PLR 1026026: IRS approved proposed sales of remainder interests without changing trust tax treatment

Plain-English summary

The IRS considered a proposed judicial construction of a spendthrift clause and proposed sales of remainder interests in an old family trust. It concluded that the construction and sales would not affect the trust's GST-tax-exempt status because the trust was irrevocable before September 25, 1985, had no later additions, and the changes would not shift beneficial interests to a lower generation or extend vesting. The proposed sales, priced using the trust assets' value and the applicable § 7520 actuarial factor, would not create taxable gifts for the buyers or sellers. The court construction would not itself create realization of income for the trust or remaindermen because it would not change their property interests or legal entitlements. Each seller's gain would equal the amount realized over the adjusted basis of the remainder interest, subject to the letter's stated limitations and no opinion on state-law authorization.

Ruling snapshot

• Question: Would a court-approved construction of a spendthrift clause and proposed sales of trust remainder interests affect GST exemption, gift tax, or recognition and calculation of gain or loss?
• Outcome: approved
• Key authorities: IRC §§ 61, 1001, 1011, 1012, 2501, 2511, 2512, 2601, 2611, 2631, 2652, and 7520; Treas. Reg. §§ 1.1001-1, 25.2512-5, 26.2601-1, 26.2652-1, and 1.1012-1; IRC § 6110(k)(3)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201026026 Third Party Communication: None
Release Date: 7/2/2010 Date of Communication: Not Applicable
Person To Contact:
Index Number: 1001.00-00, 2501.00-00, ---------------, ID No. -------------
2601.00-00 Telephone Number:
---------------------
--------------------------------- Refer Reply To:
------------------------------- CC:PSI:04
---------------------------------------- PLR-147900-09
------------------------- Date:
February 24, 2010

     Re: --------------------------------------
     --------------

Legend

      Decedent          =        -----------------
      State X           =        -------------
      Year 1            =        -------
      Spouse            =        -------------------------
      Child 1           =        ----------------------------
      Child 2           =        ----------------------------
      Child 3           =        -------------------------
      Grandchild 1 =             --------------------------------
      Grandchild 2 =             ------------------------
      Grandchild 3 =             ---------------------
      Grandchild 4 =             ----------------------------------
      Trust             =        ---------------------------------------------------------------------------------
      Charity 1         =        -----------------------------------------------------------
      Charity 2         =         ------------------------------------------------------
      -----------------------------------------------------------
      Year 2            =        -------
      Year 3            =        -------
      Greatgrandchild 1 = ---------------------------------
      Greatgrandchild 2 = ----------------------------
      Greatgrandchild 3 = ------------------------------
      Greatgrandchild 4 = ------------------------------------------
      Greatgrandchild 5 = -----------------------------
      Greatgrandchild 6 = ------------------------------
      Greatgrandchild 7 = -------------------------
      Year 4            =        --------

PLR-147900-09 2

     Trust 1           =         --------------------------------------------------------------------------------

     --------------------------------------------------
     Trust 2           =         --------------------------------------------------------------------------------

     --------------------------------------------------
     Trust 3           =         --------------------------------------------------------------------------------

     --------------------------------------------------
     Trust 4           =         --------------------------------------------------------------------------------

     --------------------------------------------------
     Date 1            =        -----------------
     State Y           =         -------------

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

  This responds to a letter dated August 19, 2009, and other correspondence,

requesting rulings regarding the income, gift, and generation-skipping transfer (GST) tax
consequences of a proposed judicial construction of Trust to permit proposed sales of
remainder interests in Trust.

Facts

    The facts submitted and representations made are as follows. Decedent, a

resident of State X, died testate in Year 1, a date prior to 1969. Article Sixth of
Decedent's will created Trust to benefit Child 1, Child 2 and his issue, Child 3 and her
issue, and Spouse. Under the will, upon the termination of Trust, the trustee will
distribute the corpus and undistributed income to Charity 1 and Charity 2. Trust will
terminate upon the last to die of Spouse, Child 1, Child 2, Child 3, Grandchild 1,
Grandchild 2, Grandchild 3, Grandchild 4, Greatgrandchild 5, Greatgrandchild 6, and
Greatgrandchild 7. Spouse, Child 1, Child 2, and Child 3 are deceased. Child 2 had no
issue. Child 3 is survived by Grandchild 1, Grandchild 2, Grandchild 3, and Grandchild
4 (collectively, Grandchildren) and eleven greatgrandchildren (collectively,
Greatgrandchildren), which includes Greatgrandchildren 1 through 7. Under the will,
Grandchildren and Greatgrandchildren are the current income beneficiaries of Trust.
This private letter ruling request pertains to the proposed sales of interests in Trust by
Greatgrandchild 1, Greatgrandchild 2, Greatgrandchild 3, and Greatgrandchild 4.

     The will also contains a spendthrift clause which provides that:

     each beneficiary hereunder is hereby restrained from anticipating, encumbering,
     alienating, or in any other manner assigning his or her interest or estate in either
     principal or income, and is without power to do so, nor shall such interest or

PLR-147900-09 3

   estate be subject to his or her liabilities or obligations, nor to judgment or other
   legal process, bankruptcy proceedings or claims of creditors or others. All
   income and principal, or either of them, shall be payable and deliverable only and
   personally to the respective beneficiaries entitled thereto.

   In Year 3, pursuant to a Year 2 court order and Year 2 settlement among the

parties, Charity 1 sold its remainder interest in Trust to Greatgrandchildren. For
purposes of this ruling, after the sale, Greatgrandchild 1, Greatgrandchild 2, and
Greatgrandchild 3 each owned a 4 1/6 percent remainder interest in Trust and
Greatgrandchild 4 owned a 12 1/2 percent remainder interest in Trust. In Year 4,
pursuant to a court order, Greatgrandchild 4 sold a 2 1/2 percent remainder interest in
Trust to other relatives. The Year 4 court order stated that the spendthrift clause of
Trust does not prohibit the sales because the clause applies only to beneficial interests
arising under the terms of Decedent’s will and does not apply to interests acquired after
Decedent’s death under the Year 2 settlement.

     Greatgrandchild 1, Greatgrandchild 2, and Greatgrandchild 3 each propose to

sell all or part of his or her 4 1/6 percent remainder interest in Trust to Trust 1, Trust 2,
and Trust 3, respectively. Trust 1, Trust 2, and Trust 3 are trusts that were previously
established by Grandchild 2 to benefit Greatgrandchild 1, Greatgrandchild 2, and
Greatgrandchild 3, respectively. Greatgrandchild 4 proposes to sell all or part of her 10
percent remainder interest in Trust to Trust 4. Trust 4 was previously established by
Grandchild 4 to benefit Greatgrandchild 4.

    On the date of the proposed sales of the remainder interests in Trust, all of the

assets of Trust will be marketable securities with the fair market value of the trust assets
determined by prices listed on an established exchange. Each proposed seller intends
to sell his or her remainder interest in Trust for a sales price equal to (i) the fair market
value of Trust property as of the date of sale, multiplied by (ii) the § 7520 actuarial
remainder factor then in effect, and multiplied again by (iii) the fraction representing the
portion of the entire remainder subject to the sale. The purchase price will be paid to
the respective Greatgrandchild in cash.

   Under the terms of Trust 1, Trust 2, and Trust 3, each Greatgrandchild is the

primary beneficiary of his or her respective trust during his or her life. Subject to certain
withdrawal rights, each trustee may, in the trustee’s uncontrolled discretion at any time
or times and for any reason, pay any part of the income and principal of the trust to any
among the primary beneficiary and the primary beneficiary’s issue, whenever born.
Moreover, the trustee may add the spouse of the primary beneficiary or the spouse of
any of the primary beneficiary’s issue to whom net income and/or principal may be paid.
Any net income not distributed will be added to the principal of the trust. A primary
beneficiary is granted a testamentary special power to appoint the trust property to any
persons in a specified class. Trust 1, Trust 2, and Trust 3 will terminate, unless sooner
terminated, upon the first to occur of the death of the primary beneficiary and all of his
PLR-147900-09 4

or her issue whenever born, or the expiration of ninety years beginning on Date 1.
Upon termination, the trustee shall distribute the remaining principal of the trust in
accordance to the primary beneficiary’s exercise of the special power of appointment or
in default of such exercise, to the then living issue of the primary beneficiary, by right of
representation. If there are no living issue of the primary beneficiary, then to the living
issue of Grandchild 2, by right of representation.

    Under the terms of Trust 4, Greatgrandchild 4 is the primary beneficiary of Trust

4 during her life. The trustee shall pay so much or all of the income and principal of a
primary beneficiary’s trust to the primary beneficiary for the health, support and
maintenance in reasonable comfort, and education of the primary beneficiary during the
primary beneficiary’s lifetime. A primary beneficiary is granted a testamentary special
power to appoint in trust that beneficiary’s share to any persons and organizations in a
specified class. Any part of that share the primary beneficiary fails to appoint will be
divided per stirpes among the primary beneficiary’s living descendants, or if none, then
per stirpes among the living descendants of the nearest ancestor of the primary
beneficiary who is a descendant of Grandchild 4 who has one or more descendants
then living, or if also none, then per stirpes among Grandchild 4’s then living
descendants. If there are no living descendants of Grandchild 4, then the remaining
trust assets will be distributed to a class of named nieces and nephews or charities as
the trustee shall choose. Trust 4 is subject to State Y law which does not follow the
common law rule against perpetuities.

   It is represented that no additions, constructive or otherwise, have been made to

Trust subsequent to September 25, 1985, and that, other than the earlier court order
and settlement, Trust has not been amended or otherwise altered in any manner since
September 25, 1985.

   The trustee of Trust petitioned the appropriate court for an order that construes

the spendthrift provision of Trust to permit the proposed sales. The court‘s order states
that the spendthrift clause of Trust does not prohibit the proposed sales of the
purchased remainder interests because the spendthrift clause does not apply to the
interests acquired after Decedent’s death under the Year 2 settlement, but only to
beneficial interests arising under the terms of Decedent’s will itself.

   The trustee has requested the following rulings:

   1. The court construction of the spendthrift clause and the provisions of Trust to

allow the proposed sales of remainder interests in Trust will not affect the exempt status
of Trust for GST tax purposes.

   2. The proposed sales of remainder interests in Trust will not affect the exempt

status of Trust for GST tax purposes.
PLR-147900-09 5

   3. The proposed sales of remainder interests in Trust will not result in any

taxable gifts for federal gift tax purposes as to the buyers or sellers of such interests.

   4. The court approval of the proposed sales of remainder interests in Trust will

not result in the recognition of gain or loss to Trust or any trust beneficiaries.

   5. A gain or loss for each of the proposed sales will equal the difference between

the amount realized for the remainder interest and the adjusted basis of the remainder
interest.

Law and Analysis

Rulings 1 & 2:

   Section 2601 of the Internal Revenue Code imposes a tax on each generation-

skipping transfer which includes under § 2611(a) a taxable distribution, a taxable
termination, and a direct skip.

   Section 2631(a) provides that, for purposes of determining the inclusion ratio,

every individual shall be allowed a GST exemption amount which may be allocated by
such individual (or his executor) to any property with respect to which such individual is
the transferor. Section 2631(b) provides that any allocation under § 2631(a), once
made, shall be irrevocable.

   Under § 2652(a)(1), for purposes of chapter 13, the term “transferor” means the

decedent, in the case of any property subject to tax imposed by chapter 11 and, the
donor, in the case of any property subject to tax imposed by chapter 12. The individual
with respect to whom property was most recently subject to federal estate or gift tax is
the transferor of that property for purposes of chapter 13. Section 26.2652-1(a)(1) of
the Generation-Skipping Transfer Tax Regulations. Thus, an individual may be a
transferor even though there is no transfer of property under local law at the time the
federal estate or gift tax applies. Section 26.2652-1(a)(2) provides that for purposes of
chapter 13, a transfer is subject to federal gift tax if a gift tax is imposed under § 2501(a)
(without regard to exemptions, exclusions, deductions, and credits).

    Under § 1433(a) of the Tax Reform Act of 1986 (Act), the generation-skipping

transfer tax is generally applicable to generation-skipping transfers made after October
22, 1986. Under § 1433(b)(2)(A) of the Act and § 26.2601-1(b)(1)(i), the tax does not
apply to any generation-skipping transfer from a trust, if the trust was irrevocable on
September 25, 1985, and no addition (actual or constructive) was made to the trust after
that date. Under § 26.2601-1(b)(1)(ii), any trust in existence on September 25, 1985,
will be considered irrevocable unless the settlor had a power that would have caused
inclusion of the trust in his or her gross estate under § 2038 or § 2042, if the settlor had
died on September 25, 1985.
PLR-147900-09 6

    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 generation-skipping transfer tax will not cause the trust to lose its
exempt status.

    Section 26.2601-1(b)(4)(i)(D) provides that a modification of the governing

instrument of an exempt trust (including a trustee distribution, settlement, or
construction that does not satisfy paragraph (b)(4)(i)(A), (B), or (C) of this section) 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. 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.

   In the present case, Trust is not subject to GST tax because it became

irrevocable before September 25, 1985. It is represented that no additions, constructive
or otherwise, have been made to Trust subsequent to that date.

   The court construction of the spendthrift clause and the provisions of Trust to

allow the proposed sales of remainder interests in Trust and the proposed sales of
remainder interests in Trust will not shift any beneficial interests in Trust to a lower
generation and will not extend the time for vesting of any beneficial interest in Trust
beyond the period provided for in the original trust. Accordingly, based upon the facts
submitted and the representations made, and pursuant to § 26.2601-1(b)(4)(i)(D), we
conclude that the court construction of the spendthrift clause and the provisions of Trust
to allow the proposed sales of remainder interests in Trust will not affect the exempt
status of Trust for GST tax purposes. Further, the proposed sales of remainder
interests in Trust will not affect the exempt status of Trust for GST tax purposes.

   We note that, under § 2652(a)(1), Grandchild 2 is the transferor of Trust 1, Trust

2, and Trust 3 and Grandchild 4 is the transferor of Trust 4 for GST tax purposes.

Ruling 3:

    Section 2501 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.
PLR-147900-09 7

   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 2512(b) provides
that where property is transferred for less than an adequate consideration in money or
money’s worth, then the amount by which the value of the property exceeded the value
of the consideration is deemed a gift.

   Under § 25.2512-5 of the Gift Tax Regulations, in general, the fair market value

of remainders transferred by gift is the present value of the remainders determined by
use of the appropriate § 7520 actuarial factor.

    Section 7520(a) provides that the value of an annuity, any interest for life or a

term of years, or any remainder interest or reversionary interest is determined under
tables prescribed by the Secretary and by using an interest rate (rounded to the nearest
two-tenths of one percent) equal to 120 percent of the applicable federal midterm rate
for the month in which the valuation date falls.

   In the proposed sales of remainder interests in Trust, the sales price of the

remainder interests will equal (1) the fair market value of Trust assets on the date of
sale, (2) multiplied by the § 7520 actuarial remainder factor then in effect, and (3) then
multiplied by the fraction representing that portion of the remainder interest subject to
the sale. The sales price will be paid in cash. Based upon the facts submitted and the
representations made, we conclude that the proposed sales of remainder interests in
Trust will not result in any taxable gifts for federal gift tax purposes as to the buyers or
sellers of such interests.

Ruling 4:

 Section 61 provides that gross income means all income from whatever source

derived. 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

shall be the excess of the amount realized therefrom over the adjusted basis provided in
§ 1011 for determining gain, and the loss shall be the excess of the adjusted basis
provided in such section for determining loss over the amount realized. Section 1001(b)
provides 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.

Section 1001(c) provides that, except as otherwise provided in subtitle A, the entire

amount of the gain or loss, determined under § 1001, on the sale or exchange of
property shall be recognized.
PLR-147900-09 8

  Section 1.1001-1(a) of the Income Tax Regulations 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 as
loss sustained.

  An exchange of property results in the realization of gain or loss under § 1001 if

the properties are materially different. Cottage Savings Ass’n v. Commissioner, 499
U.S. 554 (1991). In Cottage Savings, the Supreme Court held that mortgage loans
made to different obligors and secured by different homes embody distinct legal
entitlements, and that the taxpayer realized losses when it exchanged participation
interests in different loans. Id. In defining what constitutes a “material difference” for
purposes of § 1001(a), the Court stated that properties are “different” in the sense that
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.

  The issue for purposes of this ruling is whether the remaindermen of Trust would

have the same property interests and legal entitlements as a result of the court’s
determination that the spendthrift clause does not prohibit the proposed sales of the
remainder interests. It is represented that the court has entered a preliminary order
determining that the spendthrift clause does not prohibit the proposed sales. The
court’s preliminary order becomes effective only upon the issuance of the requested
letter ruling.

  Because the court’s construction of the spendthrift clause does not change the

property interests and legal entitlements of the remaindermen, the court’s construction
of the spendthrift clause does not give rise to a realization of income to the
remaindermen or Trust under §§ 61 or 1001.

Ruling 5:

   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 § 1011 for determining gain, and the loss shall be the excess of the adjusted
basis provided in such section for determining loss over the amount realized. Section
1001(b) provides 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.

   Section 1001(c) provides that, except as otherwise provided in subtitle A,

the entire amount of the gain or loss, determined under § 1001, on the sale or exchange
of property shall be recognized.

  Section 1001(e) provides that, in determining gain or loss from the sale or other

disposition of a term interest in property, that portion of the adjusted basis of such
PLR-147900-09 9

interest which is determined pursuant to § 1014, 1015, or 1041 (to the extent that such
adjusted basis is a portion of the entire adjusted basis of the property) shall be
disregarded. The term “term interest in property” means a life interest in property, an
interest in property for a term of years, or an income interest in a trust.

    Section 1.1001-1(f)(2) provides that the term “term interest in property” does not

refer to remainder or reversionary interests in the property itself or other interests in
property which will ripen into ownership of the entire property upon termination or failure
of a preceding term interest.

  Section 1012 generally provides that the basis of property shall be the cost of the

property.

    Section 1.1012-1(a) defines cost to be the amount paid for the property in cash

or other property. In the present case, Greatgrandchild 1, Greatgrandchild 2,
Greatgrandchild 3, and Greatgrandchild 4 purchased their remainder interests in Trust
from an unrelated third party, Charity 1. Consequently, under § 1012, the basis of each
of their respective interests is the amount that each paid for the property. Each would
recognize gain from the sale of the remainder interest equal to the difference between
the amount realized over the adjusted basis of the remainder interest.

   We express no opinion on whether the proposed sales are authorized under

Trust or applicable state laws.

   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-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.
PLR-147900-09 10

  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
                                  (Passthroughs & Special Industries)

Enclosures (2)

cc: