Grandfathered trust modification permitted.

As a general rule, the generation-skipping transfer (GST) tax is applicable to certain property transfers made by a member of an older generation to one or more members of a younger generation. For example, a transfer called a direct skip may be a cash gift from a grandfather to a grandchild. A taxable distribution might be a transfer to a grandchild from a trust that a grandfather established for his children and grandchildren. Alternatively, a taxable termination may occur on the death of a father that leaves the grandchild as the sole beneficiary of a trust established by the grandfather.

The GST tax is set at the highest Federal estate tax rate (55%). For most purposes, the tax applies to property transfers made after Oct. 22, 1986. An exception is that the GST tax does not apply to transfers to (or from) an irrevocable trust created on or before Sept. 25, 1985. An irrevocable trust created before that time is said to be "exempt" or "grandfathered;" GSTs from a grandfathered trust to its beneficiaries are not subject to the GST tax. Of course, if additional assets were contributed to a grandfathered trust after Sept. 25, 1985, any subsequent distributions from the trust to "skip" persons would be subject to the GST tax in an amount proportionate to the subsequent trust contribution (as of the new contribution's date).

Many of the GST rules are complex and, for some issues, the Service has been slow to publish needed guidance. Often, the trustee of a grandfathered trust is hesitant to make minor or administrative changes to the trust, for fear that such modification may cause the trust to lose its grandfathered status. As a result, taxpayers may feel compelled to request a letter ruling (which costs $5,000) for any possible type of change to an exempt trust's terms. For example, two beneficiaries of a grandfathered trust may not agree with the trustee's investment philosophy and want the trust to be divided into two separate trusts, with the same terms but different trustees. Would such a division cause the trust to lose its grandfathered status?

Over the years, the Service has issued numerous rulings on changes that will cause a trust to lose its grandfathered status. The IRS has consistently adhered to the position that a modification to a grandfathered trust would be permitted if it did not change the quality, value or timing of any trust beneficial interest. Thus, if after a proposed modification of an exempt trust, none of the beneficial interests had changed, the Service might issue a ruling that permitted the modification.

However, cautious trustees of exempt trusts who would like to make administrative modifications do not necessarily want to depend on a ruling issued to another taxpayer on facts not exactly similar to theirs. If a change to a trust is desired, taxpayers want to be certain that the anticipated revision will not taint the trust's grandfathered status.

To address taxpayers' concerns and expressly reduce the number of ruling requests for nominal trust changes, on Nov. 18, 1999, the Service issued Prop. Regs. Sec. 26.2601-1, to clarify the so-called effective-date rules. These regulations provide guidance on the types of modifications, constructions and settlement of controversies that can be freely made to an exempt trust by a trustee, without endangering the trust's grandfathered status and without prior IRS authorization or approval.

As additional guidance on a controversial GST issue, Prop. Regs. Sec. 26.2601-1 gives the Service's position on when an exercise or lapse of a general power of appointment over an otherwise grandfathered trust results in GST tax.

Prop. Regs. Sec. 26.2601-1(b)(4) includes four basic rules for determining when a modification, a judicial construction, a settlement agreement or other trustee action can be made without prior IRS approval and without fear that the trustee's action will cause a trust to lose its exempt, grandfathered status. The rules apply only for GST tax purposes. They do not, however, apply in determining whether a trust modification might result in a taxable gift, cause a trust's assets to be included in a decedent's gross estate or cause gain or loss to be realized for income tax purposes.

The first of the four trust modification rules provides that a distribution of trust principal from an exempt trust to a new trust will not cause the new trust to lose its exempt status, if:

1. The exempt trust's terms authorize the trustee to make distributions to a new trust without the consent or approval of any beneficiary or court; and

2. The new trust's terms do not postpone the vesting of trust principal beyond the perpetuities period applicable to the original trust.

The perpetuities period is a reference to a universal trust rule known as "the Rule Against Perpetuities." In general, that rule states that the life of a trust cannot be longer than a life in being at the creation of the trust plus 21 years (plus, if necessary, a reasonable period of gestation). That rule has since been modified to include a period of no longer than 90 years. Thus, under Prop. Regs. Sec. 26.2601-1 (b) (4), if a new, exempt trust can otherwise be created, its life can be stated as either no longer than a life in being at the creation of the exempt trust plus 21 years or, alternatively, no longer than 90 years from the creation of the new trust.

The second new trust modification rule states that a court-approved settlement of a bona fide controversy as to the administration of a trust or the construction of terms of the governing instrument will not cause an exempt trust to lose its status, if:

1. The settlement is a result of arm's-length negotiations; and

2. The settlement is within the range of reasonable outcomes under the governing instrument and applicable state law addressing the issues resolved by the settlement.

The third rule provides that a judicial construction of a governing instrument to resolve an ambiguity in the terms of the instrument or to correct a recorder's error will not cause an exempt trust to lose its grand-fathered status, if:

1. The judicial action involves a bona fide issue; and

2. The construction is consistent with applicable state law that would be applied by the state's highest court.

The fourth and final rule provides that a modification of the governing instrument of an exempt trust by judicial reformation or by nonjudicial reformation that is valid under state law, will be permitted if:

1. The modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation (as defined in Sec. 2651) than the person who held the beneficial interest prior to the modification; and

2. 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. Prop. Regs. Sec. 26.2601-1 provides seven examples to illustrate the above-mentioned rules. As a secondary matter,

Prop. Regs. Sec. 26.2601-1 attempts to settle a GST controversy involving two conflicting Court of Appeals decisions, Simpson, 183 F3d 812 (8th Cir. 1999), and Peterson Marital Trust, 78 F3d 795 (2d Cir. 1996). These cases have similar facts and were concerned with the exercise or lapse or both of a general power of appointment created in a grandfathered trust. Based on Peterson Marital Trust (and its position as set out in Prop. Regs. Sec. 26.2601-1 (b)(1)(v)(A)), the transfer of property pursuant to the exercise, release or lapse of a general power of appointment created in a pre-Sept. 25, 1985, trust is not a transfer under the trust but, rather, a transfer by the power-holder occurring when the exercise, release or lapse of the power becomes effective. Thus, if a grandmother holds a general power of appointment created by her deceased husband in an exempt trust, the exercise of that power in favor of a skip person will be a GST subject to the GST tax. On the other hand, if the powerholder were the son of the creator of the exempt trust, there would be no GST on the exercise, release or lapse of a general power in favor of the creator's grandchildren.

The existing regulations, as clarified by Prop. Regs. Sec. 26.2601-1, in effect state that the fact that a general power of appointment is in an exempt, grand-fathered trust is irrelevant in determining whether an exercise of a general power in an exempt trust is a taxable GST.

Simpson, in a persuasive decision, holds to the contrary. It states that the exercise of the general power by the grandmother in the above example would not be a GST, due to the plain language of the enacting statute. The court pointed out that Section 1433(b)(2)(A) of the Tax Reform Act of 1986 states that the GST tax would not apply to "any generation-skipping transfer under a trust which was irrevocable on September 25, 1985, but only to the extent that such transfer is not made out of corpus added to the trust after September 25, 1985."

Because these two decisions conflict, they could be appealed to the U.S. Supreme Court, which could result in a revision of this section of the regulations.

FROM LEE A. DUNN, NEW BERN, NC