A recent Private Letter Ruling addressed some interesting issues relating to a modification of an irrevocable trust under state law that is made with the consent of the settlor and all beneficiaries.
A. Section 2036/2038 Inclusion in Settlor. The question was raised whether the settlor was at risk for inclusion of the trust assets in his or her taxable estate by reason of participation in the modification process. That is, was the exercise of his rights under state law sufficient to show that he has a retained interest in the trust under Section 2036 or 2038?
The IRS ruled that the settlor suffered no estate tax exposure. First, the IRS noted that the settlor did not retain the possession or enjoyment of, or the right to the income from, the trust property. Further, the IRS noted that Section 2038 will not apply if a settlor decedent held a power that could be exercised only with the consent of all parties having an interest in the transferred property, and the power adds nothing to the rights of the parties under local law (Treas. Regs. §20.2038-1(a)(2)). Since the beneficiaries were consenting to the modifications, even if the statutory modification power was an issue for the settlor, the regulation would apply to provide further protection against taxable estate inclusion.
B. Gift Tax Exposure to Settlor. The issue was also raised whether the Settlor’s consent to the modification could result in gift tax liability to the settlor. The IRS ruled that there was no gift tax exposure. First, the IRS noted that the settlor’s original gift to the trust was a completed gift since he did not retain any power to change the disposition for his own benefit or for the benefit of another. Further, and similar to the 2038 Regulation discussed above, Treas. Regs. §25.2511-2(e) provides that a donor is considered to have a power if it is exercisable by him in conjunction with any person not having a substantial adverse interest in the disposition of the transferred property or its income. Here, the power that the settlor had under state law to modify the trust could only be exercised with all of the beneficiaries (who thus have a substantial adverse interest), and thus for both of the above reasons the IRS saw no gift tax issues for the settlor.
C. GST Exemption Preserved. The trust at issue was exempt from generation-skipping tax by reason of allocation of the settlor’s GST exemption to it. The issue was raised whether the modification of the trust could jeopardize the exempt status of the trust.
The IRS noted that there is no guidance regarding whether the partial termination or modification of a trust will affect the status of a trust that is exempt from GST tax because sufficient GST exemption was allocated to it. So the IRS instead applied its regulations whether a “grandfathered” generation skipping trust is modified in a manner that the exempt status would be lost – i.e. Treas. Regs. §26.2601-1(b)(4). The IRS found that under the regulations the modifications did not rise to a level that would result in loss of exempt status - the partial termination and modification would 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 partial termination and modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust.
While the exempt trust rules do not directly apply to this question, the IRS noted that “[a]t a minimum, a partial termination or modification that would not affect the GST status of a grandfathered trust should similarly not affect the exempt status of [a trust that is exempt by reason of allocation of GST exemption].” Accordingly, the IRS ruled that the partial termination and modification of the trust did not cause it to lose its exempt GST status.
COMMENT: Modification of irrevocable trusts with the involvement of the settlor are common. Confirmation that such modifications do not adversely impact the settlor when the settlor retained no rights or interest over the trust, and further do not upset the GST exempt status of the trust, is reassuring.
However, there may be circumstances when the modification may involve a shift of a beneficial interest to a lower generation – such a circumstance would not fit within the facts of this ruling on the GST issue. Presumably that should not impact the exemption allocation, but it does remain an open issue.