In a recent private letter ruling,1 the Internal Revenue Service concluded that certain trust modifications didn’t result in the loss of grandfathered generation-skipping transfer (GST) exempt status or the assets of the trust being included in the taxpayer’s gross estate.
Inter Vivos Trust Created
The grantor created an irrevocable inter vivos trust for the benefit of the taxpayer and the taxpayer’s issue (the trust) on Date 1, which was prior to Sept. 25, 1985, meaning the trust was grandfathered2 and exempt from the GST tax under Internal Revenue Code Section 2601.
The original trustees of the trust were A and B (no relation to the taxpayer) and C (who’s the taxpayer’s mother). If any trustee fails or ceases to act, the grantor, or, if the grantor is then dead, D, has the power to appoint a successor. If neither the grantor nor D is then living, the Bank shall become successor trustee. On Date 2, A resigned as trustee, and the grantor appointed the taxpayer as trustee, to serve with B and C. On Date 3, the Bank declined to act as successor trustee. On Date 4, B resigned as trustee, leaving the Taxpayer and C as the remaining trustees.
Pursuant to the trust, discretionary distributions may be made to the taxpayer and the taxpayer’s issue during the taxpayer’s lifetime. On the taxpayer’s death, the taxpayer has a limited power of appointment (POA). In default of such exercise, the property shall be distributed to the taxpayer’s issue, or, if none are then living, to the taxpayer’s heirs-at-law. Further, only a trustee who isn’t also a beneficiary of the trust may make discretionary distributions to or for the benefit of a beneficiary who’s a trustee of the trust. If no such trustee is then acting, such distributions are prohibited.
As long as both the taxpayer and C are trustees, no additional trustee (or successor trustee) may be appointed. Only a corporate trustee may appoint a co-trustee (and then only if no individual is then serving), and only a sole individual trustee may appoint a successor trustee. If a beneficiary of the trust was the sole trustee, he wouldn’t be able to make any distributions to himself.
Petition to Modify Succession and Distribution Provisions
On Date 5, the taxpayer filed a petition in state court to modify the trustee succession provisions and the distributions provisions of the trust (the trustee modifications and the distribution modifications, respectively).
The proposed trustee modifications provide, in pertinent part, that: (1) each co-trustee may appoint a successor and revoke such appointment, with or without cause, at any time before such appointment becomes effective, (2) each trustee may appoint a co-trustee and remove that co-trustee, with or without cause, without appointing a successor trustee, (3) the taxpayer has the power to remove any trustee, provided that they appoint an independent trustee,3 and (4) the taxpayer may transfer the remove and replace power to any of the grantor’s issue.
The proposed distribution modifications provide, in pertinent part, that: (1) a beneficiary acting as sole trustee may make income and principal distributions for their health, education, maintenance and support (HEMS), and (2) a trustee appointed by the beneficiary may only make distributions for that beneficiary’s HEMS, unless the trustee is an independent trustee.
Court Approves Proposed Modifications
The court approved the proposed modifications, contingent on the Internal Revenue Service issuing the following favorable rulings:
- Neither the trustee modifications nor the distribution modifications shift the beneficial interest in the trust to a beneficiary occupying a lower generation (as that term is defined in IRC Section 2651) than the person holding the interest under the original trust, and neither will extend the time for vesting beyond the perpetuities period of the original trust, so the trust will retain its GST tax exempt status.
- The powers given to the taxpayer won’t result in the trust assets being included in the taxpayer’s gross estate.
Trust Modification Safe Harbor Satisfied
The IRS found that the proposed modifications satisfied the two-prong “trust modification safe harbor” of Treasury Regulations Section 26.2601-1(b)(4)(i)(D), which provides that a modification won’t taint GST tax-exempt status if it: (1) doesn’t shift a beneficial interest in the trust to a beneficiary occupying a lower generation than the person holding the interest under the original trust, and (2) doesn’t extend the period for vesting of any beneficial interest in the trust beyond that provided in the original trust. The proposed trustee modifications and distributions modifications won’t shift any beneficial interest to a beneficiary occupying a lower generation and won’t extend the time for vesting of any beneficial interest.
The IRS further ruled that the powers reserved to the taxpayer under the proposed modifications (specifically, the power to make distributions to himself and the power to remove and replace trustees) don’t constitute a general POA that would trigger gross estate inclusion. The IRC defines a “general power of appointment” as a power exercisable in favor of the decedent, his estate, his creditors or the creditors of his estate, however, a power to invade property for the benefit of a decedent that’s limited by an ascertainable standard (HEMS, for example) isn’t considered a general POA.4 The IRC provides that the power of a donee to remove or discharge a trustee and appoint himself may be a POA.5 If the donee may only appoint trustees that aren’t “related or subordinate” to him (as those terms are used in IRC Section 672), the power won’t be considered a general POA.6 Because the taxpayer could only make distributions to himself pursuant to an ascertainable standard and any trustee appointed by taxpayer couldn’t be “related or subordinate,” the IRS found that the proposed modifications didn’t constitute a general POA.
While a PLR may not be cited as precedent,7 this recent PLR provides practitioners with some useful insight into the practical ways in which a “broken trust” may be modified to correct faulty fiduciary provisions and achieve a grantor’s objectives without jeopardizing a trust’s grandfathered status.
Endnotes
1. Private Letter Ruling 201634016 (Aug. 19, 2016).
2. On Oct. 22, 1986, the Department of Treasury began imposing the modern version of the generation-skipping transfer (GST) tax. Generally, a GST tax is imposed on transfers to grandchildren and other more remote descendants (that is, to an individual who’s two or more generations below the transferor) without an intervening imposition of the estate or gift tax. A special rule was implemented along with the GST tax, later explained in detail as Treasury Regulations Section 26.2601-1(b), which provided that if a trust became irrevocable on or before Sept. 25, 1985, such trust generally wouldn’t be subject to the GST tax. Such trusts are commonly referred to as “GST grandfathered trusts.” The taxpayer has represented that no additions, actual or constructive, have been made to the trust after Sept. 25, 1985.
3. “Independent trustee” was defined in the proposed modifications as a trustee who wasn’t the grantor, a descendant of the grantor, any beneficiary or possible distributee of the trust, any spouse or parent of such person or any related or subordinate party of such person, as those terms are used in Internal Revenue Code Section 672(c).
4. IRC Section 2041(b)(1)(A); IRC Section 2514(c)(1).
5. Treas. Regs. Section 20.2041-1(b)(1); Treas. Regs. Section 25.2514-1(b)(1).
6. Revenue Ruling 95-58.
7. IRC Section 6110(k)(3).
Catrina A. Crowe is an associate in the Private Client Services Department of Proskauer Rose LLP in the Boca Raton office.