In Private Letter Ruling 201429009 (released July 18, 2014), the Internal Revenue Service concluded that the value of assets held in a family trust aren’t includible in a decedent’s gross estate, except for the value of a “5 or 5” power held by a decedent at his death.
The Trust’s Terms
A decedent and his spouse created a joint revocable trust. The spouse predeceased the decedent, leaving behind the decedent, their son, daughter and four grandchildren. Article 4 of their joint revocable trust provided that during their lives, the trustee shall pay income and principal of each trustor’s share as directed by the decedent or his spouse. It also provide that while they were alive, they each would hold a power to revoke their share. After one of them died, the surviving spouse could amend any trust share over which he had a general non-lapsing power of appointment (POA) over principal, except for retirement benefits. Article 3 provided that as to property transferred to a trustee while they were both alive, they would hold the trust estate as tenants in common. Each spouse would own a separate share of an undivided, one-half beneficial interest.
On a certain date, the decedent and his spouse entered into a property agreement, in which they agreed that all joint tenancy property that would be transferred to the trust would be characterized as tenants in common, rather than as joint tenancy. Article 7 provided that on the date of the first spouse to die, the trustee shall distribute the remaining trust estate into two separate shares: a survivor’s share, which would consist of the surviving spouse’s separate share and be deemed the “surviving trust,” and a family share, deemed the “family trust,” which would consist of all assets of the decedent’s separate share not distributed to the survivor’s share. Under Article 8, the trustee must pay at least annually, the net income of the survivor’s trust, as the surviving spouse directs. Any undistributed net income from the survivor’s trust must be added to principal. The trustee must also pay to the surviving spouse principal of the surviving trust for the surviving spouse’s comfort, welfare and happiness. The trustee must also pay to the surviving spouse any principal that the surviving spouse directs.
When the surviving spouse dies, the trustee must distribute principal, accrued income and undistributed income, to any person or entity that the now-deceased spouse directed through his will or living trust. No exercise of this general POA would be effective unless it referred to the trust agreement and indicated an intention to exercise the general POA.
With regard to the family trust, under Article 9, the trustee must pay at least annually, net income to the surviving spouse, as the trustee deems proper for the surviving spouse’s health, education, maintenance and support. The decedent and his spouse had previously recommended that the trustee first exhaust principal from the survivor’s trust before making discretionary payments of principal to the surviving spouse from the family trust.
Each calendar year, the surviving spouse would have the power to withdraw principal from the family trust, not to exceed the greater of $5,000 or 5 percent of the assets of the family trust (the 5 or 5 power). Article 11, which applies only after both spouses had died, provides that on the death of the surviving spouse, a trustee must divide into specified amounts both the survivor’s trust and the family trust, into separate shares for the couple’s daughter, son and grandchildren. The trustee of the son’s share was to distribute to him all the net income and principal free of trust. The trustee of the daughter’s share was to distribute income and principal for the daughter’s health, education, maintenance and support. Net income not distributed must be accumulated and combined with the principal. On the daughter’s death, the trustee must distribute the balance to the daughter’s then-living descendants per stirpes.
With regard to each grandchild’s share, the trustee shall distribute income and principal for each grandchild’s health and education. Any income not distributed will accumulate and be added to principal. When any beneficiary becomes 30 years old, the trustee shall distribute the accumulated income and principal to that beneficiary, free of trust. If a grandchild died prior to distribution of his share, the trustee shall distribute the balance of the trust share to that beneficiary’s then-living decedent per stirpes.
Funding of the Trusts
The decedent’s spouse predeceased him, and the decedent became the sole trustee and beneficiary of the surviving trust and the family trust. He was thus able to withdraw income and principal as he wished and possessed a testamentary general POA over the survivor’s trust. Under the family trust, the decedent could receive distributions of income and principal limited to an ascertainable standard of health, education, maintenance and support. The decedent also held the lapsing 5 or 5 power over family trust principal. The family trust became irrevocable on the decedent’s spouse’s death; the survivor’s trust remained revocable.
Under the joint revocable trust, the survivor’s trust should have been funded with the decedent’s 50 percent beneficial interest as a tenant in common, and the family trust should have been funded with his spouse’s 50 percent beneficial interest as a tenant in common. After the decedent’s spouse had died, however, a law firm incorrectly advised the decedent that the survivor’s trust wouldn’t be funded from the family trust and that 100 percent of the trust assets remained as the family trust. As a result, the decedent failed to segregate the assets of the survivor’s trust and the family trust and instead, administered them both as a combined trust. He bought securities, reinvested dividends and retained holdings indefinitely.
The decedent then retained a new law firm that advised him that he’d been incorrectly funding and administering the trusts. The decedent took corrective measures to allocate assets to the survivor’s trust and to the family trust. The decedent distributed income and principal from the survivor’s trust and the family trust and properly reported distributions on his individual federal and state income tax returns.
The decedent’s executors now ask the IRS to rule that the value of the assets of the family trust aren’t includible the decedent’s gross estate, except for his 5 or 5 power. The IRS granted such a ruling.
The Gross Estate
Internal Revenue Code Sections 2036(a) and 2038(a)(1) determine which property shall be included in a decedent’s gross estate. Under IRC Section 2041(a)(2), the value of a gross estate includes property over which a decedent has a general POA at the time of his death. In the instant case, the IRS looked to Revenue Ruling 78-74, 1978-1 C.B. 287, Estate of Kinney v. Commissioner, 39 T.C. 728 (1963) and Estate of Bell v. Comm’r, 66 T.C. 729 (1976), to ascertain whether the value of the assets of the family trust are includible in the decedent’s gross estate. The IRS noted that the Bell court considered two principles when determining the value of a portion of a trust includible in a decedent’s gross estate: 1) where property transferred by several grantors to a trust is commingled with other property and can’t be identified, a proportionate formula may be appropriate; and 2) if specific property transferred by a decedent is capable of identification, the value of such specified property should be included in the gross estate.
In the instant case, the assets of the survivor’s trust and the family trust weren’t properly segregated after the spouse’s death. Rather, the assets were administered as a combined trust. The decedent, as both trustee of the survivor’s trust and the unlimited income and principal beneficiary, could amend the survivor’s trust during his lifetime. He also held a non-lapsing general POA over its assets. With regard to the family trust, the decedent was the trustee and income and principal beneficiary, as limited by an ascertainable standard. He also held a 5 or 5 power over the family trust assets. Before the decedent’s death, however, he took corrective measures as trustee to properly allocate assets of the survivor’s trust and the family trust. The IRS found that through a forensic review of the historical financial records, the decedent was able to ascertain and track the assets that should have been allocated to the family trust at his spouse’s death. Therefore, the IRS determined that the value of the family trust assets aren’t includible in the decedent’s gross estate, except for the value of the 5 or 5 power held by the decedent at his death.