Trust settlement preserves grandfathered GST exemption

Plain-English summary

An irrevocable trust created before September 25, 1985 divided its assets into separate shares for the grantor's children. One child later died without a spouse or descendants, did not exercise her appointment power, and the trust agreement did not state how her share should pass in that situation. The trustees and potential beneficiaries negotiated a settlement after considering several possible interpretations, and a state court approved the agreement. No additions had been made to the trust after the grandfathering date. The IRS concluded that the settlement resolved a genuine construction issue, resulted from arm's-length negotiations, and fell within the range of reasonable outcomes under the trust and state law. Terminating the trust and distributing its assets under the settlement therefore would not trigger generation-skipping transfer tax.

Ruling snapshot

• Question: Will the court-approved settlement and trust termination cause generation-skipping transfer tax?
• Outcome: No, the settlement preserves the trust's grandfathered GST-exempt status.
• Key authorities: IRC §§ 2601, 2611, and 2652; Treas. Reg. § 26.2601-1(b)(4)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201606002                                              Third Party Communication: None
Release Date: 2/5/2016                                         Date of Communication: Not Applicable
Index Number: 2601.00-00
                                                               Person To Contact:
---------------------------------                              ---------------, ID No. ----------------
------------------------------------------------------------   Telephone Number:
------------------------                                       --------------------
---------------------------                                    Refer Reply To:
---------------------------------                              CC:PSI:04
                                                               PLR-115077-15
         RE: --------------------------------------------- Date:
---------------------------------------------------------  October 13, 2015
         -----------------------------------




LEGEND

Date 1                     =        -----------------
Grantor                    =        ---------------------
Trust Agreement            =        ----------------------------------------------------------------------
Child 1                    =        -------------------------------
Child 2                    =        -------------------------
Child 3                    =        -------------------------
Child 4                    =        --------------------------
Child 5                    =        --------------------------
Child 6                    =        --------------------------
Trust                      =         --------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------
State 1                    =        --------
Side Agreement             =         -----------------------------------------------------------------
----------------------------------------------------------------------------------------------------------
------------------------------------------------
Date 2                     =        --------------------------
Corporate Trustee =                 ------------------------------------------
State 2                    =        ------------
Individual                 =        ----------------
State 2 Court              =        ------------------------------------------------
Date 3                     =        -------------------------
Date 4                     =        -----------------------
Grandchild 1               =        -------------------------
Grandchild 2               =        --------------------------
Grandchild 3               =        ------------------
Child 2’s Widow            =        --------------
PLR-115077-15                                             2

Child 4’s Widow            =        --------------
Grandchild 4               =        ------------------------
Grandchild 5               =        --------------------------
Grandchild 6               =        ------------------
Date 5                     =        ------------------------
Date 6                     =        ---------------------
x                          =        ----------
y                          =        ----------
Date 7                     =        -----------------------
Citation 1                 =         --------------------------------------------------------------------------------
--------------------------------------------
Citation 2                 =        ---------------------------------------------------------------------------------

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

       This letter responds to your authorized representative’s letter, dated
April 10, 2015, requesting rulings concerning the generation-skipping transfer (GST) tax
consequences of a court-approved settlement agreement.

FACTS

         The facts submitted and representations made are as follows:

       On Date 1, a date prior to September 25, 1985, Grantor established an
irrevocable Trust Agreement, creating separate trusts for the benefit of Grantor’s
children.

        Section 3.01 of Trust Agreement provides that the trustees shall divide the trust
property into separate trusts, equal in value, one for each of the following children and
stepdaughter of Grantor: Child 1, Child 2, Child 3, Child 4, Child 5, and Child 6.
Accordingly, upon execution of the Trust Agreement, the trust property was divided
immediately into six separate trusts of equal value for the Grantor’s children
(individually, “Child Trust”). This ruling request pertains to the trust (“Trust”) that was
established for the benefit of Child 1.

       Section 3.01 further defines “sons and daughters of the Grantor” as the
above-named children together with any child hereinafter born to or adopted by Grantor.
In determining whether any person is a child, grandchild or descendant for purposes of
Trust Agreement, legal adoption, single or successive, shall be the equivalent of blood
relationship.

       Section 3.02(a) provides, in part, that after a son or daughter of the Grantor
reaches the age of twenty-one, the trustees shall pay all the net income of his trust to
him in convenient installments at least as often as quarter-annually. However, the
PLR-115077-15                                   3

trustees may in their discretion withhold from any son or daughter of the Grantor so
much of the income of his trust as the trustees determine not to be required for his
support, comfort, education and welfare, or for any other purpose the trustees believe to
be to his best interest. The trustees may in their discretion pay to one or more of the
descendants of any son or daughter of the Grantor so much of any income withheld
from such son or daughter as the trustees determine to be required or desirable for his
or their support, comfort, education and welfare, or for any other purpose the trustees
believe to be to his or their best interests. Whenever the trustees determine that the
income of any son or daughter of the Grantor from all sources known to the trustees,
together with any resources that might be made available by enforcement of any
obligation of the Grantor to support and educate him, is not sufficient for his reasonable
support, comfort and education and that of his immediate family, the trustees may pay
to him or use for his benefit, so much of the principal of his trust as the trustees
determine to be required for those purposes.

        Section 3.02(b) provides that upon the death of any son or daughter of the
Grantor, the trustees shall distribute his trust to, or in trust for the benefit of, such person
or persons among the spouse of such son or daughter and the Grantor’s descendants,
as he appoints and directs by will. However, no greater interest may be appointed for
the benefit of a spouse of such son or daughter than the net income from such trust until
such spouse’s death or remarriage. To the extent that he does not effectively exercise
his power of appointment, the trustee shall divide, hold and distribute his trust as
follows: the trustee shall first divide such trust into equal trusts, one for each then living
child of such son or daughter of Grantor, “a grandchild of Grantor,” and one for the then
living descendants, collectively of each then deceased grandchild of Grantor. The
share established for the descendants, collectively, of each then deceased grandchild of
Grantor shall be divided and allocated into portions per stirpes for the benefit of such
then living descendants of such deceased grandchild. Each share established for a
grandchild of Grantor and each portion established for a descendant of a deceased
grandchild of Grantor shall be held as a separate and independent trust designated by
the name of such grandchild or descendant of a deceased grandchild (individually,
“Descendant Trust”).

       Section 3.02(b) also provides terms of a Descendant Trust that are similar to the
terms of a Child Trust. However, after any grandchild or descendant of a grandchild of
Grantor has attained the age of thirty years, the trustees shall distribute to him the
balance of his trust. Upon the death of any grandchild or descendant of a grandchild of
Grantor prior to becoming entitled to receive full distribution of his trust, the trustees
shall distribute his trust to or for the benefit of such person or persons among the
spouse of such grandchild or descendant of a grandchild of Grantor and Grantor’s
descendants, as he appoints and directs by will. However, no greater interest may be
appointed for the benefit of a spouse of such grandchild or descendant of a grandchild
of Grantor than the net income from such trust until such spouse’s death or remarriage.
To the extent that he does not effectively exercise his power of appointment, the trustee
PLR-115077-15                                 4

shall distribute his trust, subject to the provisions of Section 4.01 of Trust Agreement, to
his then living descendants, if any per stirpes, and, if none, to his then living brothers
and sisters, if any, in equal shares, the then living descendants of any deceased brother
or sister to take such deceased brother’s or sister’s share per stirpes, and if there are no
then living brothers or sisters or descendants of a deceased brother or sister of said
decedent, then in equal shares among the living grandchildren of Grantor, the then
living descendants of any deceased grandchild to take such deceased grandchild’s
share, per stirpes.

       Section 4.07 provides that no trust created hereunder or by any power of
appointment hereunder shall continue for more than twenty-one years after the death of
the last survivor of the Grantor and the Grantor’s descendants and their spouses living
on Date 1. At that time, the trustees are to distribute each remaining portion of the trust
property to the beneficiary or beneficiaries, the current income, and if there is more than
one beneficiary, in the proportions in which they are beneficiaries, and if their interests
are indefinite, the trustees shall distribute the trust per stirpes to those beneficiaries as
are descendants of the Grantor, or if no beneficiary is a descendant of the Grantor, to
those beneficiaries in equal shares.

       Trust Agreement does not include a provision regarding which state’s law will
govern the validity, construction or administration of Trust. Trust Agreement was
executed and initially administered in State 1. Section 8.09 provides whenever the
trustees consider it advantageous to the beneficiaries of any trust, the trustees may
transfer the situs of any trust and in so doing may appoint, as a successor trustee, any
person or corporation authorized under the laws of the United States or of any state to
administer trusts by a written instrument delivered to the successor.

       A Side Agreement executed on or before Date 2, by Child 1, as the income
beneficiary and individual co-trustee of Trust, and Corporate Trustee provided, among
other things, that the situs of Trust is State 2 and the laws governing the administration
of Trust shall be of State 2. The current trustees of Trust are Individual and
Corporate Trust (collectively, “Trustees”). By order of State 2 Court dated Date 3,
State 2 governs the administration of Trust and State 1 continues to govern matters
pertaining to the validity and construction of Trust Agreement and Trust.

       Child 1 died on Date 4, without a surviving spouse or living descendants.
Child 1’s will provides that all of Child 1’s assets are to be used for animal welfare and
makes no specific bequest or devise of her assets to any individual or trust. Child 1 did
not exercise her testamentary power of appointment over the assets of Trust in her will.

       Child 2 and Child 4 predeceased Child 1. Child 2 was survived by one biological
child, Grandchild 1, and two adopted children, Grandchild 2 and Grandchild 3.
Accordingly, under the terms of Trust Agreement, Grandchild 2 and Grandchild 3 are
descendants of Child 2. It is represented that the terms of the adoptions qualify
PLR-115077-15                                5

Grandchild 2 and Grandchild 3 as descendants of Child. In his will, Child 2 exercised
his testamentary power of appointment to distribute the assets of Child 2’s Child Trust to
a trust (“Family Trust”) for the benefit of Grandchild 1 and Child 2’s Widow. Counsel to
the trustees of the Family Trust represent that the Family Trust complies with the
requirements of Trust Agreement, including the limitations with respect to the interest of
Child 2’s Widow in the Family Trust. Grandchild 1 and Grandchild 2 have living
children.

       Child 4 was survived by Child 4’s Widow, Grandchild 4, Grandchild 5, and
Grandchild 6. The terms of Child 4’s will exercised his testamentary power of
appointment to distribute the assets of Child 4’s Child Trust to separate trusts for the
benefit of Child 4’s Widow, Grandchild 4, Grandchild 5, and Grandchild 6. Grandchild 4
and Grandchild 6 have living children.

       Child 1 failed to exercise her testamentary power of appointment over the assets
of Trust in her will. Trust Agreement is silent as to the distribution provisions of Trust
upon the death of Child 1 with no surviving spouse or descendants. Consequently, the
proper distribution of Trust assets under Trust Agreement is in issue. Trustees of
Trust 1 communicated with the representatives of the living descendants of Grantor and
trustees of the trusts that are potential beneficiaries under Trust regarding distributions
of the assets of Trust. The Trustees entered into arm’s length negotiations with the
potential beneficiaries. As part of the negotiations, the parties considered alternative
constructions of Trust Agreement. A Distribution Alternatives Schedule containing
several possible distribution alternatives was circulated among the parties. To date,
there are twenty-nine individuals representing the possible descendants of Grantor.

        On Date 5, the Trustees filed a petition with State 2 Court in order to preserve
claims concerning the proper distribution of Trust and to delineate the various issues
and the possible distribution schemes that may result from the resolution of the issues.
All interested parties, including the Attorneys General of State 1 and State 2, received
notice and service of process regarding the petition.

       Over the next two years, the parties entered into extensive negotiations, a
settlement was consummated, and the parties executed a Settlement Agreement and
Mutual Release, dated Date 6 (“Settlement Agreement”).

        The Settlement Agreement provides in relevant part: (1) the Settlement
Agreement is contingent upon approval by State 2 Court; (2) the Settlement Agreement
is contingent upon Trustees receiving a favorable private letter ruling from the
Internal Revenue Service that the termination of Trust and the distribution of the assets
of Trust pursuant to the terms of Settlement Agreement will not result in tax under the
provisions of chapter 13; (3) Grandchild 2 and Grandchild 3 will each receive outright
distributions from Trust equal to $x ($y in the aggregate); (4) the assets of Trust, after
payment to Grandchild 2 and Grandchild 3 and net of costs, will be distributed in five
PLR-115077-15                                  6

equal shares to the following: (i) Family Trust; (ii) Child 3’s Child Trust; (iii) Child 4’s
children, Grandchild 4, Grandchild 5, and Grandchild 6, further divided among them in
equal shares; (iv) Child 5’s Child Trust; and (v) Child 6’s Child Trust; and (5) neither
Child 2’s Widow nor Child 3’s Widow shall have any right or interest in any asset
distributed from Trust. On Date 7, State 2 Court entered an Order approving the
Settlement Agreement.

       It is represented that no additions (actual or constructive) have been made to
Trust since September 25, 1985.

      You have requested a ruling that termination of Trust and distributions of the
assets of Trust pursuant to the terms of the Settlement Agreement will not result in GST
tax under the provisions of Chapter 13 of the Code.

LAW AND ANALYSIS

       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) 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-115077-15                                  7


        Section 26.2601-1(b)(4)(B) provides that a court-approved settlement of a bona
fide issue regarding the administration of the trust or the construction of terms of the
governing instrument will not cause an exempt trust to be subject to the provisions of
chapter 13, if (1) the settlement is the product of arm’s length negotiations; and (2) the
settlement is within the range of reasonable outcomes under the governing instrument
and applicable state law addressing the issues resolved by the settlement. A settlement
that results in a compromise between the positions of the litigating parties and reflects
the parties’ assessments of the relative strengths of their positions is a settlement that is
within the range of reasonable outcomes.

       The trustees represent that Trust was irrevocable on September 25, 1985 and
that there were no additions to Trust after September 25, 1985. Accordingly, Trust is
exempt from GST tax.

       Under State 1 law, the construction of a will or trust is based on the intent of the
testator or settlor. See Citation 1. Where a trust is silent on a particular question in the
sense that it contains no express answer to the question, then a construction of the trust
is necessary. Citation 2.

       The parties were represented by separate counsel and the Settlement
Agreement was signed by the individual party or on behalf of his or her minor and
unborn descendants. Accordingly, the Settlement Agreement is a product of arm’s
length negotiations.

        In this case, the fact that Trust did not contain a distribution provision in the event
Child 1 died with no surviving spouse or descendants created a bona fide issue
regarding the construction of Trust. The parties considered various constructions of
Trust in order to reach a compromise regarding the distribution of the terminating
distributions of Trust. The terms of the Settlement Agreement are a compromise of the
parties’ respective adverse economic interests in Trust. State 2 Court approved the
Settlement Agreement. We conclude that the Settlement Agreement and State 2
Court Order represent a compromise between the positions of the litigating parties and
reflects the parties’ assessments of the relative strengths of their positions and therefore
is within the range of reasonable outcomes.

       Accordingly, based upon the facts provided and representations made, we
conclude that the requirements of § 26.2601-1(b)(4)(i)(B) are satisfied and rule that
termination of Trust and distributions of the assets of Trust pursuant to the terms of the
Settlement Agreement will not result in GST tax under the provisions of Chapter 13 of
the Code.
PLR-115077-15                                  8

       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.

      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 Associate Chief Counsel
                                       (Passthroughs & Special Industries)




Enclosures (2)
             Copy for section 6110 purposes
             Copy of this letter


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