TC upholds GSTT Regs.

In Estate of Gerson, 127 TC No. 11 (10/24/06), the Tax Court held that the exercise of a testamentary general power of appointment (GPA) by a decedent in favor of her grandchildren was subject to generation-skipping transfer tax (GSTT). In so holding, it ruled that Regs. Sec. 26.2601-1(b) (1)(i) was a reasonable interpretation of the grandfathering provision contained in Section 1433 (b)(2)(A) of the Tax Reform Act of 1986 (TRA '86).

Facts

In Gerson, the decedent's husband had created a revocable trust that became irrevocable on his death. On his death, the trust agreement provided that the trust was to be divided into three separate trusts. One was a marital trust for the decedent's benefit; the trust agreement provided for the distribution of income and principal to the decedent during her life and granted her a GPA at death. The decedent's husband died on July 22, 1973. The decedent died on Oct. 20, 2000, and exercised her GPA in favor of a trust for the benefit of her grandchildren and more remote descendents.

The decedent's estate included the corpus of the marital trust under Sec. 2041 (regarding the inclusion in a decedent's gross estate of property over which he or she had a GPA). The estate, however, did not list this property as subject to GSTT, taking the position that such property was transferred under a grandfathered GSTT-exempt trust pursuant to TRA '86 Section 1433(b)(2)(A). Attached to the Federal estate tax return was Form 8275-R, Regulation Disclosure Statement, in which the estate took the position that Regs. Sec. 26.2601-1(b)(1)(i) was an invalid attempt by Treasury to rewrite TRA '86 Section 1433(b)(2)(A).

Service's Stance

The IRS took the position that the marital trust property subject to the decedent's GPA was not exempt from GSTT under Regs. Sec. 26.2601-1(b) (1)(i); thus, it assessed a GSTT deficiency of $1,144,465, arguing that the exercise of the decedent's GPA in favor of a trust for the benefit of her grandchildren and more remote descendents was a "direct skip" under Sec. 2612(c) for GSTT purposes.

Law

Under TRA '86 Section 1433(a), GSTT generally applies to all GSTs made after Oct. 22, 1986 (the date the TRA '86 was enacted).TRA '86 Section 1433(b)(2), however, exempts transfers by certain trusts from GSTT. A trust exempt under TRA '86 Section 1433(b)(2) is often referred to as an "exempt trust" or a "grandfathered trust"; specifically, the GSTT does not apply to any:

1. Transfer from a trust that was irrevocable on Sept. 25, 1985, to the extent the transfer is not made out of additions to the trust after Sept. 25, 1985.

2. GST under a will or revocable trust executed before Oct. 22, 1986, if the decedent died before 1987.

3. GST under a mist, to the extent such trust consists of property included in the gross estate of a decedent or reinvestments thereof, but only if the decedent was, on Oct. 22, 1986, under a mental disability to change the disposition of his or her property and did not regain competence to dispose of the property before death.

In 1995, Treasury promulgated Regs. Sec. 26.2601-1(b)(1)(i) (TD 8644, 12/26/95), which provided that the grandfathering rules do not apply to a pro-rata portion of any GST under an irrevocable trust if additions are made to the trust after Sept. 25, 1985. In 1999, Regs. Sec. 26.2601-1(b)(1)(i) was amended to further provide that the grandfathering rules do not apply to a transfer of property pursuant to the exercise, release or lapse of a GPA treated as a taxable transfer for gift or estate tax purposes; such a transfer is treated as made by the person holding the power when the exercise, release or lapse becomes effective, and is not considered a "transfer under a trust" irrevocable on Sept. 25,1985.

Precedents

Regs. Sec. 26.2601-1(b)(1)(i) followed the IRS's loss in Simpson, 183 F3d 812 (8th Cir. 1999). In Simpson, the decedent exercised a testamentary GPA granted under a marital trust created in 1966; thus, the property passed to her grandchildren (who were skip persons as defined in Sec. 2612).The Eighth Circuit concluded that the transfer to the grandchildren was exempt from GSTT under TRA '86 Section 1433(b)(2)(A), because the transfer was "under a trust" irrevocable on Sept. 25,1985.

The Simpson facts were similar to those previously presented in Peterson Marital Trust, 78 F3d 795 (2d Cir. 1996), aff'g 102 TC 790 (1994). In Peterson, the decedent had a testamentary GPA to appoint property in a grandfathered GSTT-exempt marital trust created under her husband's will. Rather than appoint the property outright, she allowed the power to lapse; the property passed to her husband's grandchildren, who were skip persons. The Second Circuit concluded that the transfer did not pass "under" the marital trust and, thus, was subject to GSTT.

That court noted that the effective-date provisions in TRA '86 Section 1433(b)(2) were designed to protect taxpayers who, on the basis of pre-existing rules, made arrangements that they could not now correct and for which the new TRA '86 provisions produced an undesirable result. It concluded that there was no basis to apply the protection of these provisions to the trust before it, because the arrangement could have been changed to avoid GSTT through the exercise of the decedent's GPA in favor of nonskip persons.

Prop. Regs.

Treasury and the IRS explain in the preamble to the proposed regulations that the addition of the GPA language to Regs. Sec. 26.2601-1(b)(1)(i) was meant to follow the Second Circuit's opinion in Peterson and reject the Eighth Circuit's opinion in Simpson. The preamble states that Treasury and the Service believe there is no substantive difference between Simpson (in which property passed pursuant to the exercise of a GPA) and Peterson (in which property passed pursuant to the lapse of a GPA).

The preamble goes on to state that property subject to a GPA is the equivalent of an ownership right in such property, and that the value of such property is includible in the gross estate of the person holding the power at death, under Sec. 2041(a).

It further notes that the person holding the power can avoid GSTT consequences by appointing such property to nonskip persons. Finally, the preamble states that the proposed regulations are meant to clarify that the transfer of property pursuant to the exercise, release or lapse of a GPA created in a grandfathered GSTT-exempt trust is not a "transfer under the trust" but a transfer by the person holding the power at the time the exercise, release or lapse becomes effective. Thus, such a transfer is not deemed a transfer under a trust irrevocable on Sept. 25, 1985.

Gerson

The Tax Court noted that Regs. Sec. 26.2601-1(b)(1)(i) is an interpretive regulation, which is to be accorded less deference than legislative regulations issued under a specific grant of authority.

It first looked to determine if Congress had spoken directly to the question of whether the exercise, release or lapse of a GPA granted under a grandfathered GSTT-exempt trust was a "transfer under the trust" for purposes of TRA '86 Section 1433(b)(2)(A). The court determined that Congress had not so spoken.

It then reviewed the relevant cases, the amendment of Regs. Sec. 26.2601-l(b) (1)(i) and the TRA '86 legislative history. The court noted that the legislative history revealed Congressional intent to (1) apply Federal transfer taxes as uniformly as possible and (2) tax GSTs having a similar effect in a similar manner.

The Tax Court ruled that Regs. Sec. 26.2601-1(b)(1)(i) harmonizes the origin and purpose of TRA '86 Section 1433(b)(2)(A) and achieves the consistency and uniformity Congress desired. The court noted that GPAs are equated to outright ownership by the person holding the power. It also noted that uniformity was promoted by the regulation, as it equates the exercise of a GPA with the lapse of such a power. Thus, the court ruled for the IRS.

The opinion was a fully reviewed one, in which six judges joined with the opinion's author, Judge Harry Haines. There was one concurrence in result only; a dissent by Judge David Laro was joined by four other judges (one also wrote a separate dissent).The Laro dissent opines that TRA '86 Section 1433(b)(2)(A) is clear and unambiguous, and that property passing under a GPA, whether by exercise, release or lapse, is a "transfer under a trust" for purposes of the statute.

Conclusion

As the Tax Court is the first court to consider the validity of Regs. Sec. 26.2601-1(b)(1)(i), it remains to be seen whether the other courts will agree with its interpretation. In addition to the Second and Eighth Circuits, the Ninth Circuit in Bachler, 281 F3d 1078 (9th Cir. 2002), also considered whether a GPA was covered under the exception in TRA '86 Section 1433(b)(2)(A). The Ninth Circuit followed the Eighth Circuit's opinion in Simpson. Because the transfer was deemed to have occurred in 1997, the Ninth Circuit declined to consider the applicability of Regs. Sec. 26.2601-l(b)(1)(i).

Gerson is appealable to the Sixth Circuit, a court which has yet to consider the issue. Given the size of the deficiency assessed by the IRS, it is probable that this case will be appealed. While it is unclear how other courts may weigh in, it is clear that an estate that finds itself in Tax Court on this issue will be looking to an appellate court to resolve the matter.

FROM JUSTIN RANSOME, CPA, J.D., MBA, WASHINGTON, DC