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Tax Law Update: July 2019

David A. Handler and Alison E. Lothes highlight the most important tax law developments of the past month.

• Two private letter rulings regarding generation-skipping transfer (GST) tax elections—In PLR 201921004 (Dec. 11, 2018), a taxpayer established multiple trusts, one for each of his grandchildren. Under each trust, distributions could be made to the grandchild beneficiary as the trustees determined. When the grandchild reached age 30, the trust was to terminate. If the grandchild died before age 30, the trust property was payable to his issue, otherwise divided among all of the taxpayer’s grandchildren then living.

On the Forms 709 filed by the taxpayer, he and his spouse elected to split gifts. The gifts to the trusts were incorrectly reported as indirect skips, the taxpayer elected out of the automatic allocation rules of GST tax exemption under Section 2632(c) and no GST tax was paid.

The taxpayer’s spouse died, and presumably in the process of preparing her estate tax return, the error of reporting the gifts to the trusts as indirect skips was discovered. The taxpayer requested a ruling regarding the GST status of the trusts and the allocation of GST tax exemption. The Internal Revenue Service confirmed that the transfers to the trusts were direct skips because all beneficiaries of the trusts were at least two generations below the transferor (that is, skip persons). The taxpayer’s attempt to elect out of automatic allocation to indirect skips had no effect because the transfers were direct skips. Therefore, the taxpayer’s GST tax exemption was automatically allocated to the transfers to the trusts. (The PLR doesn’t note it, but if the gifts were split, the spouse’s GST tax exemption would have been automatically allocated as well, to one-half of the gifts.)

Similarly, in PLR 201920001 (May 17, 2019), a taxpayer created trusts for each of his children’s children. Each trust immediately split into a separate trust for each respective grandchild. Distributions could be made to the grandchild for his/her health, education, welfare and support. On the beneficiary’s death, the beneficiary could appoint the remaining trust property by direction in his/her will (without restriction). If the grandchild didn’t exercise this power, the trust property would be distributed to the grandchild’s issue, otherwise to the issue of the taxpayer’s children. Each grandchild was also given a withdrawal right (without restriction) over additions to his/her respective trust, exercisable within 14 days of the addition. If the withdrawal right wasn’t exercised, it would lapse.

The taxpayer and his spouse made gifts to the trusts during their lives, reported the gifts and made the election to split the gifts. After the taxpayer’s death, the spouse continued to make gifts to the trusts. The trustees later realized that the drafting errors resulted in: (1) each beneficiary having a testamentary general power of appointment (GPA), and (2) withdrawal rights over the full amount of the gifts and not just the annual exclusion amount. This caused the property to be includible in the beneficiaries’ estates, which wasn’t the taxpayer’s intention, as he intended the trusts to be GST tax exempt. (The portion of the withdrawal right that exceeded the greater of $5,000 or 5% of the trust was treated as a gift by the grandchildren when it lapsed, causing inclusion under Internal Revenue Code Section 2036, and the GPA caused inclusion under IRC Section 2041.)

The trustees filed a petition to reform the trusts, and the probate court, pursuant to state law, issued an order that limited each beneficiary’s GPA to exclude the beneficiary, his creditors, his estate and the creditors of his estate and restricted each beneficiary’s withdrawal rights to the amount that wouldn’t be considered a GPA under IRC Section 2514 (the “5 and 5” amount). The order was contingent on receiving a favorable ruling from the IRS.

The IRS confirmed that the reformation of the trusts would be respected (retroactively) because it was made pursuant to state law, and the trust instruments, affidavits and other evidence indicated that the reformation conformed to the grantor’s intent and was necessary to achieve his objectives. As a result, the trusts’ property wouldn’t be includible in any beneficiary’s estate nor would the reformation cause any beneficiary to be treated as making a gift of the trust property. Lastly, as direct skips, the transfers to the trusts automatically used the taxpayer’s and his spouse’s GST tax exemptions (one-half each while they split gifts and the spouse’s GST tax exemption in years after the taxpayer’s death).

These rulings show the complexities of drafting GST trusts and the need to be careful and accurate in preparing the gift tax returns properly.

• PLR regarding trustee powers and incidents of ownership—In PLR 201919002 (May 10, 2019), the trustee of a trust petitioned a local court to modify the terms of the trust to restrict certain trustee powers over life insurance. The trustee’s parent (the settlor) had established the trust for the trustee’s benefit. He (the child beneficiary) was the sole trustee of the trust. The trust instrument provided the following:

• The trustee was granted the power to own and acquire life insurance on the life of any person in which the trust or its beneficiaries had an insurable interest.

• The trustee had the power to pay premiums or other charges due on insurance policies, but premiums paid for insurance on the settlor’s life had to be paid out of corpus.

• The child beneficiary (who, again, was also the trustee) had a special testamentary power of appointment (POA) over the trust property, exercisable in favor of his descendants.

• The settlor didn’t intend that the trustee have any power over trust property that would result in inclusion of trust assets in his taxable estate.

• A special co-trustee was to be appointed if the trustee would possess any incidents of ownership over any life insurance policy on the life of the trustee. 

The trustee proposed to purchase a survivorship policy on his and his spouse’s lives. However, given his powers as trustee over the policy and the special POA granted to him as a beneficiary, the trustee was concerned that the policy proceeds would be taxable in his estate. IRC Section 2042 includes insurance proceeds in the taxable estate if the decedent has any “incidents of ownership” in the policy. Under the Treasury regulations, incidents of ownership are the rights that the insured generally has in the economic benefits of the policy, which include the right to change the beneficial interests in the policy, surrender or cancel the policy, assign the policy, pledge the policy or obtain a loan against the surrender value.

The beneficiary trustee petitioned the local probate court to modify the trust to: (1) restrict the POA so that it wasn’t applicable to life insurance or its proceeds, and (2) add an “Insurance Trustee” who would have sole authority over the insurance policies and require that the premium payments for insurance on a beneficiary or a trustee be made out of corpus. The court approved the modifications.

The IRS confirmed that, due to the modifications made by the court order, as long as the insured beneficiary wasn’t serving as the Insurance Trustee, because the problematic powers would be eliminated prior to the acquisition of the survivorship policy, the beneficiary trustee wouldn’t possess any incidents of ownership over any life insurance policy obtained by the trust on his life and that the proceeds of such policy wouldn’t be includible and potentially taxable in his estate under IRC Section 2042.

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