PLR 200652040: Trust accounting modifications preserve GST exemption and ESBT eligibility

Plain-English summary

Trustees sought tax rulings for court-approved changes allowing a longstanding family trust and six subtrusts to determine income and adjust between income and principal under state law. The trusts were represented to have been irrevocable on September 25, 1985, with no later additions. The IRS ruled that the changes and administration under the state adjustment statute would preserve exemption from generation-skipping transfer tax and would not make beneficiaries taxable gift donors. The changes also created no materially different legal interests and therefore no gain or loss under section 1001. The trusts would retain their eligibility as electing small business trusts under section 1361(e). The ruling did not determine the holding company's eligibility or election as an S corporation.

Ruling snapshot

• Question: Do court-approved trust income and principal adjustments disturb GST exemption, trigger gift or income tax, or end ESBT eligibility?
• Outcome: Approved: exemption and ESBT eligibility preserved, with no taxable gift or section 1001 disposition.
• Key authorities: IRC §§ 2601, 2501, 2511, 1001 and 1361(e); Treas. Reg. §§ 26.2601-1(b)(4) and 1.643(b)-1.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200652040
Third Party Communication: None
Release Date: 12/29/2006
Date of Communication: Not Applicable
Index Number: 2601.04-01, 2511.00-00,
61.00-00, 1001.00-00,
Person To Contact:
1361.00-00, 1361.03-00
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Telephone Number:
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Refer Reply To:
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CC:PSI:B04
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PLR-143150-06
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Date: SEPTEMBER 19, 2006

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Re: ----------------------------------------
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LEGEND:
Subtrust 1 = ------------------------------------------------------------------------------
Subtrust 2 = -------------------------------------------------------------------------------
Subtrust 3 = -------------------------------------------------------------------------------------------------------------------
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Subtrust 4 = -----------------------------------------------------------------------------------------------------------
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Subtrust 5 = -------------------------------------------------------------------------------------------------------------
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Subtrust 6 = ---------------------------------------------------------------------------------------------------------------
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Trust = -------------------------------------------------------------------
Decedent = ------------------
Spouse = ------------------------
A = ------------------------
B = --------------------
C = ------------------
D = ----------------------
Date 1 = --------------------
Date 2 = -----------------
Date 3 = -------------------------
$a = -----------
Corporation = ----------------------------------------
Company = -------------------------------------
Holding Company = --------------------------
Co-trustee = -------------------------------------
State = -------------
Local Court = ----------------------------------------------------------

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the Act = ----------------------------------------------------------------------------
Statute A = ----------------------------------------------------------------
Statute B = -----------------------------------------------------------------
Statute C
=
---------------------------------------------------------------------------- Dear ---------------:

This is in response to the May 4, 2005 letter and other correspondence requesting rulings on the income, gift, and generation-skipping transfer (GST) tax consequences of the proposed modification of certain trusts.

The facts submitted are as follows. Decedent died testate on Date 1, before September 25, 1985. Decedent was survived by Spouse, and three children, A, B, and C. There were no children of Decedent who predeceased him leaving issue.

Under Article VIII of Decedent’s will, the residue of the estate passed to the Trust.
Under Article VIII, Paragraphs A and C of the will: (i) $a is to be paid annually to Spouse from the income of the trust; (ii) $a of the remaining income is to be paid annually in equal shares to Decedent’s children; and (iii) the remaining income is to be paid annually in equal shares to Spouse and each of Decedent’s children.

Under Article VIII, Paragraph G, on Spouse’s death, her interest is to pass to Decedent’s children with the result that all of the Trust income would be paid in equal shares to A, B, C. Under Paragraph F, on the death of a child of Decedent (i.e., A, B, or C), the deceased child’s interest is to pass to that child’s issue per stirpes. If the child leaves a surviving spouse, the child may appoint to the surviving spouse a one-fourth share of the child’s interest. On the death of a deceased child’s issue, the deceased issue’s interest is to pass to his or her issue. If the deceased issue has no issue, the interest is to pass to the remaining issue of the deceased child. Under Paragraph J, the trustees may divide the trust nearly as possible in the exact proportions required.

Under Paragraph D, a child of Decedent who has attained age 31 is to receive his or her share of income outright. Under Paragraph E, the income otherwise payable to a beneficiary under age 21, who is the issue of a deceased child of Decedent, after deduction for expenses of support, maintenance and education, is to be accumulated until the beneficiary attains age 21. At that time, the accumulation is to be paid over to the beneficiary, and he or she is to receive outright distributions of income thereafter.

Under Paragraph H, except as provided in Paragraph I, no distribution of corpus may be made until the termination of the Trust. Under Paragraph I, the trustees have the discretionary power to use corpus, if deemed reasonably necessary, for the care, support or education of a child of Decedent or a deceased child’s issue, or in extraordinary emergencies, after taking into consideration any other income or funds available for this purpose. Paragraph J authorizes the trustees, at their discretion, to divide the Trust into separate trusts for the benefit of the Trust beneficiaries. Under Paragraph Q, stock

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dividends are not to be considered as income, but rather shall be considered as an increment in value of corpus. No appreciation in value of corpus shall be considered as income but likewise as an increment in value of corpus. All cash dividends, except liquidating dividends, are to be considered as income.

Under Paragraph K, the trust is to terminate on the death of the last survivor of Spouse, Decedent’s children, all of Decedent’s nieces and nephews living at Decedent’s death, and all of the children of B, plus an additional period of 21 years. On termination of the Trust, the entire corpus and all accumulated income are to be distributed to the persons entitled to the income in accordance with their respective interests under Article VIII.

Spouse died on Date 2. Subsequently, A and B died. In accordance with Paragraph J of Article VIII, the trustees administered the Trust as separate subtrusts, Subtrusts 1-6. The current income beneficiary of Subtrust 1 is C, and the current income beneficiaries of Subtrusts 2-6 are the issue of A and B.

The Trust was initially funded with shares of Corporation, which became a wholly owned subsidiary of Company. The Trust’s shares of Corporation were exchanged for shares of Company. Corporation’s operating business was sold in Year. Company changed its name to Holding Company and continued as a corporate entity. Holding Company is an S corporation for federal tax purposes. Each subtrust has elected to be an “electing small business trust” under section 1361(e)(1)(B).

Effective September 1, 2002, State enacted the Act, which includes Statute A and Statute B, governing the administration of trusts.

Under Statute A, (1) in allocating receipts and disbursements to or between principal and income, a fiduciary shall: (a) administer a trust in accordance with the terms of the trust, even if there is a different provision in the Act; (b) administer a trust in accordance with the Act if the terms of the trust do not contain a different provision or give the fiduciary a discretionary power of administration; (c) add a receipt or charge a disbursement to principal to the extent that the terms of the trust and the Act do not provide a rule for allocating the receipt to or between principal and income; (2) a fiduciary may administer a trust by the exercise of a discretionary power of administration given to the fiduciary by the terms of the trust, even if the exercise of the power produces a result different from a result required or permitted under the Act; (3) in exercising the power to adjust under Statute B, or a discretionary power of administration regarding a matter within the scope of the Act, whether granted by the terms of the trust or as provided in the Act, a fiduciary shall administer a trust impartially, based on what is fair and reasonable to all of the beneficiaries except to the extent that the terms of the trust clearly manifest an intention that the fiduciary shall or may favor one or more of the beneficiaries. A determination in accordance with the Act is presumed to be fair and reasonable to all of the beneficiaries.

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Under Statute B, (1) a fiduciary may adjust between principal and income to the extent the fiduciary considers necessary if the fiduciary invests and manages trust assets as a prudent investor, the terms of the trust describe the amount that may be distributed to a beneficiary by referring to the trust’s income, and the fiduciary determines, after applying the provisions of Statute A(1) and (2), that the fiduciary is unable to comply with Statute A(3); (2) in deciding whether and to what extent to exercise the power conferred by Statute B(1), a fiduciary shall consider all factors relevant to the trust and its beneficiaries; (3) in exercising discretion under Statute B, a professional trustee may adopt a policy that applies to all trusts, or a policy that applies to individual trusts or classes of trusts, stating whether and under what conditions it will use the adjustment power and the method of making adjustments.

Statute C contains the State prudent investor rule.

On Date 3, Local Court, pursuant to Co-trustee’s petition, issued an order modifying the Trust (and each subtrust), as follows: (i) the limitations of Paragraph Q in Article VIII shall not apply in determining trust income; (ii) income is to be determined in accordance with the Act; and (iii) the trustees are to have the power to distribute corpus to the extent necessary to allow the trustees to exercise their power to adjust under Statute B. In making determinations, the trustees may consider: (a) the overall return on investments that have been or will be generated from the trust principal each year; (b) the level of distributions that have been historically provided to the beneficiaries; and (c) the impact inflation has on the value of the trust principal to future beneficiaries and the value of the distributions to current beneficiaries. The Local Court order is contingent on the receipt of a private letter ruling issued by the IRS that the modifications will not affect the generation-skipping transfer tax exempt status of the Trust or the subtrusts.

It is represented that the Trust (including the separate subtrusts) was irrevocable on September 25, 1985, and there were no additions made after September 25, 1985.

You have requested the following rulings:

(1) The judicial modifications will not cause the Trust or a subtrust to lose its status as exempt from generation-skipping transfer tax.

(2) The judicial modifications will not result in a taxable gift under section 2501.

(3) The judicial modifications will not cause there to be a disposition for purposes of section 1001 and will not result in the recognition of gain or loss.

(4) The judicial modifications will satisfy the requirements of section 1361(e)(1).

Rulings 1 and 2

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Section 2501 imposes a tax on the transfer of property by gift by an individual.

Section 2511 provides that the tax imposed by section 2501 applies whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible.

Section 2512(a) provides that, if a gift is made in property, the value thereof at the date of the gift shall be considered the amount of the gift.

Section 2601 imposes a tax on every generation-skipping transfer (“GST”) made after October 26, 1986.

Under section 1433(a) of the Tax Reform Act of 1986 (Act) and section 26.2601- 1(a), the GST tax is generally applicable to GSTs made after October 22, 1986. However, under section 1433(b)(2)(A) of the Act and section 26.2601-1(b)(1)(i), the GST tax does not apply to a transfer under a trust that was irrevocable on September 25, 1985, but only to the extent that the transfer is not made out of corpus added to the trust after September 25, 1985 (or out of income attributable to corpus so added). Under section 26.2601-1(b)(1)(ii), any trust in existence on September 25, 1985, will be considered irrevocable unless the decedent had a power that would have caused inclusion of the trust in his or her gross estate under section 2038 or 2042, if the decedent had died on September 25, 1985.

Section 26.2601-1(b)(4)(i) provides rules for determining when a modification, judicial construction, settlement agreement, or trustee action with respect to a trust that is exempt from the GST tax under section 26.2601-1(b)(1), (2), or (3) will not cause the trust to lose its exempt status. Under the regulation, unless specifically provided otherwise, these rules are applicable only for purposes of determining whether an exempt trust retains its exempt status for GST tax purposes. Thus (unless specifically noted), the rules do not apply in determining, for example, whether the transaction results in a gift subject to gift tax, or may cause the trust to be included in the gross estate of a beneficiary, or may result in the realization of gain for purposes of section 1001.

Section 26.2601-1(b)(4)(i)(D)(1) provides that a modification of the governing instrument of an exempt trust, including a trustee distribution, settlement, or construction (that does not satisfy section 26.2601-1(b)(4)(i)(A), (B), or (C)) by judicial reformation, or nonjudicial reformation that is valid under applicable state law, will not cause an exempt trust to be subject to the provisions of chapter 13, if the modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation (as defined in section 2651) 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.

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Section 26.2601-1(b)(4)(i)(D)(2) provides that a modification of an exempt trust will result in a shift in beneficial interest to a lower generation beneficiary if the modification can result in either an increase in the amount of a GST transfer or the creation of a new GST transfer. To determine whether a modification of an irrevocable trust will shift a beneficial interest in a trust to a beneficiary who occupies a lower generation, the effect of the instrument on the date of the modification is measured against the effect of the instrument in existence immediately before the modification. If the effect of the modification cannot be immediately determined, it is deemed to shift a beneficial interest in the trust to a beneficiary who occupies a lower generation (as defined in section 2651) than the person or persons who held the beneficial interest prior to the modification. A modification that is administrative in nature that only indirectly increases the amount transferred (for example, by lowering administrative costs or income taxes) will not be considered to shift a beneficial interest in the trust. In addition, administration of a trust in conformance with applicable local law that defines the term income as a unitrust amount (or permits a right to income to be satisfied by such an amount) or that permits the trustee to adjust between principal and income to fulfill the trustee's duty of impartiality between income and principal beneficiaries will not be considered to shift a beneficial interest in the trust, if applicable local law provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust and meets the requirements of section 1.643(b)-1.

Section 26.2601-1(b)(4)(i)(E), Example 12 considers a situation where, in 1980, the Grantor, a resident of State X, establishes an irrevocable trust for the benefit of Grantor’s child, A, and A’s issue. The trust provides that trust income is payable to A for life and upon A’s death, the remainder passes to A’s issue per stirpes. In 2002, State X amends its income and principal statute to permit the trustee to make adjustments between income and principal when the trustee invests and manages the trust assets under the state's prudent investor standard, the trust describes the amount that shall or must be distributed to a beneficiary by referring to the trust's income, and the trustee after applying the state statutory rules regarding allocation of receipts between income and principal is unable to administer the trust impartially. The provision permitting the trustees to make these adjustments is effective in 2002 for trusts created at any time. The trustee invests and manages the trust assets under the state's prudent investor standard, and pursuant to authorization in the state statute, the trustee allocates receipts between the income and principal accounts in a manner to ensure the impartial administration of the trust. The example concludes that the administration of the trust in accordance with the state statute will not be considered to shift any beneficial interest in the trust. Therefore, the trust will not be subject to the provisions of chapter 13. Further, no trust beneficiary will be treated as having made a gift for federal gift tax purposes, and neither the trust nor any trust beneficiary will be treated as having made a taxable exchange for federal income tax purposes.

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In the instant case, the Trust (including the subtrusts) was irrevocable on September 25, 1985, and there have been no additions made to the trusts after September 25, 1985. The trustees propose to administer Subtrusts 1-6 pursuant to State Statute B, a statute that is similar to the state statute described in section 26.2601-1(b)(4)(i)(D)(2) and section 26.2601-1(b)(4)(i)(E), Example 12. Therefore, administration of Subtrusts 1-6 in accordance with State Statute B will not be considered to shift any beneficial interest in Trust or the subtrusts for GST tax purposes, nor will administration of Subtrusts 1-6 in accordance with State Statute B cause any beneficiary to be treated as making a gift. The modifications to the Trust instrument, as described above, are consistent with the administrative powers the trustees would otherwise possess in administering the subtrusts under Statute B.

Accordingly, based on the facts submitted and representations made, we conclude that:

(1) Administration of the Trust and subtrusts pursuant to Statute B and the modification of the Trust instrument as described above, will not cause the Trust, or Subtrusts 1-6 to lose status as exempt from GST tax; and

(2) Administration of the Trust and subtrusts pursuant to Statute B and the modification of the Trust instrument as described above, will not cause any beneficiary of a subtrust to be treated as making a gift for federal gift tax purposes.

Ruling 3

Section 61(a)(3) provides that gross income includes gains derived from dealings in property and, under section 61(a)(15), from an interest in a trust.

Section 1001(a) provides that the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in section 1011 for determining loss over the amount realized.

Section 1001(b) states that the amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received. Under section 1001(c), except as otherwise provided in subtitle A, the entire amount of gain or loss, determined under section 1001, on the sale or exchange of property shall be recognized.

Section 1.1001-1(a) provides that the gain or loss realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income or loss sustained.

Section 1015(b) provides that if property is acquired after December 31, 1920, by

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a transfer in trust (other than by a transfer in trust by a gift, bequest or devise), the basis shall be the same as it would be in the hands of the grantor increased in the amount of gain or decreased in the amount of loss recognized by the grantor on such transfer.

Section 1.643(b)-1 provides that a switch between methods of determining trust income authorized by state statutes will not constitute a recognition event for purposes of section 1001 and will not result in a taxable gift from the trust’s grantor or any of the trust’s beneficiaries.

In Cottage Savings Ass’n v. Commissioner, 499 U.S. 554 (1991), a financial institution exchanged its interests in one group of residential mortgage loans for another lender’s interest in a different group of residential mortgage loans. The two groups of mortgages were considered “substantially identical” by the agency that regulated the financial institution. The issue presented was whether a sale or exchange had taken place resulting in a realization of gain or loss under section 1001.

The Court concluded that section 1.1001-1 reasonably interprets section 1001(a) and stated that an exchange of property gives rise to a realization event under section 1001(a) if the properties exchanged are "materially different." Cottage Savings, 499 U.S. at 560-61. In defining what constitutes a "material difference" for purposes of section 1001(a), the Court stated that properties are "different" in the sense that is "material" so long as their respective possessors enjoy legal entitlements that are different in kind or extent. Cottage Savings, 499 U.S. at 564-65. The Court held that mortgage loans made to different obligors and secured by different homes did embody distinct legal entitlements, and that the taxpayer realized losses when it exchanged interests in the loans. Cottage Savings, 499 U.S. at 566.

It is consistent with Cottage Savings to find that the interests of the beneficiaries of the Trust (including the subtrusts) after the judicial modification will not differ materially from their interests prior to the judicial modification. Because the Act grants the trustees the power to administer the trusts in the same manner as proposed in the modifications, the modifications are not treated as an exchange of interests by the beneficiaries or the trusts. Except for the changes described above, all other provisions of the modified Trust (and subtrusts) will be identical to the original Trust. Accordingly, the proposed judicial modification will not result in a material difference in kind or extent of the legal entitlements enjoyed by the beneficiaries. The judicial modification of the Trust (and the subtrusts) will not cause there to be a disposition for purposes of section 1001, and no gain or loss is recognized for purposes of section 1001.

Ruling 4

Section 1361(a)(1) provides that the term “S corporation” means, with respect to any taxable year, a small business corporation for which an election under section 1362(a) is in effect for such year.

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Section 1361(b)(1) defines a “small business corporation” as a domestic corporation which is not an ineligible corporation and which does not (A) have more than 100 shareholders, (B) have as a shareholder a person (other than an estate, a trust described in section 1361 (c)(2), or an organization described in section 1361(c)(6)) who is not an individual, (C) have a nonresident alien as a shareholder, and (D) have more than one class of stock.

Section 1361(c)(2)(A)(v) provides that an ESBT (as defined in section 1361(e)) is a permitted S corporation shareholder. Section 1361(e)(1)(A) provides that for purposes of section 1361, and except as provided in section 1361(e)(1)(B), the term ESBT means any trust if (i) the trust does not have as a beneficiary any person other than an individual, an estate, or an organization described in section 170(c)(2), (3), (4), or (5); (ii) no interest in the trust was acquired by purchase; and (iii) an election under section 1361(e) applies to the trust.

Section 1361(e)(1)(B) provides that the term “electing small business trust” shall not include (i) any qualified subchapter S trust (as defined in subsection (d)(3)) if an election under subsection (d)(2) applies to any corporation the stock of which is held by such trust, (ii) any trust exempt from tax under this subtitle, and (iii) any charitable remainder annuity trust or charitable remainder unitrust (as defined in section 664(d)).

Section 1361(e)(3) provides that such an election is to be made by the trustee and is to apply to the tax year of the trust for which made and all subsequent tax years unless revoked with the consent of the Service.

Based solely on the information submitted and the representations made, we conclude that after the proposed judicial modifications are adopted, the modifications will not result in a change in the beneficiaries of the Trust (or the subtrusts) or otherwise alter the qualification of the trusts as an electing small business trust (ESBT). Thus, the Trust and the subtrusts will continue to satisfy the eligibility requirements of section 1361(e).

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. Specifically, no opinion is expressed concerning whether Holding Company is eligible to be treated as an S corporation, or the validity of its election to do so.

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This ruling is directed only to the taxpayers requesting it. Section 6110(k)(3) provides that it may not be used or cited as precedent. In accordance with the power of attorney on file with this office, a copy of this letter is being sent to your authorized representative.

Sincerely,

George L. Masnik
Chief, Branch 4
Office of Associate Chief Counsel
(Passthroughs & Special Industries)
Enclosures
Copy for section 6110 purposes