Modification of GST Grandfathered Trusts
Analyzing PLRs 202432016 and 202432013
Table of Contents
Intro and Background
Many of the private letter rulings published by the IRS with regard to generation-skipping transfer tax (GST) deal with late elections out of automatic allocation of GST exemption under IRC Sections 2632(c) or 2632(e). It is rare to see rulings dealing with trust modifications and decantings, especially for grandfathered trusts, which can be a minefield.
We are in an age where many GST tax issues have been deferred from a time where either (1) the current iteration of GST tax laws was not in force (usually before late 1986), or (2) the GST exemption was much lower ($1,000,000 from 1986-1999, with indexing of that amount for inflation through 2003 before coupling it to the estate tax exclusion starting in 2004).
During this almost 40-year period, we have seen significant changes to state law governing trusts. Irrevocable trusts can now be modified, sometimes through judicial or nonjudicial procedures, sometimes through the exercise of a nonfiduciary power of appointment, and sometimes by the exercise of a fiduciary’s distribution powers to send income and principal to a new or modified/restated trust (this distribution commonly being known as “decanting”). The common law perpetuities period, traditionally limited to 21 years after the death of a life in being at the time of the creation of the trust, has been extended or even eliminated depending on the situs of the trust but could still affect the combined assets of a dynasty trust.
Where GST tax is concerned, trusts that were irrevocable as of September 25, 1985 are grandfathered in to the GST tax. Generally, these trusts will not be subject to GST tax except to the extent of actual or constructive additions made to such trusts after that date. But, modifications of grandfathered trusts can cause loss of exempt status unless the rules of Treas. Reg. 26.2601-1(b)(4) are followed. These rules can make practitioners apprehensive to approach modification, even when there is a legitimate issue warranting modification.
In particular, the general requirements that give practitioners pause with respect to a modification, judicial construction, settlement agreement, or trustee action are:
The vesting of property (at the end of the perpetuities period) cannot be extended beyond 21 years after the death of a life in being when the trust became irrevocable, with an alternate path looking at 90 years after a trust became irrevocable; and
Especially for a modification (but also a nonconforming trustee distribution, settlement, or judicial construction), a beneficial interest in the trust cannot be shifted to any beneficiary occupying a lower generation than the person(s) holding the beneficial interest before the modification or action - generally defined as an increase in a GST transfer, or the creation of a new GST transfer.
For ease of discussion, we will call requirement 1 the “Perpetuities Rule” and requirement 2 the “Shifting Rule.”
Treas. Reg. 26.2601-1(b)(4)(i)(E) has several examples of successfully meeting these requirements, but are lacking in examples of what not to do. Two recent Private Letter Rulings, PLRs 202432016 and 202432013, illustrated such issues - but with positive results for the trust in question.
PLR 202432016
This Ruling involved a trust originally established as a revocable trust, that later became irrevocable on the settlor’s death. The trust was a common trust for all of settlor’s issue, calling for distribution of all income at least quarterly to settlor’s issue per stirpes (as determined at the time of the distribution).
Subsequent analysis implied that this was a grandfathered trust.
At issue was the language dealing with trust termination. Settlor’s children were deceased, and the trust called for outright distribution to settlor’s issue on a date that is 21 years after the date of death of settlor’s last living child. The distribution language called for outright distribution to the “issue of settlor then living, per stirpes” on that date. A subsequent definition defined issue to mean issue of settlor “living at that time.”
To resolve the ambiguity between whether the trust was to be divided at the generation of settlor’s children (both deceased), or settlor’s grandchildren (the oldest generation with living representatives), the trustees filed a petition in state court to modify the trust based on construction of the per stirpes distribution. The state court interpreted the per stirpes distribution to require division at the level of settlor’s deceased children, creating one equal share for the descendants of child 1 and another equal share for the descendants of child 2. Per stirpital divisions would then follow from each equal share among grandchildren or their represented family units.
With court order in hand, the trustees sought a ruling from the IRS that neither the construction of the trust, nor the division of the trust between the two children’s respective family units, would cause a loss of the trust’s exempt status.
As for the judicial construction, Treas. Reg. 26.2601-1(b)(4)(i)(C) allows exempt status of a grandfathered trust to remain undisturbed so long as (1) there is a bona fide issue, and (2) the construction is consistent with applicable state law that would be applied by the highest court in the state. Luckily, in this Ruling, the facts were extremely similar to Treas. Reg. 26.2601-1(b)(4)(i)(E), Example 3, which had an opposite outcome (per capita division at the grandchildren’s level) but nonetheless led the Service to conclude that the judicial construction in this case would meet the relevant requirements.
On the trust division, Treas. Reg. 26.2601-1(b)(4)(i)(E), Example 5 just happened to illustrate almost the exact challenge posed by the facts in the Ruling. Again, the Service piggybacked on this Example to conclude that the immediate trust division would satisfy the Perpetuities Rule and Shifting Rule.
PLR 202432013
This Ruling was heavy in facts, spanning multiple prior modifications ending in an immediate modification to a grandfathered testamentary trust for one child of settlor that was approved by a state court pending a positive written determination from the Service (which, spoiler, was granted). Prior modifications had split the child’s trust into two separate shares - one for grandchild 1, and one for grandchild 2 (note that child was still living). This Ruling involved the trust for grandchild 2. A companion ruling was issued for the trust for grandchild 1 under PLR 202432012, which is not separately discussed in this article.
Instead of rehashing the extremely confusing paths of modification, there were a couple of key changes that stood out as being highly relevant in the Service’s analysis:
A “decanting-lite” modification allowing income and principal distributions, and terminating distributions at child’s death, for a grandchild, descendant of grandchild, or (upstream in the event of no grandchild or descendants) descendant of Settlor (each a “primary beneficiary”) to pass into a trust share to be administered under a newly-added trust provision with similar distribution terms as the parent trust in lieu of outright distributions. (Note that anything for grandchild 1 went to the grandchild 1 trust, which was not the subject of this modification or ruling.) Importantly, within this new trust, distributions after child’s death could only be made to the primary beneficiary and not the primary beneficiary’s descendants.
This new trust provision added a testamentary general power of appointment for each primary beneficiary with respect to any share that was subject to administration under the new provision, with takers in default (other than grandchild 1) having their own shares created per stirpes subject to the same distribution terms and testamentary general power of appointment.
From a GST tax perspective, the Service noted that the Perpetuities Rule would be satisfied notwithstanding the grant of general powers of appointment to each trust beneficiary. In this vein, the Service noted that the general power of appointment itself would cause each beneficiary holding such a power to become the new “transferor” for GST tax purposes. Importantly, the creation of a new general power of appointment did not (in the eyes of the Service) violate the Shifting Rule.
In terms of the trust interests themselves, the Service concluded:
After the proposed modifications, Child and Child’s descendants, including Grandchild 2 and Grandchild 2’s descendants, have the same interests they had before the proposed modifications, except that trust property that would have been distributed free from trust to a beneficiary may or will be retained in separate trust for the sole lifetime benefit of such beneficiary.
This is important, because this reflects the framework to extend a trust in lieu of outright distributions to generation 2+ beneficiaries that would otherwise be made at the death of a generation 1 beneficiary without violating the Shifting Rule. This appears to be the product of a combination of (1) limiting distributions from the extended trusts to the primary beneficiary, coupled with (2) the grant of a testamentary general power of appointment to such primary beneficiary.
Beyond GST tax, since the beneficiaries were deemed to have substantially the same beneficial interests both before and after the modifications, the Service concluded (1) there would be no gift made (for gift tax purposes) between beneficiaries, and (2) there would be no transfer(s) of property resulting in an income-taxable exchange of beneficial interests under IRC 1001.
Conclusion
Grandfathered trusts can present several challenges that confuse even the most advanced tax practitioners. Handling these trusts with kid gloves can be important to avoid loss of GST tax exemption.
These issues will become more frequent, as previously-grandfathered trusts reach the termination phase (given that many are approaching 39 years from the latest permitted time of becoming irrevocable). As seen above, termination can present issues in determining who exactly should receive a terminating distribution. Alternatively, it can present issues on whether (from a creditor protection perspective, for example) it makes sense to extend the trust for at least one more generation.
While I wouldn’t exactly call these challenges “easy,” another issue ripe for the picking for both grandfathered trusts and otherwise GST-exempt trusts (by allocation) involves the classic ages-and-stages trust calling for fractional outright distributions (often to a generation 1 beneficiary) upon achieving certain ages. Finding ways to avoid this outcome can be difficult, and the universe of possibilities can hinge on a difference between “may” and “shall” while also considering a trustee’s power to withhold distributions in certain scenarios.