IRS Considers Proposed Modification to Trust

In Private Letter Ruling 201528014 (released July 10, 2015), a decedent’s will established two trusts, dividing the residue of his estate equally for the benefit of his daughter and son and their respective children.  Under the trust, each child would receive two-thirds of the net income of his or her respective trust for his or her life, at least quarterly.  The child’s descendants would receive the remaining one-third of the net income.  After the child died, the income was payable to his or her descendants until the trust terminated.

The son, who had no descendants, died shortly after the decedent and, pursuant to the decedent’s will, the assets held in his trust funds passed to the daughter’s trust.   The trust was converted to five percent unitrust, which was paid to the daughter (two-thirds) and her descendants (one-third).  The five percent unitrust amount was calculated based on the value of the trust assets on the last business day of the prior taxable year.

The daughter died, survived by one son and two daughters.

Proposed Modification

The trustee and beneficiaries proposed to modify the trust (pursuant to a state statute) to provide that the calculation of the unitrust amount be based on the average net value of the trust assets valued on the last business day of the three prior taxable years rather than the value of trust assets as of the last business day of just the prior taxable year.  The trustee requested several rulings to make sure that the new method of calculating the unitrust amount wouldn’t have adverse generation-skipping transfer (GST), gift or income tax consequences.

The trust was irrevocable on Sept. 25, 1985, prior to the implementation of the GST tax, and as a result, was exempt from the GST tax.  The trustee noted that there were no additions to the trust after Sept. 25, 1985. The trustee requested a ruling that the proposed modification wouldn’t cause the trust to lose its grandfathers status. 

The general rule for modifications to GST exempt trusts is provided by Treasury Regulations Section  26.2601-1(b)(4)(i)(D)(1), which states that a modification by reformation valid under state law won’t cause an exempt trust to lose its status if the modification doesn’t shift a beneficial interest to any beneficiary who occupies a lower generation than the persons who held the beneficial interest prior to the modification and the modification extends the time for the vesting of a beneficial interest beyond the rule against perpetuities period provided in the original trust.  In addition, a modification that’s administrative in nature and only indirectly increases the amount transferred won’t be considered a shift in beneficial interests.

GST Exempt Status Not Affected

The PLR cites to an Example in the Regulations in which converting an income interest to a unitrust interest isn’t a shift to a beneficial interest in a trust for GST tax purposes.  The trust had already been converted to a unitrust prior to the ruling request, which focused only on the method of calculating the unitrust amount.  Noting that the state statute allowed the modification to the calculation of the total return, the PRL held that the trust’s GST exempt status wasn’t affected.

No Gift Tax

The trustee also requested a ruling on whether any beneficiaries would be deemed to have made a gift due to the change in the method of calculating the unitrust amount.  Citing to the same Example in the Regulations, the IRS ruled that the modification wouldn’t subject either the trust or the beneficiaries to gift tax.

No Gain or Loss Under IRC Section 1001

Further, the trustee requested a ruling that the modification wouldn’t constitute a sale or disposition and, thus, not cause the trust or the beneficiaries to realize a gain or loss under Internal Revenue Code Section 1001.  Under IRC Section 1001, gain or loss is recognized on the exchange of property differing materially in kind or in extent.  However, the Regulations under IRC Section 643 provide that a switch between the methods of determining trust income authorized by state statute won’t constitute a recognition event for purposes of Section 1001 (and also won’t result in a taxable gift by the trust grantor or any of its beneficiaries).

The PLR held that modifying the calculation method of the unitrust amount is an exercise of the trustee’s authority under state statute and not a sale or exchange of a materially different interest by a beneficiary.  As a result, the modification wasn’t considered a sale or disposition of property and didn’t cause the trust or any of the beneficiaries to realize a gain or loss under Section 1001.