Trust’s modification does not lose its GST tax-exempt status

In IRS Letter Ruling 202206008 released Feb. 11, 2022, the IRS ruled that trust modifications under a settlement agreement creating a formula testamentary general power of appointment in one of the trust’s beneficiaries would not result in the loss of the trust’s GST tax-exempt status and would result in only the trust property subject to the beneficiary’s general power of appointment being included in the beneficiary’s gross estate.

A parent’s will left the remainder of the parent’s estate to two trusts, Trust A and Trust B. Trust B was the subject of the ruling request. Regarding the administration of Trust B, the will provided that all of the net income was to be distributed to the parent’s child (Child) during Child’s life. Regarding Trust B’s corpus, the trustee had the discretion to make distributions as the trustee deemed necessary for the maintenance, education, welfare, and comfort of any of the trust’s beneficiaries. Upon Child’s death, Trust B was to terminate and be distributed, per stirpes, to Child’s surviving descendants.

The parent died prior to Sept. 25, 1985, therefore grandfathering Trust B for GST tax purposes (i.e., the trust was not subject to GST tax).

A controversy arose regarding the administration of Trust B when the trustee wanted to exercise its discretion to provide Child with a power of appointment over certain assets of Trust B (which authority the trustee had under the will). The other beneficiaries of the trust opposed the proposed exercise of the trustee’s discretionary authority. Litigation was commenced, and the parties reached a court-approved settlement agreement.

The settlement agreement granted Child a testamentary general power of appointment to appoint “the largest portion of Trust B that could be included in Child’s federal estate without increasing the total amount of the ‘Transfer Taxes’ actually payable at Child’s death over and above the amount that would have been actually payable in the absence of this provision. The term ‘Transfer Taxes’ means all inheritance, estate, and other death taxes, plus all federal and state GST taxes, actually payable by reason of Child’s death.” In the event Child failed to exercise the testamentary general power of appointment, property subject to the power was to be distributed per stirpes to Child’s thenliving descendants.

The parties requested a ruling (1) that the settlement agreement would not result in the loss of Trust B’s GST tax-exempt status and (2) that Child’s testamentary general power of appointment under the settlement agreement would result in only the property subject to the power being included in Child’s estate.

Regarding the GST tax-exempt status of Trust B, the IRS cited the criteria in Regs. Sec. 26.2601-1(b)(4)(i)(D), as it normally does when considering whether modifications to a grandfathered trust cause the trust to lose its grandfathered status: (1) whether the modification shifts a beneficial interest in the trust to a beneficiary who occupies a lower generation than the persons who held the beneficial interest prior to the modification and (2) whether the modification extends the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust.

The IRS ruled that the settlement agreement (1) did not shift a beneficial interest in Trust B to a person in a generation lower than those persons included in the original trust and (2) did not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust.

Regarding Child’s testamentary general power of appointment, the IRS looked to Sec. 2041(a)(2), which includes in a decedent’s estate any property over which a decedent had a general power of appointment at the time of his or her death.

The IRS ruled that the settlement agreement would include in Child’s estate only that property in Trust B over which Child exercised a testamentary general power of appointment.

The ruling on the creation of a formula testamentary clause is an issue that the IRS is not known to have previously ruled on — not because it had a no-rule position on the issue, but because the IRS has never been formally asked to rule on it. Many estate planners have avoided using this formula testamentary general power of appointment because they believe it might include the entire trust — not just the part of the trust subject to the power in the beneficiary’s estate — or that the IRS may not give it effect under some theory of economic substance. This ruling reflects the IRS’s reasoning that it does not cause inclusion of the entire trust.

Why did the trustee seek to grant Child a testamentary general power of appointment? One reason may be that it was for estate planning purposes, but that is unlikely because the trust was already free from estate and GST taxes — unless the trust was about to terminate and there was a desire among the parties to move assets to a new GST tax-exempt trust using Child’s GST exemption. The likely reason is that it was an income tax play to have assets of the trust included in Child’s estate to get a basis step-up without incurring estate tax (because Child had available GST exemption). Then again, it could have been done for both reasons.

The ruling states that only Child’s exercise of the testamentary general power of appointment would cause inclusion of Trust B property in his estate. However, Sec. 2041(a)(2) applies to any property over which a decedent had a general power of appointment at the time of his or her death. Thus, the IRS’s ruling on the issue is that the property over which Child had a general power of appointment is included in Child’s estate regardless of whether Child exercises the power. However, if Child does not exercise the power, what trust property would be included in the taxpayer’s estate that would be stepped up?