Unitrust conversion preserved a grandfathered trust's GST exemption

Plain-English summary

A trust created by a decedent who died before December 26, 1985, remained exempt from generation-skipping transfer tax because it was irrevocable before the grandfathering date and had received no later additions. After moving the trust's situs, the trustee proposed replacing its income formula with a state-law unitrust percentage between three and five percent and adopting a statutory ordering rule for characterizing distributions. The local statute treated these changes as trust administration and provided a reasonable allocation between income and remainder beneficiaries. The IRS ruled that the changes would not shift a beneficial interest to a lower-generation beneficiary or extend the time for vesting. The trust therefore would retain its GST-exempt status. The ruling did not address gift tax or income tax consequences.

Ruling snapshot

• Question: Would the unitrust conversion and distribution-ordering rule cause the grandfathered trust to lose its GST exemption?
• Outcome: Approved: the trust retained exempt status.
• Key authorities: IRC § 2601; Treas. Reg. §§ 1.643(b)-1 and 26.2601-1(b)(1)(i) and (b)(4)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201825007                                              Third Party Communication: None
Release Date: 6/22/2018                                        Date of Communication: Not Applicable
Index Number: 2601.00-00
                                                               Person To Contact:
----------------------------------------------------------     ------------------------, ID No. --------------
---------------------------------------------                  Telephone Number:
---------------------------                                    ----------------------
------------------------------------                           Refer Reply To:
                                                               CC:PSI:04
         Re: -------------------------------                   PLR-129846-16
                                                               Date:
                                                               March 15, 2018


LEGEND

Decedent                            =        -----------------
Trust                               =        ------------------------------------------------------------------------
--------------------------------------------------------------------------------------
-------------------------------------------------------------------------
Daughter                            =        -------------------------
Grandchild 1                        =        ---------------------------------
Grandchild 2                        =        ------------------------------
Grandchild 3                        =        --------------------------------
GGC1                                =        ----------------------------
GGC 2                               =        ------------------------------
GGC 3                               =        -------------------------------
Trustee                             =        ---------------------------------------------
x                                   =        -----
y                                   =        ---------
Date 1                              =        --------------------
Date 2                              =        ------------------
Date 3                              =        ----------------------------
Court A                             =        -------------------------------------------------------------
Court B                             =        ------------------------------------------
State A                             =        -----------
State B                             =        --------------
State A Statute                     =        ------------------------------------------
State B Statute                     =        --------------------------------------------------------
State B Court                       =        ---------------------------------------
PLR-129846-16                                2

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

This letter responds to your representative’s letter of September 23, 2016, and other
correspondence, requesting a ruling concerning the generation-skipping transfer (GST)
tax consequences of proposed modifications to a trust.

FACTS

The facts and representations submitted are summarized as follows.

Decedent died testate on Date 1 (a date prior to December 26, 1985). Under
Paragraph Sixth of Decedent’s will, Decedent established Trust for the benefit of
Decedent’s daughter (Daughter) and her descendants.

Under Paragraph SIXTH (a) of the will, for so long as Daughter or any of Daughter’s
children then living survives, and for twenty-one years thereafter, all of the net Trust
income is to be paid one-half to Daughter during her life and the other one-half to
Grandchild 1, Grandchild 2, and Grandchild 3 and their issue until the last survivor of
Grandchild 1, Grandchild 2, and Grandchild 3 has died. Distributions are to be made
quarterly.

Under Paragraph SIXTH (b) of the will, on the death of the last survivor of Grandchild 1,
Grandchild 2, and Grandchild 3 (and after the death of Daughter), the Trust corpus is to
be divided into three equal shares and administered for twenty-one years as follows:
the income from one share is to be paid quarterly to the issue of Grandchild 1; the
income from the second part is to be paid quarterly to the issue of Grandchild 2; and the
income from the third part is to be paid quarterly to the issue of Grandchild 3. On the
expiration of the twenty-one years, the trustees are to sell the Trust corpus and divide
the proceeds into three equal shares and pay one share to the issue of Grandchild 1,
one share to the issue of Grandchild 2, and one share to the issue of Grandchild 3. In
the event of the death of all three of Decedent’s grandchildren without leaving issue,
Trust is to be reduced to cash and paid to Decedent’s heirs in accordance with the
statute of descent and distribution.

Trust was initially administered in State A. On Date 2, Court A (in State A) signed a
final order modifying the method of determining Trust income. Under the modification,
Paragraph SIXTH (a) and (b) provides that the annual distribution amount to be paid by
the trustees (during the Trust term) is to be an amount equal to the greater of the Trust’s
annual net income or x percent of the Trust’s total value as determined on the first day
of each year. In all other respects, the provisions of the modified Trust are identical to
those of the original Trust. The court order referred to State A Statute as the basis for
the modification. The Date 2 order was contingent on receipt of a ruling from the
PLR-129846-16                                  3

Internal Revenue Service that the modification will not cause Trust to lose its exempt
status for purposes of the GST tax under § 2601 of the Internal Revenue Code (Code),
which ruling was issued on Date 3.

Subsequently, the situs of Trust was changed to State B. Trustee, a corporate trustee,
is the current trustee. Trustee seeks to modify the method of determining Trust income,
as authorized by and in accordance with State B Statute. Under the proposal,
Paragraph SIXTH (a) and (b) will provide that the annual distribution amount to be paid
by the trustees (during the Trust term) is to be an amount equal to y percent of Trust’s
total value, as determined on the first day of each year, i.e., a y percent unitrust amount.

Trustee also seeks to provide an ordering rule for determining the character of annual
Trust distributions, for income tax purposes, in accordance with State B Statute. Under
the ordering rule, distribution amounts made from Trust will be considered paid from the
following sources in order of priority: (1) from net accounting income determined as if
Trust were not a unitrust, (2) from ordinary income not allocable to net accounting
income, (3) from net realized short-term capital gain and then from net realized long-
term capital gain, and (4) from principal.

In all other respects, the terms of Trust will be identical to those of the original Trust. It
is represented that no additions or contributions have been made to Trust after
September 25, 1985.

Presently, Daughter, Grandchild 2, and Grandchild 3 are deceased. Grandchild 2 is
survived by three children (GGC 1, GGC 2, and GGC 3). Grandchild 3 died without
issue. Grandchild 1 is living and has no issue.

You have asked us to rule that the modification of the method of determining Trust
income and the adoption of an ordering rule, as proposed, will not cause Trust to lose
its exempt status for GST tax purposes under § 2601.

LAW AND ANALYSIS

Section 2601 of the Code imposes a tax on every GST, which is defined under § 2611
as a taxable distribution, a taxable termination, and a direct skip.

Under § 1433 of the Tax Reform Act of 1986 (the Act), 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) of the Generation-Skipping Transfer Tax Regulations,
the tax does not apply to a transfer under a trust that was irrevocable on September 25,
1985, except to the extent the transfer is made out of corpus added to the trust by an
actual or constructive addition after September 25, 1985.
PLR-129846-16                                 4

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 GST tax 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 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.

Section 26.2601-1(b)(4)(i)(D)(2) provides that, for purposes of § 26.2601-1(b)(4)(i)(D), 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.
PLR-129846-16                                  5

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. Example 10 concludes that 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 in the original trust. Therefore, the trust will not be
subject to the provisions of chapter 13.

Section 26.2601-1(b)(4)(i)(E), Example 11, considers the following situation. In 1980,
Grantor, a resident of State X, established an irrevocable trust for the benefit of
Grantor’s child, A, and A’s issue. The trust provides that trust income is payable to A for
life and upon A’s death the remainder is to pass to A’s issue, per stirpes. In 2002,
State X 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. For a trust
established prior to 2002, the statute provides that the new definition of income will
apply only if all the beneficiaries who have an interest in the trust consent to the change
within two years after the effective date of the statute. The statute provides specific
procedures to establish the consent of the beneficiaries. A and A’s issue consent to the
change in the definition of income within the time period, and in accordance with the
procedures, prescribed by the state statute. For GST tax purposes, Example 11
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 any
beneficial interest in the trust. Therefore, the trust will not be subject to the provisions of
chapter 13 of the Code. This conclusion would be the same if the beneficiaries’ consent
was not required, or, if the change in administration of the trust was changed to State X
from a state whose statute does not define income as a unitrust amount or if the situs
was changed to such a state from State X.

Section 1.643(b)-1 of the Income Tax Regulations provides, in part, that “income,” when
not preceded by the words “taxable,” “distributable net,” “undistributed net,” or “gross,”
means the amount of income of an estate or trust for the taxable year determined under
the terms of the governing instrument and applicable local law. 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. A switch between methods of determining trust income authorized by state
PLR-129846-16                                 6

statute will not constitute a recognition event for purposes of § 1001 and will not result in
a taxable gift from the trust’s grantor or any of the trust’s beneficiaries. 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 and may result
in taxable gifts from the trust’s grantor and beneficiaries, based on the relevant facts
and circumstances. This section is effective for taxable years of trusts and estates
ending after January 2, 2004.

Under State B Statute, a trustee, other than an interested trustee may, in its sole
discretion and without the approval of State B Court, convert an income trust to a total
return unitrust, reconvert a total return unitrust to an income trust, or change the
percentage used to calculate the unitrust amount in a total return unitrust. A “total
return unitrust” is defined as an income trust that has been converted under State B
Statute or the laws of any other jurisdiction that permits an income trust to be converted
to a trust in which a unitrust amount is treated as the net income of the trust. State B
Statute further provides that the percentage to be used in determining the unitrust
amount shall be a reasonable current return from the trust, in any event not less than
3 percent nor more than 5 percent of the fair market value of the trust. The fair market
value of the trust shall be determined at least annually, using such valuation date or
dates or averages of valuation dates as are deemed appropriate. State B Statute
further provides that the trustee shall consider the unitrust amount as paid first from net
accounting income determined as if the trust were not a unitrust, then as paid from
ordinary income not allocable to net accounting income, then as paid from net short-
term capital gain and then from net long-term capital gain, and finally as coming from
trust principal. State B Statute provides that it shall be construed as pertaining to the
administration of a trust.

In this case, Trustee proposes to switch methods of determining Trust income. Under
the proposed method, the annual distribution amount will be a unitrust amount of
y percent of Trust’s total value, which is an amount no less than 3 percent and no more
than 5 percent of the trust assets. The administration of Trust as proposed is
specifically authorized by and in conformance with State B Statute (the applicable local
law), which provides for a reasonable apportionment between the income and
remainder beneficiaries and otherwise meets the requirements of § 1.643(b)-1.
Accordingly, under § 26.2601-1(b)(4)(i)(D)(2), we conclude that the administration of
Trust using the proposed method of determining Trust income will not be considered to
shift a beneficial interest in the trust for GST tax purposes. See § 26.2601-1(b)(4)(i)(E),
Example 11. Furthermore, we conclude that the proposed ordering rule, which is
administrative in nature and specifically applies to trusts administered under State B
Statute, will not shift a beneficial interest 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. See § 26.2601-1(b)(4)(i)(E), Example 10. Additionally,
neither the switch in methods of determining trust income nor the adoption of the
PLR-129846-16                                  7

proposed ordering rule will extend the time for vesting of any beneficial interest in the
trust beyond the period provided for in the original trust. Accordingly, we conclude that
the modification of the method of determining Trust income and the adoption of an
ordering rule, as proposed, will not cause Trust to lose its exempt status for GST tax
purposes under § 2601.

Except as expressly provided herein, no opinion is implied or expressed concerning the
federal tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. We are not ruling with regard to any gift tax or income tax
consequences of the proposed modification and administration of Trust.

This ruling is directed only to the taxpayers 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 representatives.

The ruling contained in this letter is 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,


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


Enclosures:
      Copy for § 6110 purposes
      Copy of this letter




cc: