointed net income and principal would be distributed to a foundation.
Each family trust would terminate on the earlier of: 1) the expiration of the rule against perpetuities (RAP), or 2) the death of the last to die of the beneficiaries of the family trust. If any family trust ended because the RAP had expired, the accumulated net income and principal would be distributed, in equal shares, per stirpes, to the living beneficiaries of the family trust. If a family trust ended because of the second occurrence, the accumulated net income and principal would be distributed, in equal shares, to the other family trusts, to the alternative mechanism, or to the foundation, in that order.
The trustor may borrow part of the accumulated net income and trust principal (the borrowing power). The trustee would determine the interest rate, which couldn’t be less than a reasonable market rate of interest at the time the loan was made. The trustor could release the borrowing power, and the trustee could make loans to any person.
The Distribution Adviser/Trustee/Trust Protector
The distribution adviser, the independent trustee (which was a trust company), the trust protector and their successors weren’t related or subordinate to the trustor, as defined by Internal Revenue Code Section 672(c). All of them had no interest in the trust estate; couldn’t benefit by the exercise or nonexercise of any power, authority or discretion given to them by the trust or by law; and possessed such power, authority or discretion without causing income, accumulated income or principal to be attributable to any beneficiary (excluding the trustor) for income, gift tax or estate tax purposes.
Who Owns the Trust Property?
To determine if the trustor was the owner of the trust property, the IRS looked to IRC Sections 673 through 678, which describe the instances in which a grantor or another person is treated as the owner of a portion of a trust. Specifically IRC Section 674(a) provides that a grantor is treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income is subject to a power of disposition, exercisable by the grantor or a nonadverse party, without the approval or consent of any adverse party. “Adverse party” is defined as a person with a substantial beneficial interest in a trust who would be adversely affected by the exercise or nonexercise of a power that he possesses respecting the trust, including a general POA (IRC Section 672(a)). A “nonadverse party” is any person who isn’t an adverse party (Section 672(b)). Section 675(2) provides that a grantor will be treated as the owner of any portion of a trust in respect of which a power exercisable by the grantor or a nonadverse party enables the grantor to borrow the corpus or income, directly or indirectly, without adequate interest or without adequate security except where a trustee (other than the grantor) is authorized under a general lending power. And, Section 677 provides, in part, that the grantor is the owner of any portion of a trust if the income, without the approval or consent of an adverse party is, or, in the discretion of the grantor or a nonadverse party, may be (1) distributed to the grantor or the grantor’s spouse; or (2) held or accumulated for future distribution to the grantor or the grantor’s spouse. Thus, under Sections 671, 674(a), 675(2) and 677, the IRS concluded that the trustor was the owner of the trust.
The IRS next addressed whether the trustor’s contribution to the trust was a completed gift that would be subject to federal gift tax. Treasury Regulations Section 25.2511-2 distinguishes between complete gifts, in which a donor parts with dominion and control so as to leave him powerless to change its disposition, and incomplete gifts, in which a donor reserves a power to revest beneficial title in herself. The IRS also considered Estate of Sanford v. Commissioner, 308 U.S. 39 (1939), in which the U.S. Supreme Court determined that a grantor’s gift was complete when he relinquished his right to change the beneficial interests in a trust. In this instance, the trustor retained a consent power over the trust income and principal. And, under Treas. Regs. Section 25.2511-2(e), a donor is still considered to have a power if it’s exercisable by her in conjunction with any person not having a substantial adverse interest in the disposition of the trust property. In this case, the distribution adviser had no substantial adverse interest in the disposition of trust property because he was merely a coholder of the trustor’s consent power. As such, the trustor’s retention of the consent power caused the transfer of property to the trust to be wholly incomplete for federal gift tax purposes.
Moreover, the trustor also retained a lifetime limited POA to appoint income and principal to the issue of her father or to a foundation. The trustor could only exercise the lifetime limited POA in conjunction with the trust protector. The trust protector, however, was merely a coholder of the POA and as such, had no substantial adverse interest in disposing the assets transferred by the trustor to the trust. The reserved POA gave the trustor the power to change the interests of the beneficiaries, and under Treas. Regs. Section 25.2511-2(c), this reserved power causes a gift to be incomplete. The retention of the lifetime limited POA therefore caused the transfer of property to the trust to be wholly incomplete for federal gift tax purposes.
Finally, the trustor’s testamentary limited POA to appoint trust property to her father’s issue or to a foundation is also considered a retention of dominion and control over the remainder (Treas. Regs. Section 25.2511-2(b)). The retention of this power causes the transfer to be similarly incomplete regarding the trust remainder for federal gift tax purposes.
The trustor retained dominion and control over the income and principal until the distribution adviser or trustee exercised its distribution power. As such, the trustor’s power over the income and principal was presently exercisable and not subject to a condition precedent. Therefore, even if either of the actions of third parties (that is, the distribution adviser or the trustee) could defeat the trustor’s ability to change beneficial interests, her transfer of assets to the trust was wholly incomplete for gift tax purposes.
The IRS determined that the trustor’s contribution of property to the trust wasn’t a completed gift subject to federal gift tax, and any distribution from the trust to the trustor was “merely a return of trustor’s property.” However, the IRS did find that any distribution of income or principal by the distribution adviser from the trust to any beneficiary, other than the trustor, was a completed gift by the trustor at the time of the distribution. Likewise, the trustor’s exercise of her lifetime limited POA in favor of any individual other than herself was a completed gift of appointed property. And, on the trustor’s death, the FMV of the property in the trust would be includible in her gross estate for federal estate tax purposes.