IRS has privately ruled that no adverse income or transfer tax consequences will result from the reformation of a grandfathered generation-skipping transfer (GST) tax trust.
Facts. Grantor created Trust before Sept. 26, '85. Son and Bank are co-trustees (Trustees). They permissibly divided Trust into two trusts, Trust 1 for the benefit of Son, Spouse and their issue, and Trust 2 for the benefit of Daughter and her issue. The ruling request involves Trust 1.
Under Trust's terms, during Son's life, all income from Trust 1 is to be distributed to Son. In the event Spouse survives Son, the income will be divided and distributed between Spouse and each of the children of Son and Spouse. After the death of Son, Spouse and Daughter, the income is to be distributed to Grantor's grandchildren and to the issue of a deceased grandchild.
Son has sole investment authority over Trust assets, provided that Son is serving as one of the trustees of Trust. Trust provides, generally, that Bank will rely on Son's investment advice and follow Son's instructions. In the event of Son's resignation, death or inability to serve as a trustee, Bank will serve as sole trustee.
Trust defines “income” as all of the income of the trust estate, less costs of administration and all proper charges against the estate.
Subject to exceptions, State Statute 1 allows a trustee to adjust between principal and income to the extent the trustee considers necessary if the trustee invests and manages the trust assets as a prudent investor, and the terms of the trust describe the amount to be distributed to a beneficiary by referring to the trust's income.
Under State Statute 2, in exercising the power to adjust under Statute 1, a fiduciary generally must administer a trust or estate impartially, based on what is fair and reasonable to all the beneficiaries.
State Statute 3 provides statutory provisions for the resolution of disputes and other matters involving trusts and estates.
State Statute 4 provides that if all parties agree to a resolution of any dispute under State Statute 3, then the agreement must be a written agreement signed by all parties. The written agreement is binding and conclusive on all persons interested in the trust.
Trustees and the beneficiaries of Trust 1 entered into a nonjudicial dispute resolution agreement (Agreement) pursuant to State Statute 3. It is intended to become effective upon issuance of a favorable private letter ruling from IRS. Under the Agreement, the Trustees and the beneficiaries have agreed to amend and modify Trust 1 in numerous ways including the following:
... To address the adjustment of receipts between principal and income; and
... To provide that Bank may exercise its discretion to adjust receipts between income and principal.
Trustees sought and IRS issued six favorable rulings, as follows.
No gain or loss. Under Reg. §1.643(b)-1, an allocation of amounts between income and principal pursuant to applicable local law will be respected if local law provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust for the year, including ordinary and tax-exempt income, capital gains, and appreciation. For example, a state statute that permits the trustee to make adjustments between income and principal to fulfill the trustee's duty of impartiality between the income and remainder beneficiaries is generally a reasonable apportionment of the total return of the trust. A switch between methods of determining trust income authorized by state statute will not constitute a recognition event for purposes of Code Sec. 1001. Accordingly, IRS ruled that the reformation of Trust 1 and Bank's power to adjust between principal and income won't constitute a sale, exchange, or other disposition of Trust 1's assets and won't result in the recognition of any gain or loss by Trust 1 or the beneficiaries.
Income items. IRS further ruled that Bank's adjustment between principal and income and any resulting distributions of capital gain to Son will be treated as income under Reg. §1.643(b)-1.
No one treated as owner of trust. Under Code Sec. 678(a), a person other than the grantor is treated as the owner of any portion of a trust with respect to which (1) he has a power exercisable solely by himself to vest the corpus or the income therefrom in himself, or (2) he has previously partially released or otherwise modified such a power and after the release or modification retains such control as would, within the principles of Code Sec. 671 to Code Sec. 677, subject a grantor of a trust to treatment as its owner.
IRS said the ability of Bank to make adjustments between income and principal to fulfill its duty of impartiality does not cause it to have a power exercisable solely by itself to vest the corpus or the income therefrom in itself under Code Sec. 678(a)(1). IRS also said that the execution of Agreement constitutes a switch between methods of determining trust income authorized by State Statute 1 and does not cause any of the beneficiaries to hold a power exercisable solely by any beneficiary to vest the corpus or the income therefrom in himself under Code Sec. 678(a)(1). In addition, IRS said the switch won't constitute a release or modification of a power described in Code Sec. 678(a)(12 by either Bank or the beneficiaries. Thus, IRS ruled that Bank's possession and exercise of the power to adjust between principal and income won't cause any of the beneficiaries of Trust 1 or Bank to be treated as the owner of any part of the Trust 1's assets under Code Sec. 678.
GST tax background and ruling. The GST tax generally applies to generation-skipping transfers made after Oct. 22, '86. (Tax Reform Act of '86 (TRA '86) §1431(a)) However, it doesn't apply to any generation-skipping transfer from a trust that was irrevocable on Sept. 25, '85. The exception doesn't apply to a transfer made out of corpus added to the trust after Sept. 25, '85. (TRA '86 §1433(b)(2)(A)) Under Reg. §26.2601-1(b)(4)(i)(D)(1), a modification of the governing instrument by judicial reformation, or nonjudicial reformation that is valid under applicable state law, will not cause an exempt trust to be subject to the GST tax, if the modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation 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. As shown in Reg. §26.2601-1(b)(4)(i)(E), Example 12, under Reg. §26.2601-1(b)(4)(i)(D)(2), the administration of a pre-Sept. 25, '85 trust in conformance with a state law that defines income as a unitrust amount, or permits equitable adjustments between income and principal to ensure impartiality, and that meets the requirements of Reg. §1.643(b)-1(a), is not a modification that shifts a beneficial interest to a lower generation beneficiary, or increases the amount of a generation-skipping transfer.
IRS observed that the beneficiaries have entered into Agreement with Son and Bank, as trustees, to reform Trust 1 to clarify and amend Trustees' investment responsibilities and to allow Bank to make adjustments between principal and income pursuant to State Statute 1 and State Statute 2, statutes similar to those described in Reg. §26.2601-1(b)(4)(i)(D)(2)) and Reg. §26.2601-1(b)(4)(i)(E), Example 12. Therefore, IRS ruled that the reformation of Trust 1 and Bank's power to adjust between principal and income won't cause Trust 1 to lose its grandfathered status.
No gifts. Reg. §26.2601-1(b)(4)(i)(E), Example 12 concludes that where a trustee administers a trust in accordance with a state statute that permits the trustee to make adjustments between income and principal, no trust beneficiary will be treated as having made a gift for federal gift tax purposes. Consequently, IRS ruled that the reformation of Trust 1 pursuant to Agreement, and the power of Bank to adjust between principal and income pursuant to State Statute 1, will not cause any beneficiary to have made a transfer of property for gift tax purposes.
No inclusion in estate. Under Code Sec. 2041(a)(2), the gross estate includes property over which the decedent possessed at the time of death a general power of appointment created after Oct. 21, '42. The reformation of Trust 1 and Bank's power to adjust between principal and income won't cause any part of Trust 1's assets to be included in a beneficiary's estate under Code Sec. 2041.
IRS observed that Bank is the only trustee with the power to make adjustments between income and principal under Agreement and State Statute 1. No beneficiary of Trust 1 has any power over Trust 1's assets other than the power of management and investment of assets. Accordingly, IRS ruled that the reformation of Trust 1 and Bank's powers to adjust between principal and income pursuant to Agreement and State Statute 1 will not cause any portion of Trust 1's assets to be included in a beneficiary's gross estate under Code Sec. 2041.
References: For trust accounting income, see FTC 2d/FIN ¶C-1001A; United States Tax Reporter ¶6434.02. For the GST trust grandfather rule, see Federal Tax Coordinator 2d ¶R-9531; United States Tax Reporter Estate & Gift ¶26,014.01.