PLR 200012011: S election steps preserve a grandchild's trust GST exemption

Plain-English summary

Two grandparents established irrevocable trusts holding corporate stock. After an initial period of charitable distributions, the trusts' property was allocated among twelve separate shares for grandchildren and their descendants. One grandchild's trust held stock in a corporation planning an S election. Its trustee proposed to consent to the election, elect treatment as an electing small business trust, and sign a shareholder agreement. Based on the representation that the trust was irrevocable by September 25, 1985 and had received no later additions, the IRS ruled that these steps would not change the beneficiaries' interests or end the generation-skipping transfer tax exemption. Distributions to skip persons would remain exempt if no later additions occurred. The IRS did not decide whether the trust qualified as an electing small business trust.

Ruling snapshot

• Question: Would the proposed S election steps end the grandchild's trust GST exemption?
• Outcome: Approved for GST purposes, subject to no post-September 25, 1985 additions.
• Key authorities: IRC §§ 2601 and 1361(e); Treas. Reg. § 26.2601-1(b)(1).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury Number: 200012011 Release Date: 3/24/2000 P.O. Box 7604
Index No.: 2601.00-00
Ben Franklin Station
Washington, DC 20044

Person to Contact:

Telephone Number:

Refer Reply To:
CC:DOM:P&SI:4/PLR-105134-99

November 15, 1999

Re:

Legend:
Trust 1 =

Trust 2 =
Trust A =
Beneficiary =
Trustee =
Grandparent 1 =
Grandparent 2 =
Date 1 =
Date 2 =
x
=
y
=
Corporation =
Charity A =
Charity B =
Charity C =

Dear
:
This is in response to your letter dated February 26, 1999, in which you requested a ruling regarding the application of the generation-skipping transfer (GST) tax provisions of Chapter 13 of the Internal Revenue Code. Specifically, you requested a ruling that the exempt status of Trust A for GST tax purposes would not be affected by the following: (i) the Trustee’s consent to Corporation’s S election on behalf of Trust A; (ii) the Trustee’s execution of an "electing small business trust" election on behalf of Trust A; and (iii) the Trustee’s execution of the shareholder agreement on behalf of Trust A.

According to your submission, on Date 1, Grandparent 1 transferred x shares of Corporation common stock to Trust 1, an irrevocable trust. On the same date, Grandparent 2 transferred y shares of Corporation common stock to Trust 2, an irrevocable trust. Pursuant to the terms of both trust agreements, from Date
PLR-105134-99
-2-
1 until Date 2, the net income from these trusts was distributed annually in equal amounts to Charity A and Charity B.

On Date 2, pursuant to the terms of Article 2(e) of Trust 1, the Trustee divided Trust 1 into equal shares, one share for each grandchild of Grandparent 1 then living and one share for each deceased grandchild leaving one or more descendants then living. Twelve such shares were created and held as separate trusts in the names of the living and deceased grandchildren of Grandparent

1. Trust A was established under the terms of Article 2(e) for
   the benefit of Beneficiary and her issue.

   Also on Date 2, pursuant to the terms of Trust 2, the trust
   estate of Trust 2 was transferred to the then acting trustee of Trust 1, added equally to the shares created under that agreement, and held, administered, and disposed of in accordance with the provisions of Trust 1 governing such shares.

   Article 2(g) of Trust 1 provides that after Date 2, and
   during the lifetime of each living grandchild, the Trustee shall pay to or expend for the benefit of such grandchild so much or all of the net income and principal of the share designated by the grandchild’s name as the Trustee in its discretion deems to be for the grandchild’s best interests and welfare. Subject to this provision in favor of each living grandchild, so much or all of the net income and principal of the share designated by the name of the grandchild shall be paid to or expended for the benefit of the descendants of the grandchild as shall be living from time to time, at such times, in such equal or unequal proportions among them, and in such manner as the Trustee in its discretion deems to be for the best interests and welfare of such descendants, individually and as a group.

   Article 2(h) states that upon the death of a grandchild
   after division of the trust estate into shares, or upon division of the trust estate into shares if a grandchild is then deceased, the share designated by the name of such grandchild is to be held in trust, or distributed to or in trust, for the benefit of any one or more of such grandchild’s spouse and descendants, and the spouses of such descendants, in such amount and in such manner and upon such terms and conditions as such grandchild shall appoint by his or her last will, specifically referring to the power of appointment conferred upon him or her. In default of the exercise of the power of appointment by such grandchild and upon the death of such grandchild or upon division of the trust estate into shares, as the case may be, the grandchild’s share of the trust estate, or the part not effectively appointed, shall be distributed per stirpes to his or her then living descendants, if any. If there are no living descendants, the trust estate, or the part not effectively appointed, shall be distributed equally to such of Grandparent 1's other grandchildren who are then
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   living, per capita. However, the then living descendants of any other deceased grandchild shall take per stirpes the share which the deceased grandchild would have received if living. Each portion otherwise distributable to a grandchild or descendant of a grandchild for whom a share of the trust estate is then being held is to be added to such share, and if at such time there is no other grandchild or descendant of a deceased grandchild then living, the corpus is to be distributed to Charity C.

   Article 2(l) of Trust 1 states that notwithstanding any
   provision in the trust agreement to the contrary, the trusts created under the instrument or pursuant to the exercise of any power of appointment under the instrument are to terminate not later than twenty-one years after the death of the last survivor of Grandparent 1’s descendants living on Date 1. If the trusts created have not sooner terminated, the Trustee is to pay over, transfer, and deliver the trust estate to the persons then entitled to receive the income therefrom, in the same shares or portions in which such income is then being paid to them.

   The primary asset of Trust A is stock in Corporation, a C
   corporation. The Corporation’s Board of Directors proposes to elect to treat Corporation as a small business corporation (an "S corporation"). Trustee proposes to consent to the S election. In order to convert Corporation to an S corporation, each of its shareholders must be eligible to hold S corporation stock as of the first day of the year for which the election is to take effect. Trustee proposes to make an election under § 1361(e)(3) to treat Trust A as an electing small business trust so that it can qualify as an eligible S corporation shareholder.

   In an effort to ensure the continuing qualification of
   Corporation as an S corporation, Trustee intends to enter into a shareholder agreement with Corporation and Corporation’s other shareholders to protect the S election.

   Under the Section 3(a) of the proposed shareholder
   agreement, no shareholder may transfer, and no person may acquire, the legal or beneficial ownership of any share if such transfer or acquisition would cause the S status of the Corporation to terminate. Specifically, no transfer may be made to any person that is not eligible to be a shareholder of an S corporation under the applicable provisions of the Code as in effect at the time of the purported transfer. In addition, no shareholder may affirmatively transfer shares to a person if the transfer would cause the Corporation to exceed the maximum number of persons who are allowable S corporation shareholders.

   Section 3(b) of the proposed shareholder agreement provides
   that no shareholder shall make any transfer of shares to any trust having multiple beneficiaries or amend any trust that owns
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   shares to increase the number of beneficiaries unless all such beneficiaries are persons eligible to be transferees pursuant to Section 3(a) and immediately after such transfer or amendment, the number of shareholders the Corporation is deemed to have for purposes of § 1361 would not exceed the maximum number of persons who are allowable S corporation shareholders pursuant to that section.

   Notwithstanding any other provision of the shareholder
   agreement, the shareholders and the Corporation acknowledge and agree in Section 3(c) that none of the following shall be prohibited by the terms of this shareholder agreement: (i) the addition of a trust beneficiary due to the birth of an additional descendant of Grandparent 1; (ii) the exercise of a power of appointment granted to a beneficiary pursuant to the terms of any irrevocable trust that is in existence on the date of the agreement and that owns shares; (iii) the transfer of shares to any person in whose favor a power of appointment described in (ii) above is exercised; or (iv) the distribution of shares to (A) a beneficiary of any irrevocable trust that is in existence on the date of the agreement and that owns shares, pursuant to the terms thereof or (B) to the beneficiary of any trust created pursuant to the exercise of a power of appointment described in (ii) above, even if such addition, exercise, or distribution shall cause the termination of the Corporation’s S election.

   Section 3(d) provides that prior to any transfer or other
   disposition of shares, if the Corporation in its discretion so requires, an opinion of counsel to the Corporation must first be received by the Corporation (the cost of which shall be borne by the shareholder whose shares are to be transferred or disposed of) that the transferee is (i) eligible to be a shareholder of an S corporation in accordance with the applicable requirements of the Code or (ii) that the transfer otherwise is allowable pursuant to the provisions of the shareholder agreement.

   In addition to the other requirements of Section 3 of the
   shareholder agreement, Section 3(g) provides that no transfer of shares (including, without limitation, transfers pursuant to Section 3(c)) shall be permitted, and no purported transfer shall be effective, until a permitted transferee has executed a Supplemental Signature Page to the shareholder agreement. All parties agree that upon execution and acceptance of a Supplemental Signature Page, the shareholder agreement shall be amended and the transferee shall have the rights and obligations of a shareholder under the agreement.

   Section 3(h) of the shareholder agreement provides that
   shareholders possessing 66 2/3% of the total voting power of all outstanding shares may at any time and from time to time agree in writing to authorize or ratify any transfer of shares which would
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   otherwise not be permitted by this agreement, in which event the transfer shall be deemed for all purposes to comply with this agreement notwithstanding any other provision of this agreement.

   Under Section 3(i), if a transfer of shares is required to
   be made pursuant to Section 3(c)(ii), (iii), or (iv) to a transferee who is not already a shareholder and who has not previously executed, or currently refuses to execute, a Supplemental Signature Page to the shareholder agreement (a non- consenting transferee), certain procedures will apply. The shareholders may allow the transfer of shares to the non- consenting transferee pursuant to the procedure set forth in Section 3(h). Otherwise, the shares that otherwise would be transferred to the non-consenting transferee shall instead be redeemed by the Corporation for a price equal to the fair market value of the shares as of the valuation date.

   Pursuant to Section 5 of the proposed shareholder agreement,
   any purported transfer in violation of the shareholder agreement shall not affect the beneficial or legal ownership of shares.

   Section 6 of the agreement states that subject to any
   limitations on dividends or other distributions imposed by statute, the Corporation shall make pro rata dividend distributions of money, based on ownership of shares, to pay the Federal, state, and local income tax on the income and gain of the Corporation (net of any tax benefits produced for the shareholders by the Corporation’s losses, deductions, and credits for the current year and for each prior year during which the Corporation’s S election was in effect) that passes through to the shareholders under the applicable provisions of the Code in respect of each taxable year (or portion thereof) of the Corporation for which its S election is in effect.
   Section 7 of the proposed shareholder agreement provides
   that the Corporation shall (a) not issue more than one class of shares, (b) use its best efforts to avoid a termination of its S election, and (c) in the event of a termination of the S election, use its best efforts to distribute to each shareholder such shareholder’s net share of the Corporation’s undistributed taxable income for all taxable years for which the S election was in effect, to the extent permitted by law and consistent with the obligations of the Corporation to creditors, agreements to which the Corporation is a party, and other business considerations, within the period when such a distribution will be considered a non-dividend distribution under § 1371(e)(1).

   Section 9 of the proposed shareholder agreement states that
   if the Corporation’s status as an S corporation is terminated inadvertently and the Corporation wishes to obtain a ruling under
   § 1362(f), each shareholder agrees to make any adjustments
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   required pursuant to § 1362(f)(4) and approved by the Corporation’s Board of Directors. A shareholder’s obligation to make such adjustments shall continue after the shareholder has ceased to own shares in the Corporation and after this agreement has terminated.

   Except as directed by the shareholder agreement, the
   existing Trustee will continue to serve in the same manner as it previously served. In addition, Trust A will continue to be administered in accordance with the terms and conditions set forth in Trust 1.

   Section 2601 imposes a tax on every generation-skipping
   transfer. Section 26.2601-1(a)(1) of the Generation-Skipping Transfer Tax Regulations provides that the GST tax applies to any generation-skipping transfer made after October 22, 1986. Section 26.2601-1(b)(1) provides an exception to this rule for any distributions from a trust that was irrevocable on September 25, 1985. However, this exception does not apply to a pro rata portion of any generation-skipping transfer under an irrevocable trust where additions were made to the trust after September 25, 1985.

   In addition, a modification to a trust that results in a
   change in the quality, value, or timing of any beneficial interest provided for under the trust instrument will cause the trust to lose its exempt status.
   Section 26.2601-1(b)(1)(v)(A) provides that, except as
   provided under § 26.2601-1(b)(1)(v)(B), where any portion of a trust remains in the trust after the post-September 25, 1985, release, exercise, or lapse of a power of appointment over that portion of the trust, and the release, exercise, or lapse is treated to any extent as a taxable transfer under chapter 11 or chapter 12, the value of the entire portion of the trust subject to the power that was released, exercised, or lapsed is treated as if that portion had been withdrawn and immediately retransferred to the trust at the time of the release, exercise, or lapse.

   Section 26.2601-1(b)(1)(v)(B) provides a special rule for
   certain powers of appointment. This section provides that the release, exercise, or lapse of a power of appointment (other than a general power of appointment as defined in § 2041(b)) will not be treated as an addition to a trust if- (1) such power of appointment was created in an irrevocable trust that is not subject to Chapter 13 under § 26.2601-1(b)(1); and (2) in the case of an exercise, such power of appointment is not exercised in a manner that may postpone or suspend the vesting, absolute ownership or power of alienation of an interest in property for a period, measured from the date of creation of the trust,
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   extending beyond any life in being at the date of creation of the trust plus a period of 21 years.

   Section 2041(b) provides that the term "general power of
   appointment" means a power that is exercisable in favor of the individual possessing the power, his estate, his creditors, or the creditors of his estate.

   In the present case, it has been represented that Trust A
   was irrevocable on September 25, 1985, and that there have been no additions, constructive or otherwise, to Trust A after that date. Based on the representations made and the facts submitted, we conclude that there is no change in the quality, value, or timing of any beneficial interest in Trust A resulting from the following: (i) the Trustee’s consent to Corporation’s proposed S election; (ii) the Trustee’s election to treat Trust A as an electing small business trust; and (iii) the Trustee’s execution of the proposed shareholder agreement. Therefore, items (i) - (iii) above will not cause Trust A to lose its exempt status with respect to the GST tax. Provided that there are no additions, constructive or otherwise, to Trust A after September 25, 1985, distributions from Trust A to skip persons will not be subject to the GST tax.

   Except as specifically ruled herein, we express no opinion
   as to the consequences of this transaction under the cited provisions of the Code or under any other provisions of the Code. Specifically, we express no opinion on whether Trust A will qualify as an electing small business trust within the meaning of
   § 1361(e).

   This ruling is directed only to the taxpayer who requested
   it. Section 6110(k)(3) provides that it may not be used or cited as precedent.

                   Sincerely,
                   Assistant Chief Counsel
                   (Passthroughs and Special Industries)
                By George Masnik
                   Chief, Branch 4
   

Enclosure
Copy for section 6110 purposes