IRS Reviews Nonjudicial and Judicial Modification of Trusts

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By Kathleen Ford Bay, Esq.

Lippincott Phelan Veidt PLLC, Austin, TX

In  a number of recent private letter rulings, the National Office has  granted taxpayers' requests that modifications to trusts (which were  exempt from generation-skipping transfer taxes) remained exempt and  did not result in any gifts. While private letter rulings and technical  advice memoranda can be quite useful when analyzing the current thinking  of attorneys at the National Office of the IRS with regard to particular  tax issues, they cannot be cited as precedent in any formal proceedings. 

PLR 201435007–PLR 201435010  and PLR 201434007–PLR 201434009

Prior  to October 8, 1990, husband, wife, and five of their six children  purchased real properties for fair market value. The children used  their own funds, i.e., not funds ever received from their parents.  Per an agreement, wife acquired a life estate, followed by a life  estate in husband, followed by a one-third interest in one child,  with the other children dividing the other two-thirds one-sixth each.  When the sixth child reached 18, the child with the one-third interest  transferred a one-sixth interest to the sixth child (and then each  of the six children owned one-sixth, subject to the life estates in their parents). The agreement provided that if real property was sold, the proceeds would be held in trust with net income to the life tenants and distribution upon their deaths. The complete trust was not contained within the agreement; rather, when the real property was sold, the parents then created the trust in order to hold and administer the net proceeds with themselves as the trustees.  When the trust was created in 2004, the family requested and received a favorable private letter ruling. The IRS ruled that the net proceeds  going into the trust would be treated as a transfer occurring prior  to the original purchase subject to the agreement on October 8, 1990,  and Chapter 14 — and, therefore, generation-skipping transfer  taxes would not apply.

The  family came to the National Office this time for rulings in connection  with: (a) a proposed modification to the trust to appoint an independent  individual co-trustee to serve with the parent co-trustees; (b) the  appointment of a successor independent trustee; (c) the provision  that there must always be an independent trustee; (d) the provision  that the parent trustee may appoint a successor independent trustee  upon the death, resignation, or incapacity of the independent trustee;  and (e) the provision that of a removal power by both the parent trustees while both are serving, and if only one of the parent trustees was serving or neither parent was serving as trustee, then with a majority of the children. The family also requested that the trust be converted to a unitrust as allowed under the applicable state's law.

In  the PLRs, the IRS ruled that the parents and children did not make  a taxable gift under §2501(a)(1),1 §2511(a), §2512(a), §2514(a), §2514(b), or §2514(c) by agreeing to  modify the trust as set forth above, by the independent trustee having  a power to adjust between principal and income per state statute,2 by the independent trustee having a power to release the adjustment power and convert the trust to a unitrust per state statute (as long as the conversion does not shift the beneficiary interest, and in this case, it did not), and by the parents and children as beneficiaries failing to object to the conversion of the trust to a unitrust. Further, the IRS ruled that none of the modifications cause §2702,  regarding certain retained interests, to apply.

PLR 201407008

Prior  to September 25, 1985, Decedent created for herself a revocable trust  which became irrevocable upon her death. Decedent died before September  25, 1985. The trust continued during the lives of her nephew and  niece, with the net income to be distributed at least quarterly to  the nephew and niece. Upon the death of each, his or her interest  was to be paid to his or her spouse and, if none, to his or her respective  issue, per stirpes, provided that the trust would terminate 21 years  after the death of nephew, niece, and their spouses and be distributed  one-half to nephew's issue and one-half to niece's issue. Nephew  was the current trustee (being the successor to the original trustee,  the brother of Decedent). If the nephew was unable to act, then the adult beneficiaries who were then entitled to income may appoint a successor trustee. No additions had been made to the trust since  Decedent's death. Per a nonjudicial agreement, the trustees and beneficiaries proposed to modify the trust so that if the nephew was unable to act as trustee, the then two specified individuals shall act as successor co-trustees, with a majority of the then-living adult issue of nephew (with respect to trustee 1) and a majority of the then-living adult issue of niece (with respect to trustee 2) who are income beneficiaries having the right to appoint a successor co-trustee. Also, nephew could name both successors as co-trustees with him.

The  IRS ruled that the proposed successor trustee modification did not  create a general power of appointment under §2041 or §2514 and the exercise of  the power to appoint successor trustees did not cause any portion  of the trust to be includible in the taxable estate of any trust beneficiary or be a transfer for gift tax purposes under §2035 through §2038; and the proposed modifications  did not cause the trust to lose its exempt generation-skipping transfer  tax status, and no distributions from the trust will be subject to  generation-skipping transfer taxes.

PLR 201436036

Trustors  created an irrevocable trust for Beneficiary and funded it. The trust granted to Beneficiary a testamentary power of appointment.  Later the trustors determined that this power of appointment was not a special or limited power of appointment, but was, instead, a general power of appointment, meaning that, unless the trust was modified, its assets would be included in the beneficiary's estate at death under §2041.  One of the trustors filed a petition to modify the trust; evidence was submitted as to the intent of all the trustors for the power of appointment to be limited so that the beneficiary could not appoint it to the beneficiary, the beneficiary's estate, creditors, or creditors of the beneficiary's estate.

The  applicable state law allows judicial reformation of a trust upon proof that the language used in the document does not reflect the original intent of the people creating the document. Under Commissioner  v. Estate of Bosch,3 only a decision from the highest court  in a state, and not a trial court, is conclusive and binding on the  federal authorities as to points of state law. Accordingly, the parties  requested a private letter ruling to determine the federal treatment  of the modification under state law. The IRS ruled that the proposed  modification did not result in the beneficiary having a general power  of appointment and the trust being includible in the beneficiary's  estate at death under §2041.  The IRS also ruled that modifying the trust so that the power of  appointment was a limited power did not constitute the exercise or  release of a general power and there is no gift under §2514.

For more information, in the Tax Management Portfolios, see Cline, 825 T.M., Powers of Appointment — Estate, Gift, and Income Tax Considerations,  and in Tax Practice Series, see ¶6230, Powers of Appointment — Section 2041.

 1 Unless  otherwise specified, all "Section" or "§"  references refer to the Internal Revenue Code of 1986, as amended,  and the regulations thereunder.

 2 Reg. §26.2601-1(b)(4)(i)(E) Ex. 12.

 3 387 U.S. 456 (1967).