In a departure from their previously announced position, the IRS recently ruled that trusts which were decanted into new trusts on slightly different terms preserved their favorable grandfathered status against the generation-skipping transfer (GST) tax (see IRS Private Letter Ruling 201711002).
The GST tax was enacted in its current form in late 1985. In general, trusts which were irrevocable prior to that date are grandfathered against the tax. If the GST tax applies to a trust, there is currently a 40 percent tax whenever distributions are made to beneficiaries who are two or more generations younger than the grantor of the trust. A grandfathered trust is not subject to this GST tax, so long as it retains its favorable grandfathered status.
The IRS has adopted regulations governing what changes can be made to a grandfathered GST Trust without jeopardizing its grandfathered status. The general concept is that the modification of the trust must not shift any beneficial interest in the trust to any beneficiary who occupies a lower generation than the beneficiaries prior to the modification, and also the modification must not extend the time for vesting of any beneficiary’s interest in the trust beyond the period provided for in the original trust.
Decanting a trust involves transferring some or all of the assets of an existing trust into a new trust created on different terms. Many states, including Kentucky, have enacted statutes expressly authorizing trust decanting. The decanting statutes allow a range of trust changes to be made, depending on the particular state. It is not uncommon to be able to change the trustee or the administrative provisions of the trust, to change the date or event of trust termination, to delete a beneficiary, or to give a beneficiary a new power of appointment over the trust, for example. The Uniform Trust Decanting Act was recently promulgated by the Uniform Law Commissioners, and may ultimately increase greatly the uniformity of trust decanting laws among the states.
In the obviously ancient trusts involved in this IRS Ruling, the modification potentially extended the termination date of the trust. Under the old trusts, the termination date was the date of death of the survivor of two great-grandchildren of the grantor of the trust. Under the new trusts after decanting, each trust would last until the death of a specified great-great-grandchild. However, each new trust still remained subject to termination under the state’s trust rule against perpetuities in effect on the date the original trusts were established. The rule against perpetuities is a trust law limiting the maximum period for the duration and vesting of trust interests. This rule varies widely from state to state. In the classic formulation, the rule against perpetuities limits the duration of trusts by requiring the vesting of all trust interests within twenty-one years after lives in being at the time that the trust was created.
There was a second mitigating factor cited in the Service’s analysis of the GST grandfathering the trust. The new trusts gave each of the great-great-grandchildren a testamentary general power of appointment over his or her trust. A general power of appointment is one exercisable in favor of yourself, your estate, your creditors or the creditors of your estate, which means that the powerholder can vest the Trust assets in himself or his estate.
Although the IRS ruling did not cite to the GST tax regulations regarding general powers of appointment, there is a specific provision in those regulations that the grandfathered status of the trust ends upon the exercise, release or lapse of the general power of appointment over the trust that is treated as a taxable transfer under the estate and gift tax system.
When this happens, the holder of the general power of appointment is deemed to be the transferor of the trust for future GST tax purposes. This change means that there can be no generation-skipping taxable transfers from any trust created by the exercise of the general power until distributions are made to beneficiaries at least two generations below the power holder. That also means that the power holder can apply his or her own generation-skipping tax exemption (currently $5,490,000) to the trust.
The IRS concluded that the retention of the trust perpetuities law limitation on the duration of the trusts, together with the general powers of appointment over the new trusts given to the great-great-grandchildren that would cause the great-great-grandchildren to become the transferors of the trust for GST tax purposes, essentially vesting the assets in that generation, were sufficient to bring the decanted trusts within the limitations required to preserve the grandfathered GST tax status of the trusts. As a result, even though the new trusts will now last until the death of the great-great-grandchild, subject to the perpetuities law limitation and the great-great-grandchildren’s general powers of appointment, the new trusts will remain grandfathered against the GST tax.
As much as the substance of the ruling is interesting and helpful, the mere fact that the IRS ruled on a trust decanting is perhaps a more significant development. The IRS had previously indicated that it would not issue tax rulings on the decanting of trusts (see IRS Rev. Proc. 2016-3). It should be noted that the ruling does not use the word “decanting.” However, the substance of the trust action, the creation of new trusts and the merger of the existing trusts into the new ones, is clearly a decanting in substance. We will all stay tuned to see whether further rulings on trust decantings will be forthcoming, whether actually using the “D” word or not.