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Effect of Trust Modifications in a Settlement Agreement


In Private Letter Ruling 202206008 (released Feb. 11, 2022), the grantor established Trust B (which was generation-skipping tax (GST) exempt) and made it irrevocable as of Sept. 25, 1985) for the benefit of the grantor’s surviving child (Child).  Trust B stipulated that the trustee must distribute all of the net income from Trust B to Child during Child’s life.  The Trustee could make distributions of principal, in its discretion, as it deemed necessary for maintenance, education, welfare and comfort of the beneficiary or beneficiaries.  On Child’s death, Trust B property would be distributed among Child’s descendants (per stirpes), otherwise heirs-at law of the grantor’s spouse (Spouse).  No additions were made to Trust B since the time of original funding.         

The parties entered into a judicial settlement, which stipulated that Trust B would be modified to give Child a testamentary generation power of appointment (GPA) to appoint a defined portion to Child’s estate.  “Defined portion” is equal to the largest portion of Trust B that could be included in Child’s federal estate without increasing total transfer taxes payable at Child’s death (over the amount that would have been payable absent the GPA).   Essentially, this provision caused an amount to be included in Child’s estate to use up an amount equal to the lesser of Child’s remaining estate tax exemption or the GST tax exemption.  The settlement defined “transfer taxes” broadly to mean all inheritance, estate and other death taxes, plus all federal and state GST taxes, actually payable by reason of Child’s death.

The taxpayer requested the following rulings: (1) The trustee’s exercise of its discretionary authority over Trust B under the terms of the settlement agreement won’t result in a transfer of property that’s subject to GST tax, and Trust B will retain its GST exempt status, and (2) The trustee’s exercise  of its discretionary authority over Trust B principal will result in only the defined portion to be included in Child’s gross estate (under Internal Revenue Code Section 2041 (a)(2)). 

 

GST Tax Issue

Under Treasury Regulations Section 26.2601-1(a), GST tax is generally applicable to GST made after Oct 22, 1986. GST tax doesn’t apply to a transfer under a trust that was irrevocable on Sept. 25, 1985, only to the extent such transfer isn’t made out of corpus added to the trust after Sept.25, 1985.       

Treas. Regs. Section 26.2601-1(b)(4)(i) provides rules for determining when a modification, judicial construction, settlement or trustee action that’s exempt from GST tax under Treas. Regs. Section 26.2601-1(b) won’t cause the trust to lose its exempt status. 

Treas. Regs. Section 26.2601-1(b)(4)(i)(D)(1) states that a modification of the trust instrument of an exempt trust, via judicial or non-judicial formation valid under state law, won’t cause an exempt trust to be subject to provisions of chapter 13, if the modification doesn’t shift a beneficial interest in the trust to a beneficiary who occupies a “lower generation” (as defined in IRC Section 2651) than the person or persons who held beneficial interest prior to the modification, and the modification doesn’t extend the vesting period of any beneficial interest beyond such period originally provided in the trust.  (A modification that’s administrative that indirectly increases amount transferred won’t shift a beneficial interest in the trust.) 

             

Treas. Reg 26.2601-1(b)(4)(i)(D)(2) states that 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: (1) an increase in the amount of a GST tax transfer, or (2)  the creation of a new GST tax 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. 

Here, the trust would be modified to grant Child a testamentary GPA under IRC Section 2041(a)(2) such that Child would have the ability to appoint to his own estate.  To the extent not exercised (or property not subject to this power),the  trustee shall distribute property among Child’s then living descendants, if any, and if none, to the heirs at law of spouse. Therefore, the PLR holds that this action doesn’t shift beneficial interest in Trust B to any beneficiary who occupies a lower generation (per Section 2651) than person/persons who held beneficial interest prior to the modification, and the modification doesn’t extend vesting time.

 

Inclusion in Child’s Estate

Section  2041(a)(2) provides that to the extent of any property with respect to which the decedent has at the time of death a GPA created after Oct. 21, 1942, such property would be includible in decedent’s gross estate under IRC Sections 2035 to 2038.  Following this, the PLR holds that only the property that’s subject to Child’s testamentary GPA is included in Child’s gross estate under Section 2041(a)(2).



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