Sixth Circuit upholds “constructive addition” generation-skipping transfer (GST) tax regulations
In Estate of Timken, 105 A.F.T.R. 2010-1347 (April 2, 2010), the U.S. Court of Appeals for the Sixth Circuit upheld the “constructive addition” regulations under IRC Section 2601 and held that the lapse of a general power of appointment (GPA) over a trust that was grandfathered from GST tax constituted a constructive addition to the trust.
Henry Timken's will created a trust. Henry had granted his surviving wife, Louise, a GPA over the trust, but Louise didn't exercise the power. On Louise's death, in default of her exercising the GPA, the trust property was to be divided and retained in trusts for the benefit of Henry's nieces and nephews. Some of Henry's nieces and nephews disclaimed their interests in the trust property, causing their shares to be divided among Henry's grandnieces and grandnephews. Louise's estate took the position that the trust was grandfathered for GST tax purposes and the transfers to trusts for Henry's grandnieces and grandnephews weren't subject to GST tax. The IRS disagreed and issued a notice of deficiency of over $4 million in GST taxes to Louise's estate, which it paid before suing for a refund.
IRC Section 2601 doesn't impose GST tax on a GST under a trust that was irrevocable on Sept. 25, 1985, as long as the transfer isn't made from corpus “added” to the trust after that date. Treas. Regs. Section 26.2601-1(b) provides that if a person releases, exercises or allows the lapse of a power of appointment after Sept. 25, 1985 and such release, exercise or lapse is a taxable transfer under IRC Chapters 11 or 12, such person is treated as having withdrawn the trust property and retransferred it to the trust. As a result, such a release, exercise or lapse of a GPA after Sept. 25, 1985 over a trust that is otherwise grandfathered from the GST tax will subject the trust property to the current GST tax rules.
The estate argued that the regulations' concept of a “constructive addition” was outside the scope of IRC Sec-tion 2601 and that the statute's use of the term “added” was intended to apply only to transfers to a trust from an outside source. However, the Sixth Circuit disagreed and held that Congress' intent in enacting the grandfathering rule was to exempt trust property only if the future GST couldn't be avoided (that is, where no power of appointment was granted and the trust property was required to pass to skip persons pursuant to the terms of the trust). The Sixth Circuit also found the constructive addition concept fair and consistent with the treatment of a GPA as outright ownership in other sections of the IRC. As a result, the regulations (1) were a reasonable construction of the statute, (2) applied to Louise's lapse of her GPA, and (3) subjected the transfers to Henry's grandnieces and grandnephews to GST tax.