Trustee replacement preserved GST status and avoided a general power

Plain-English summary

A beneficiary and individual trustees settled litigation over the administration of a pre-1985 irrevocable trust by appointing a bank as sole trustee and revising trustee succession procedures. Adult distributees could remove and replace the corporate trustee, but any replacement had to meet asset-management requirements and could not be related or subordinate to them. The IRS treated the changes as administrative modifications that did not shift beneficial interests or extend vesting, so the trust retained its exemption from generation-skipping transfer tax. Because distributions remained limited by a health, education, support, or maintenance standard, the beneficiaries' trustee-removal power did not create a general power of appointment under section 2041. The trust also could deduct reimbursed litigation expenses under section 212, subject to allocation for tax-exempt income, without treating them as section 661 distributions or section 662 beneficiary income.

Ruling snapshot

• Question: Did the court-approved trustee replacement affect the trust's GST status, create general powers of appointment, or change the treatment of reimbursed legal fees?
• Outcome: Approved.
• Key authorities: IRC §§ 212, 2041, 2601, 2611, and 2612; Treas. Reg. §§ 20.2041-1 and 26.2601-1.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201642027
Third Party Communication: None
Release Date: 10/14/2016
Date of Communication: Not Applicable
Index Number: 2601.03-01, 2501.01-00,
2041.03-00
Person To Contact:
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Refer Reply To:
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CC:PSI:B04
PLR-141552-15
Date:
June 22, 2016
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Legend

Husband = ------------------
Wife = -------------------
Grandchild 1 = ---------------------------------------------------
Grandchild 2 = ------------------------------------------------------------
Grandchild 3 = ---------------------------------------------------------------
Grandchild 4 = -------------------------------------
Daughter = ------------------------------------------------------------------
Trust 1 = ---------------------------------------------------------
Trust 2 = -----------------------------------------------------
Trust 3 = ------------------------------------------------------------
Trust 4 = -----------------------------------------------------------------------
Trust 5 = ----------------------------------------------------
Year = --------
State = ----------
State Court = -----------------------------------------------------------------------------
Settlement = ---------------------------------------------------
Agreement
-------------------------------------------------
State Statute = -----------------------------------------------------------------------
a = ------------------
Individual 1 = ----------------------
Individual 2 = ---------------------------
Individual 3 = -----------------------------
Individual 4 = -------------------------------
Individual 5 = -------------------------
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Individual 6 = --------------------------
Bank = ------------------
Date 1 = ---------------------------
Date 2 = --------------------------
Date 3 = ---------------------------
Date 4 = ------------------

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

This letter responds to your authorized representative’s letter dated December 7, 2015, requesting income, gift, estate, and generation-skipping transfer (GST) tax rulings with respect to the proposed modifications of Trust 4.

The facts and representations submitted are summarized as follows:

On Date 1, a date prior to September 25, 1985, Husband and Wife created five irrevocable trusts with substantively similar terms for different beneficiaries. Trust 1 was created for the primary benefit of Grandchild 1, Trust 2 was created for the primary benefit of Grandchild 2, Trust 3 was created for the primary benefit of Grandchild 3, Trust 4 was created for the primary benefit of Daughter, and Trust 5 was created for the primary benefit of Grandchild 4. This ruling pertains only to Trust 4.

Article I of Trust 4 provides that the trustees are to pay to or for the benefit of Daughter so much of the net income from Trust 4 as the trustees in their sole discretion shall determine to be necessary and desirable to provide for the health, education, maintenance, and support (HEMS) of said beneficiary. In the event that net income is not sufficient to provide for the health, education, maintenance, and support of said beneficiary, then the trustees may use such part of the principal as, from time to time, in their sole discretion, they may determine to be necessary for such purposes.

Article II of Trust 4 provides that upon the death of Daughter, the trustees are to pay to or for the benefit of the issue of Daughter such part of the net income from Trust 4 as the trustees in their sole discretion shall determine to be necessary and desirable to provide for the health, education, maintenance, and support of such issue. In the event that the trustees determine that the net income is not sufficient to provide for the health, education, maintenance, and support of any one or more of such issue, then the trustees may use such part of the principal as, from time to time, in their sole discretion, they may determine to be necessary for such purposes.

Article III of Trust 4 provides that in the event that Daughter and all issue of Daughter shall die prior to the final distribution of Trust 4 properties, the remaining Trust 4 properties, principal, and any accumulated income, shall be paid over and
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delivered in equal shares among the other trusts (Trust 1, Trust 2, Trust 3, and Trust 5) then in existence.

Article XII of Trust 4 provides that Trust 4 will terminate 21 years after the last to die of Grandchild 1, Grandchild 2, Grandchild 3, Daughter, or Grandchild 4. Upon termination, all of the properties remaining in Trust 4 shall be distributed to the then-living beneficiaries of Trust 4, share and share alike.

Trust 4 appoints seven initial individual trustees and Article VIII of Trust 4 identifies seven successor individual trustees of Trust 4. Article VIII of Trust 4 additionally provides that when fewer than four trustees are currently serving, the remaining trustees shall have the power and authority to appoint one or more individuals as trustees, so that at least four and not more than seven individuals may serve as trustees. Further, Article VIII of Trust 4 grants the trustees then serving the power to appoint a bank as successor trustee, to serve thereafter as the sole trustee.

Grandchild 4 died in Year without issue. Pursuant to the terms of Trust 5, the assets remaining after the death of Grandchild 4 were distributed equally among Trust 1, Trust 2, Trust 3, and Trust 4.

On Date 2, Daughter petitioned State Court, pursuant to State Statute, to modify Trust 4, specifically requesting the appointment of a corporate trustee to replace the six individual trustees then serving. The six individual trustees then serving (Individual 1, Individual 2, Individual 3, Individual 4, Individual 5, and Individual 6) also served as co-trustees of Trust 1, Trust 2, Trust 3, and Trust 4. Grandchild 1, Grandchild 2, and Grandchild 3 also filed petitions to modify the respective trust of which each is a beneficiary, and similarly requested the appointment of a corporate trustee. The petitions allege that the six individual trustees then serving failed to sufficiently communicate with the beneficiaries of the trusts concerning the investment strategies for each of the respective trusts and the respective beneficiary’s needs in relation to his or her health, education, support, and maintenance. In addition, the petitions filed by Grandchild 1, Grandchild 2, and Grandchild 3 allege that the six individual trustees then serving failed to sufficiently diversify trust assets and made questionable investments despite the potential for conflicts of interests. The six individual trustees then serving denied the allegations in the petitions and opposed the request to appoint a corporate trustee for each trust.

After an extended period of negotiations, including mediation, Grandchild 1, Grandchild 2, Grandchild 3, Daughter, and the six individual trustees entered into Settlement Agreement, which State Court approved by order dated Date 3. Settlement Agreement is contingent on the receipt of favorable rulings from the Internal Revenue Service.
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Settlement Agreement provides that Bank will be appointed to serve as the sole corporate trustee of Trust 4. In addition, Settlement Agreement provides that Trust 1, Trust 2, and Trust 3 will each be divided into two resulting trusts, with Bank serving as the sole corporate trustee of one successor trust, and Individual 1, Individual 2, and Individual 3 serving as trustees of the other successor trust.

Settlement Agreement provides that the trustee provision of Trust 4 will be modified to provide the “distributees” of Trust 4, upon application to and order of State Court at State Court’s discretion, the power to remove at any time and without cause any then-serving corporate trustee of Trust 4 by written notice delivered to such trustee, and the power to replace such trustee with another corporate trustee that—(1) has the power to act as a trustee under the laws of the state governing the administration of the trust; (2) has at least $a in assets under management; and (3) is not related or subordinate, within the meaning of § 672(c), to the “distributees” of Trust 4. Further, the trustee provisions of Trust 4 will be modified to provide the “distributees” of Trust 4, in the event the then-serving corporate trustee resigns or can no longer serve as trustee, the power to appoint a successor corporate trustee, without application to and approval by State Court, that—(1) has the power to act as a trustee under the laws of the state governing the administration of the trust; (2) has at least $a in assets under management; and (3) is not related or subordinate, within the meaning of § 672(c), to the “distributees” of Trust 4. The term “distributees” refers to a majority of the competent adult beneficiaries who are at the time authorized to receive distributions of principal or income from the trust.

Settlement Agreement modifies Trust 4 by adding provisions that address the trustees’ administration of the trust, including a provision regarding the trustee’s communications with beneficiaries.

Under Settlement Agreement, attorneys’ fees and expenses incurred by the trustees and beneficiaries relating to the litigation and the Settlement Agreement will be paid or reimbursed by Trust 1, Trust 2, Trust 3, and Trust 4. The direct payments and reimbursements shall be made from each of Trust 1, Trust 2, Trust 3, and Trust 4, pro rata, in relation to the total value of each trust.

Daughter died on Date 4, a date after State Court’s order approving Settlement Agreement.

You represent that no other additions have been made to Trust 4 since September 25, 1985.

You have requested the following rulings:

1. The modification of Trust 4 pursuant to Settlement Agreement will not cause
   Trust 4 to be subject to the provisions of chapter 13.
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2. None of the powers granted to any of the beneficiaries of Trust 4 will cause the
   assets of Trust 4 to be included in any beneficiary’s gross estate under
   § 2041(a).

3. A payment by Trust 4 to a beneficiary of Trust 1, Trust 2, Trust 3, Trust 4, or one
   of the resulting divided trusts as reimbursement for the beneficiary’s prior
   payment of attorney’s fees and expenses will not result in a deduction under
   § 661 for the reimbursing trust or gross income to the recipient beneficiary under
   § 662, but such payment will result in a deduction for the reimbursing trust under
   § 212.

Ruling 1

Section 2601 imposes a tax on every GST made after October 26, 1986. A GST is defined under § 2611(a) as (1) a taxable distribution, (2) a taxable termination, and (3) a direct skip.

Section 2612(a) provides that the term “taxable termination” means a termination (by death, lapse of time, release of a power, or otherwise) of an interest in property held in a trust unless (A) immediately after such termination, a non-skip person has an interest in such property, or (B) at no time after such termination may a distribution (including distributions on termination) be made from such trust to a skip person.

Section 2612(b) provides that the term “taxable distribution” means any distribution from a trust to a skip person (other than a taxable termination or a direct skip).

Under § 2612(c)(1), a direct skip is a transfer subject to federal estate or gift tax of an interest in property to a skip person.

Under § 1433(a) of the Tax Reform Act of 1986 (Act) and § 26.2601-1(a) of the Generation-Skipping Transfer Tax Regulations, the GST tax is generally applicable to GSTs made after October 22, 1986. However, under § 1433(b)(2)(A) of the Act and § 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 such 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 § 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.

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
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is exempt from the GST 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 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 § 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 § 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 § 26.2601-1, 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.

Section 26.2601-1(b)(4)(i)(E), Example 10 considers the following situation. In 1980, Grantor established an irrevocable trust for the benefit of Grantor's issue, naming a bank and five other individuals as trustees. In 2002, the appropriate local court approves a modification of the trust that decreases the number of trustees which results in lower administrative costs. The modification pertains to the administration of the trust and 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. In addition, the modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for
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in the original trust. Therefore, the trust will not be subject to the provisions of chapter 13.

In the present case, Trust 4 became irrevocable prior to September 25, 1985.
The trustee represents that there have been no additions, actual or constructive, to Trust 4 after September 25, 1985.

With regard to the proposed modifications of Trust 4, we conclude:

a. The modification of Trust 4 pursuant to the terms of Settlement Agreement to provide for a change in trustee and to modify the trustee succession procedures is viewed as pertaining to the administration of the trust, comparable to the administrative modification in Example 10 of § 26.2601-1(b)(4)(i)(E).

b. In addition, all other terms and trust modifications set forth in Settlement Agreement (including the trustee procedures regarding HEMS distributions, the payment of attorneys’ fees, and trustee communications with beneficiary) are viewed as administrative in nature and, under § 26.2601-1(b)(4)(i)(D)(2), will not be considered to shift a beneficial interest to a lower generation in the trust or extend the time for vesting of any beneficial interest in the trust beyond the period provided for in Trust 4.

Accordingly, based upon the facts submitted and the representations made, we further conclude that after the modification of Trust 4 pursuant to Settlement Agreement, Trust 4 will not be subject to the provisions of chapter 13.

Ruling 2

Section 2041(a)(2) provides that the value of the gross estate shall include the value of all property to the extent of any property with respect to which the decedent has, at the time of his death, a general power of appointment created after October 21, 1942, or with respect to which the decedent has at any time exercised or released a power of appointment by a disposition that is of such nature that if it were a transfer of property owned by the decedent the property would be includible in the decedent's gross estate under §§ 2035 to 2038, inclusive.

Section 2041(b)(1) provides that a general power of appointment is a power that is exercisable in favor of the decedent, the decedent's estate, the decedent's creditors, or the creditors of the decedent's estate. However, a power to consume, invade, or appropriate property for the benefit of the decedent that is limited by an ascertainable standard relating to the health, education, support, or maintenance of the decedent shall not be deemed a general power of appointment.
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Section 20.2041-1(b)(1) of the Estate Tax Regulations provides, in part, that a donee may have a power of appointment if he has the power to remove or discharge a trustee and appoint himself. For example, if under the terms of the instrument, the trustee or his successor has the power to appoint the principal of the trust for the benefit of individuals including himself, and the decedent has the unrestricted power to remove or discharge the trustee at any time and appoint any other person including himself, the decedent is considered as having a power of appointment. However, the mere power of management, investment, custody of assets, or the power to allocate receipts and disbursements as between income and principal, exercisable in a fiduciary capacity, whereby the holder has no power to enlarge or shift any of the beneficial interests therein except as an incidental consequence of the discharge of the fiduciary duties is not a power of appointment.

Rev. Rul. 95-58, 1995-2 C.B. 191, holds that a decedent/grantor's reservation of an unqualified power to remove a trustee and to appoint an individual or corporate successor trustee that is not related or subordinate to the decedent within the meaning of § 672(c), is not considered a reservation of the trustee's discretionary powers of distribution over the property transferred by the decedent/grantor to the trust. Accordingly, the trust corpus is not included in the decedent's gross estate under § 2036 or § 2038. The ruling notes that the Eighth Circuit in Estate of Vak v. Commissioner, 973 F.2d 1409 (8th Cir. 1992), concluded that the decedent had not retained dominion and control over assets transferred to a trust by reason of his power to remove and replace the trustee with a party that was not related or subordinate to the decedent. Accordingly, the court held that under § 25.2511-2(c), the decedent made a completed gift when he created the trust and transferred assets to it.

Section 672(c) defines the term "related or subordinate party" to mean any nonadverse party who is (1) the grantor's spouse if living with the grantor; or (2) any one of the following: the grantor's father, mother, issue, brother or sister; an employee of the grantor; a corporation or any employee of a corporation in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; a subordinate employee of a corporation in which the grantor is an executive.

In this case, the beneficiaries will have an increased ability to remove and replace the trustee after the modification of Trust 4. The distributees of Trust 4 can replace the corporate trustee with another corporate trustee. The trustee’s power to invade income and corpus of the trust to distribute funds to the beneficiaries is limited by an ascertainable standard relating to the health, education, support, or maintenance of the beneficiaries. Therefore, the power that the trustee has cannot be classified as a general power of appointment. Accordingly, based on the facts submitted and the representations made, we conclude that none of the powers granted to any of the beneficiaries of Trust 4 will cause the assets of any such trust to be included in any beneficiary’s gross estate under § 2041(a).
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Ruling 3

Section 212(2) states that in the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the year for the management, conservation, or maintenance of property held for the production of income.

Section 1.212-1(i) of the Income Tax Regulations provides, in part, that reasonable amounts paid or incurred by the fiduciary of a trust on account of administration expenses, including expenses of litigation, which are ordinary and necessary in connection with the performance of duties of administration are deductible under § 212, notwithstanding that the trust is not engaged in a trade or business, except to the extent that the expenses are allocated to the production or collection of tax-exempt income.

Section 265(a)(1) provides that expenses that are directly allocable to any class or classes of tax-exempt income shall be allocated to the tax-exempt income. The regulations further provide that if an expense otherwise allocable is indirectly allocable to both nonexempt and exempt income, then a reasonable proportion is allocated to each considering the particular facts and circumstances.

Whether legal fees are deductible expenses under § 212, or are capital expenses under § 263, requires an examination of the origin of the claim giving rise to the legal fees. That analysis requires that prior transactions be examined in order to determine if a cause of action originates from an ordinary or capital event. The origin of the claim doctrine was established by U.S. v. Gilmore, 372 U.S. 39, 49 (1963).

Section 263(a)(1) provides generally that no deduction is allowed for any amount paid out for new buildings or for permanent improvements or betterments. See § 1.263(a)-1(a)(1), 1.263(a)-2(a), 1.263(a)-2(h), and 1.263(a)-4 of the Income Tax Regulations.

The Supreme Court has stated that determining whether an expenditure is a current expense or a capital expenditure entails a facts and circumstances analysis with material distinctions being of degree and not of kind. In Commissioner v. Lincoln Savings & Loan Ass’n, 403 U.S. 345, 354 (1971), the Court stated that a “payment that serves to create or enhance . . . a separate and distinct additional asset” is a capital expenditure. Accordingly, the capitalization rules were initially understood to require that expenditures be capitalized only if they resulted in separate and distinct assets. However, in INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 86-87 (1991), the Court clarified Lincoln Savings by stating that creation of a separate and distinct asset is a sufficient, but not a necessary, condition to classification as a capital expenditure. In INDOPCO, the Court established the future benefit test, and stated that a taxpayer's realization of benefits beyond the year in which the expenditure is incurred is undeniably
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important in determining whether the appropriate tax treatment is immediate deduction or capitalization.

Section 1.263(a)-4 provides rules for applying § 263 to amounts paid to acquire or create intangibles. Section 1.263(a)-4(b)(1) provides that, except as otherwise provided in § 1.263(a)-4, a taxpayer must capitalize an amount paid to: (i) acquire an intangible (see § 1.263(a)-4(c)); (ii) create an intangible described in § 1.263(a)-4(d); (iii) create or enhance a separate and distinct intangible asset within the meaning of § 1.263(a)-4(b)(3); (iv) create or enhance a future benefit identified in the Federal Register or the Internal Revenue Bulletin as an intangible for which capitalization is required; and (v) facilitate (as defined in § 1.263(a)-4(e)(1)) the acquisition or creation of an intangible.

Section 1.263(a)-4(d)(2) provides, in relevant part, that a taxpayer must capitalize amounts paid to another party to create, originate, enter into, renew or renegotiate with that party any ownership interest in a corporation, partnership, trust, estate, limited liability company or other entity.

Legal fees relating to the proper investment of trust assets are a function of the management of the trust property and are deductible if they are ordinary and necessary. Trust of Bingham v. Commissioner, 325 U.S. 365, 376 (1945). In Herman A. Moore Trust v. Commissioner, 49 T.C. 430 (1968), acq., 1968-2 C.B. 21, the Service challenged the trustee’s deduction of certain attorneys’ fees in computing the trust’s income. These fees arose from an action brought by the testator’s children to accelerate their beneficial interests in the trust. Pursuant to state law, the court ordered that the attorneys’ fees for the trust, the beneficiaries and the guardian ad litem be paid from trust income. The court decided that (1) the state court decision aided the trustee in its management of the trust property, and (ii) the trust benefitted by the involvement of the beneficiaries and the guardian ad litem in the litigation. Thus, the court held that all of the litigants’ attorneys’ fees paid from trust income were deductible under § 212(2).

In the present case, the legal fees paid by beneficiaries seeking to change the trustee of the trust are not payments to acquire, create, or facilitate the acquisition or creation of an intangible. The litigation involved only the proper administration of the trust and not the beneficiaries’ ownership interests in the trust. The beneficiaries already had an ownership interest in the trust and were not seeking a redetermination of that ownership interest, but rather, merely a change in the administration of the trust. Therefore the legal fees are not subject to capitalization under § 1.263(a)-4.

Based on the facts submitted and the representations made, we conclude that the purpose of the action brought by the beneficiaries was to change the trustee and to improve the investment of the assets of the trust. Further, the trust benefited by the involvement of the beneficiaries in the proceedings. Thus, subject to allocations under
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§ 1.265-1, we conclude that the attorneys’ fees paid by Trust 4 to a beneficiary of Trust 1, Trust 2, Trust 3, Trust 4, or one of the resulting divided trusts pursuant to Settlement Agreement as reimbursement for the beneficiary’s prior payment of attorney’s fees and expenses will result in a deduction for the reimbursing trust under
§ 212. Since the attorney’s fees and expenses are deductible under § 212, it is implicit that those expenses are not deductible under § 661 or includible by the beneficiaries under § 662.

In accordance with the Power of Attorney on file with this office, we have sent a copy of this letter to your authorized representatives.

Except as expressly provided herein, we neither express nor imply any opinion concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter.

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.

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

Sincerely,

Karlene M. Lesho
Karlene M. Lesho
Senior Technician Reviewer, Branch 4
Office of the Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosures
Copy for § 6110 purposes
Copy of this letter

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