The IRS recently released Private Letter Ruling 201233008 (the “PLR”), in which the IRS ruled that a proposed partial termination and modification of a trust pursuant to state law will not (1) cause the trust to be includible in the grantor’s estate under Internal Revenue Code sections 2036 or 2038, (2) result in a transfer by settlor of trust assets pursuant to Code section 2501, and (3) will not cause the trust to lose its exempt status for purposes of chapter 13 of the Code.

The Uniform Trust Code (UTC) provides that an irrevocable noncharitable inter vivos trust may be modified or terminated upon consent of the settlor and all of the beneficiaries. U.T.C. § 411(a). From the facts set forth in the PLR, the proposed partial termination and modification of the trust at issue was likely being made pursuant to a state law version of this section of the UTC.

Pursuant to state statute, the parties proposed to terminate a portion of the Trust, which portion would be distributed outright to the current beneficiaries. The remainder of the Trust would continue to be held in trust for the same period of time as the initial trust, but would provide for mandatory distributions of income to the same beneficiaries.

IRC § 2036:

Code Section 2036 provides that a decedent’s gross estate shall include the value of property transferred by the decedent in trust, if the decedent retained or reserved “the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.” I.R.C. § 2036(a)(2). The Regulations state that:

With respect to such a power, it is immaterial (i) whether the power was exercisable alone or only in conjunction with another person or persons, whether or not having an adverse interest; (ii) in what capacity the power was exercisable by the decedent or by another person or persons in conjunction with the decedent; and (iii) whether the exercise of the power was subject to a contingency beyond the decedent’s control which did not occur before his death.” Treas. Reg. § 20.2036-1(b)(3).

IRC § 2038:

Section 2038 provides that a decedent’s gross estate shall include the value of property transferred by the decedent in trust, if the enjoyment of the interest was subject at the time of the decedent’s death to any change through the exercise of power by the decedent to “alter, amend, revoke, or terminate” the trust. The Regulations under § 2038 provide that this rule does not apply if the power can be exercised only with the consent of all parties having a vested or contingent interest, and if the power adds nothing to the rights of the parties conferred under state law. Treas. Reg. § 20.2038-1(a)(2). The comment to UTC § 411 echoes this, referencing Treasury Regulation § 20.2038-1(a)(2), and noting “[t]he settlor’s right to join the beneficiaries in terminating or modifying a trust under this section does not rise to the level of a taxable power.” UTC § 411 cmt.

In the PLR, the IRS held “Settlor has not retained for any period which does not in fact end before his death, the possession or enjoyment of, or the right to the income from the trust property. Further, pursuant to Agreement, the consent of all of the parties who have an interest in Trust is required under State Statute 1. Any right Settlor has to participate in the partial termination and modification of Trust arises solely from rights granted under State Statute 1 and may be exercised only with the consent of all of the parties having an interest (vested or contingent) in the transferred property. Therefore, based on the facts submitted and the representations made, we rule that the partial termination and modification of Trust will not cause any property of Trust to be includible in the gross estate of Settlor under s. 2036 or 2038.”

This is the first indication that the Treas. Reg. § 20.2038-1(a)(2) also applies to IRC section 2036, something that has worried advisors since the Regulation was released.

IRC § 2501:

Section 2501 imposes a tax on the transfer of property by gift. Various sections of the Gift Tax Regulations provides further statements as to when a gift is considered complete or incomplete.

In the PLR, the IRS held that, upon funding the trust, “Settlor parted with dominion and control of the transferred property. Settlor did not retain any power to change its disposition for his own benefit or for the benefit of another. Settlor did not retain the power to name new beneficiaries or to change the interests of the beneficiaries as between themselves. Settlor is a party to Agreement pursuant to the requirements of State Statute 1. The other parties to Agreement are the beneficiaries of Trust and they have a substantial interest in Trust. Therefore, Settlor is not exercising any power in conjunction with persons not having a substantial interest in Trust. Accordingly. . . the partial termination and modification of Trust will not result in a transfer by Settlor of Trust assets for purposes of s. 2501.”

IRC § 2601:

Section 2601 imposes a tax on every generation-skipping transfer. The Settlor had allocated a sufficient amount of his generation-skipping tax exemption to the trust so that the trust had an inclusion ratio of zero (in other words, the Trust was fully exempt from the generation-skipping tax).

The Generation-Skipping Transfer Tax Regulations provide guidance as to when a modification with respect to a trust that is exempt from the generation-skipping tax will not cause the trust to lose its exempt status. The Regulations provide that a modification of the governing instrument of an exempt trust that is valid under applicable state law will not cause the trust to lose its exempt status if “the modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation. . . than the person or persons who held the beneficial interest prior to the modification, and the modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust.”

The IRS held that the partial termination and modification would not shift the beneficial interest in the Trust to a lower generation, and would not extend the period of time for vesting. Therefore, “the partial termination and modification of the Trust will not cause Trust, as modified, to lose its exempt status for purposes of chapter 13.” As a reminder, private letter rulings are only binding with respect to the taxpayer who submitted the request for the ruling and cannot be relied upon by other practitioners.

With guest co-blogger, Washington University School of Law student, Anne Jump.