IRS approved conversion of an income trust to a unitrust

Plain-English summary

The IRS ruled that converting an irrevocable trust created before September 25, 1985, from an income-only trust to a total return trust under state law would not cause the trust to lose its generation-skipping transfer tax exemption. The proposed conversion would distribute a fixed percentage of the trust's assets averaged over three years instead of distributing only trust income. The IRS also ruled that the conversion would not be treated as a gift by a beneficiary or beneficiary-trustee, and would not be a sale, exchange, or other disposition causing gain or loss. These conclusions depended on the proposed conversion receiving court approval and satisfying the applicable state statute.

Ruling snapshot

• Question: Would converting the pre-1985 income trust to a state-law total return trust cause GST tax, gift tax, or gain or loss recognition?
• Outcome: Approved
• Key authorities: IRC §§ 61, 1001, 2501, and 2601; Treas. Reg. §§ 1.643(b)-1 and 26.2601-1(b)(4); Cottage Savings Ass'n v. Commissioner, 499 U.S. 554 (1991)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201025030 Third Party Communication: None
Release Date: 6/25/2010 Date of Communication: Not Applicable
Index Number: 61.00-00, 1001.00-00,
2501.00-00, 2601.00-00 Person To Contact:
---------------, ID No. ------------
----------------------------------- Telephone Number:
------------------------------------ --------------------
---------------------------------------------- Refer Reply To:
------------------------------- CC:PSI:04
PLR-142205-09
RE: ------------------------------------- Date: MARCH 10, 2010

Legend

Decedent = -----------------------
Trust = ------------------------------------------------------------
Date 1 = ------------------
Date 2 = ---------------------
Date 3 = -------------------
Date 4 = ---------------------
Child 1 = ----------------------
Child 2 = ------------------------
Grandchild 1 = -----------------------
Grandchild 2 = --------------------
Grandchild 3 = ----------------------
State = --------
Citation = ---------------------------------------------------
Court = ------------------------------------------------------------------------------------------

Statute = ----------------------------------------------
x = -------

Dear ---------------------------------------:

This responds to your letter dated August 19, 2009, and subsequent correspondence,
requesting rulings regarding the income, gift, and generation-skipping transfer (GST) tax
consequences of a proposed modification of Trust.

The facts submitted and the representations made are as follows. Decedent died
testate on Date 1, survived by his two children, Child 1 and Child 2. On Date 2,
Decedent executed a Will and amended it in a codicil on Date 3. Section 4 of Article V
of the Will establishes Trust.
PLR-142205-09 2

Section 4 of Article V provides that the trustees shall pay out or distribute one-half of the
net income of Trust to Child 1, for his life, and the remaining one-half to Child 2, for her
life. After the death of Child 1, his one-half net trust income interest shall be paid out
and distributed among his descendants, per stirpes. After the death of Child 2, her one-
half net income interest shall be paid out and distributed among her descendants, per
stirpes. Trust shall terminate 20 years after the death of the last survivor of Decedent’s
descendants living on the date of Decedent’s death, at which time the trustees shall
distribute the entire remaining trust property as then constituted to the beneficiaries at
that time of the current income in the same proportion in which they are then entitled to
receive such income.

Child 1 died on Date 4 survived by three children, Grandchild 1, Grandchild 2, and
Grandchild 3. According to the terms of Trust, Child 1’s one-half interest of Trust’s net
income has been paid in equal shares to Grandchild 1, Grandchild 2, and Grandchild 3.
Child 2’s one-half interest of Trust’s net income has continued to be paid to Child 2.
The current trustees of Trust are Grandchild 1 and Child 2, both of whom are current
income beneficiaries of Trust. Trust is governed by State law and the income required
to be distributed to the income beneficiaries of Trust is defined under the State Principal
and Income Act (Citation).

The trustees of Trust propose to petition Court to convert Trust from an income-only
trust to a total return trust (i.e., unitrust) in accordance with Statute. Statute provides
that following the conversion of a trust to a total return trust, “income” in the governing
instrument means an annual amount equal to a percentage (the “distribution
percentage”) of the fair market value of the trust’s assets averaged over a three-year
period. Under Statute, the distribution percentage must be fixed and cannot be less
than 3 percent. Therefore, the trustees will petition Court to modify Trust to provide that
Trust will distribute annual income equal to a fixed distribution percentage of x percent
of Trust assets averaged over the three preceding years.

It has been represented that no additions have been made to Trust since Decedent's
death, which was prior to September 25, 1985.

The trustees request the following rulings:

1. The proposed conversion of Trust to a Total Return Trust under State law will not
   cause Trust to lose its generation-skipping exempt status as a trust that was created
   and irrevocable on or before September 25, 1985.

2. The proposed conversion of Trust to a Total Return Trust under State law will not
   cause any beneficiary, or any trustee who is also a beneficiary, to have made a transfer,
   direct or indirect, of property for gift tax purposes.
   PLR-142205-09 3

3. The proposed conversion of Trust to a Total Return Trust under State law will not be
   considered a sale, exchange, or other disposition of property and will not cause Trust or
   any of the beneficiaries to realize gain or loss.

Rulings 1 and 2

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

Section 2511 provides that the tax imposed by § 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. Section 2611(a)
defines the term “generation-skipping transfer” as a taxable distribution, a taxable
termination, and a direct skip.

Under § 1433(b)(2)(A) of the Tax Reform Act of 1986 and § 26.2601-1(b)(1)(i) of the
Generation-Skipping Transfer Tax Regulations, the generation-skipping transfer tax
provisions do not apply to any generation-skipping transfer under a trust (as defined in
§ 2652(b)) that was irrevocable on September 25, 1985. However, this exemption does
not apply if additions (actual or constructive) are made to the trust after September 25,
1985.

Section 26.2601-1(b)(1)(ii)(A) of the Generation-Skipping Transfer Tax Regulations
provides that any trust in existence on September 25, 1985, will be considered an
irrevocable trust except as provided in § 26.2601-1(b)(ii)(B) or (C), which relate to
property includible in a grantor's gross estate under §§ 2038 and 2042.

Section 26.2601-1(b)(4) provides rules for determining when a modification, judicial
construction, settlement agreement, or trustee action with respect to a trust that is
exempt from the generation-skipping transfer tax under § 26.2601-1(b)(1), (2), or (3)
(hereinafter referred to as an exempt trust) will not cause the trust to lose its exempt
status. In general, unless specifically provided otherwise, the rules contained in
§ 26.2601-1(b)(4) are applicable only for purposes of determining whether an exempt
trust retains its exempt status for generation-skipping transfer tax purposes. 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
§ 1001.
PLR-142205-09 4

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 § 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
§ 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.

Section 26.2601-1(b)(4)(i)(D)(2) provides that for purposes of this section, 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 § 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 § 1.643(b)-1 of the Income Tax Regulations.

Section 26.2601-1(b)(4)(i)(E), Example 11, considers a situation where a trust that is
otherwise exempt from the GST tax because it was irrevocable prior to September 25,
1985, provides that trust income is payable to A for life and, upon A's death, the
remainder is to pass to A's issue, per stirpes. State X, the situs of the trust, then
amends its income and principal statute to define income as a unitrust amount of 4
percent of the fair market value of the trust assets valued annually. The example
concludes that the administration of the trust, in accordance with the state statute
defining income to be a 4 percent unitrust amount will not be considered to shift a
beneficial interest in the trust. Therefore, the trust will not be subject to the provisions of
chapter 13. Further, under the facts of the example, 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
PLR-142205-09 5

purposes.

The trustees represent that Trust was irrevocable on September 25, 1985 and that there
were no additions to Trust after September 25, 1985.

The facts in this case are similar to those set forth in Example 11 of § 26.2601-
1(b)(4)(i)(E), which concludes that the proposed conversion of a trust to a total return
trust under state law will not cause the trust to lose its GST exempt status and that no
trust beneficiary will be treated as having made a gift for federal gift tax purposes.

Provided the proposed conversion meets the requirements of State Statute and Court
issues an order approving the conversion, we conclude that the conversion of the
income interest in Trust to a unitrust interest will not be considered to shift any beneficial
interest in Trust and, therefore, will not cause Trust to lose its generation-skipping
exempt status as a trust that was created and irrevocable on or before September 25,
1985. We further conclude that the proposed conversion of Trust to a Total Return
Trust under State Law will not cause any beneficiary, or any trustee who is also a
beneficiary, to have made a transfer, direct or indirect, of property for gift tax purposes.

Ruling 3

Section 61(a)(3) provides that gross income includes gains derived from dealings in
property.

Section 1001(a) provides that the gain from the sale or other disposition of property is
the excess of the amount realized over the adjusted basis provided in § 1011 for
determining loss over the amount realized. Under § 1001(c), the entire amount of gain
or loss must be recognized, except as otherwise provided.

Section 1.1001-1(a) of the Income Tax Regulations provides that except as otherwise
provided in subtitle A of the Code, the gain or loss realized from the exchange of
property for other property differing materially either in kind or in extent, is treated as
income or as loss sustained.

An exchange of property results in the realization of gain or loss under § 1001 if the
properties exchanged are materially different. Cottage Savings Ass'n v. Commissioner,
499 U.S. 554 (1991). Properties exchanged are materially different if the properties
embody legal entitlements "different in kind or extent" or if the properties confer
"different rights and powers." Id. at 565. In Cottage Savings, 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
interest in the loans. Id. at 566. In defining what constitutes a "material difference" for
purposes of § 1001(a), the Court stated that properties are "different" in the sense that
PLR-142205-09 6

is material to the Code so long as their respective possessors enjoy legal entitlements
that are different in kind or extent. Id. at 564-65.

Section 1.643(b)-1 provides a comprehensive definition of “income” as that term applies
to trusts and estates. It provides, in part, that items such as dividends, interest, and
rents are generally allocated to income and proceeds from the sale or exchange of trust
assets are generally allocated to principal. However, 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 providing
that income is a unitrust amount of no less than 3 percent and no more than 5 percent
of the fair market value of the trust assets, whether determined annually or averaged on
a multiple year basis, is a reasonable apportionment of the total return of the trust.
Similarly, 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. Section 1.643(b)-1 further provides that a switch between methods of
determining trust income authorized by state statute will not constitute a recognition
event for purposes of § 1001. A switch to a method not specifically authorized by state
statute, but valid under state law (including a switch via judicial decision or a binding
non-judicial settlement) may constitute a recognition event to the trust or its
beneficiaries for purposes of § 1001.

Thus, § 1.643(b)-1 recognizes that the conversion of an income trust to a total return
trust or unitrust where the unitrust amount is no less than 3 percent and no more than
5 percent of the fair market value of the trust assets, whether determined annually or
averaged on a multiple year basis, is a reasonable apportionment of the total return of
the trust. Further, such conversions authorized under a governing state statute are
considered nonrecognition events for purposes of § 1001. Therefore, in the instant
case, a change in the terms of Trust from distributions of income only to distributions of
an unitrust amount of x percent of the fair market value of Trust assets determined on a
multiple year basis is consistent with applicable State law and, therefore, pursuant to
§ 1.643(b)-1, does not constitute a recognition event for purposes of § 1001.

Assuming Court approves the proposed conversion of Trust to a Total Return Trust
under the terms and conditions of the petition, we conclude that the conversion will not
be considered a sale, exchange, or other disposition of property and will not cause Trust
or any beneficiaries to realize gain or loss under § 1001.

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. The ruling(s) in this letter pertaining to the federal estate and/or generation-
PLR-142205-09 7

skipping transfer tax apply only to the extent that the relevant sections of the Internal
Revenue Code are in effect during the period at issue.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
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.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                   Sincerely,



                                   Lorraine E. Gardner
                                   Senior Counsel, Branch 4
                                   Office of Chief Counsel
                                   (Passthroughs & Special Industries)

Enclosures (2)