At the Crossroads of Trust Modifications and Charitable Deductions

Transactions involving trust modifications seem to have become more commonplace than one or two decades ago. As practitioners become more familiar with trust modifications, reformations, etc., and decanting, it is critical that practitioners (especially those not focusing on estate and trust planning) understand the tax and nontax consequences of any such transaction. In CCA 201651013 (initial response) and CCA 201747005 (response to taxpayer’s arguments in protest of response in CCA 201651013), the IRS denied a charitable deduction for contributions from a trust to charitable organizations that were made possible by a trust modification.

The original trust was for the benefit of two children of grantor during their lives and then for the benefit of the children’s descendants. The children had a testamentary power to appoint income among the grantor’s descendants, the spouses of such descendants, and charities. When one of the children died, the trustees and beneficiaries of the original trust entered into a settlement agreement to divide the original trust into two separate trusts (Trust A and Trust B) for the respective benefit of the deceased child’s descendants (Child A) and the other child (Child B). 

The trustees of Trust B petitioned the state court to approve, and the state court approved, modifications to the trust by (i) changing the testamentary power of appointment to an inter vivos power of appointment, and (ii) allowing Child B to exercise the power of appointment over principal and income in favor of two private foundations, thus causing Trust B to terminate. When Trust B filed an amended return claiming a charitable deduction for the contributions to the foundations, the IRS denied the charitable deduction amount because the payments were not considered to be made pursuant to the trust instrument. 

Section 642(c) requires that a charitable distribution be made pursuant to the terms of the governing instrument and paid during the taxable year of the deduction. In both CCAs, the Chief Counsel’s Office advised that the trust instrument modified by the court order was not the governing instrument for purposes of §642(c)(1) because the modification did not result from any conflict or resolve any ambiguity in the trust instrument or with regard to the grantor’s intent, but rather was intended only to allow Child B to exercise a power of appointment during his lifetime. Citing Rev. Rul. 59-15, the Chief Counsel’s Office noted that “court orders resulting from conflict are intended to clarify the terms of the original governing instrument”; “[b]y contrast, modification orders such as the one in this case change the terms of the governing instrument beyond its original intended terms.”

In a comparison to the Ninth Circuit’s analysis in Estate of Rapp v. Commissioner, the Chief Counsel’s Office proceeded to advise that, although it denied Trust B’s claimed deduction for charitable contributions to the private foundations, the order approving the modification did not prevent Trust B from enjoying the benefits of distributing Trust B’s assets to the private foundations. I am sure this insight instilled the taxpayer with great joy.

Although the taxpayer may not benefit from the advice, CCA 201747005 offers a glimmer of hopeful guidance to practitioners in that the Chief Counsel’s Office appears to differentiate between the impact of a decision by a state trial court and a state’s highest court when applied to a federal estate tax controversy. Would the Chief Counsel’s Office have advised differently if the taxpayer had somehow managed to have the modification approved by the highest state court? This is very possible; however, it is unclear how the taxpayer would obtain such approval without an actual conflict, which would render obtaining the order from the highest state court moot because an actual conflict would cause the modified trust to be the governing instrument.

CCAs do not generally cause much chatter among practitioners; however, this could potentially be litigated, especially considering that CCA 201651013 noted that SB/SE Examination (Examination Operations) indicated that the taxpayer engaged in similar transactions for other trusts created by the grantor of the original trust in this matter. Therefore, the amount at risk may be large enough to have the taxpayer challenge the Chief Counsel’s position in these CCAs in court.

The most practical advice that may be drawn from these CCAs is that practitioners should always consider the tax and nontax consequences prior to engaging in a trust modification or trust decanting. On the other hand, the Chief Counsel’s position may be incorrect. Oftentimes, there are both tax and nontax motivations of varying degrees to a particular transaction. The Chief Counsel’s position may be construed to deny the effect of any modification of trust for federal tax purposes (regardless of whether the modification is valid and binding under state law) and, therefore, to prevent any modification designed to provide a federal tax benefit to the taxpayer (regardless of whether the federal tax benefits were a primary or secondary motivation).