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Letter Ruling 9728043, April 15, 1997

Uniform Issue List Information:
UIL No. 2601.00-00
Tax imposed (generation-skipping transfers)

Code Sec. 2601

This is in response to your letter of September 30, 1996, requesting a ruling under §2601 of the Internal Revenue Code.

According to the facts submitted, on December 2, 1957, W created an irrevocable trust with Z as trustee. The irrevocable trust created four separate trusts, one for the benefit of W's son X ("Trust"), and one for each of W's three other children. This ruling concerns only Trust, created for son X. Presently, the cotrustees of Trust are Bank 1 and Y. Y is X's son and W's grandson.

Under the provisions of the Trust, the net income was payable to X for life, subject to the Trustee's sole discretion to accumulate all or part of the income. Upon X's death, the net income (still subject to the Trustee's discretion to accumulate) was payable as X appointed. The principal when distributable was to be distributed as X appointed. X's powers to appoint net income and to appoint principal distributed by Trust could be exercised only in X's last will and testament. The appointment may be made only for the benefit of one or more of the descendants of the Settlor (W) and their spouses, including the descendants and spouse of the child making the appointment, and corporations and associations that are operated exclusively for religious, charitable, scientific, literary, or educational purposes. The corporations and associations must be organizations a gift to which would qualify for the estate tax charitable deduction.

Upon his death on December 29, 1978, X, under Article VI of his will, exercised his powers of appointment under Trust as to both income and principal. X directed that all property subject to said powers be paid to V and Bank 2 (predecessor to Bank 1) as trustees of the "Article VI Trust". The Article VI Trust, therefore, came into existence as the result of the exercise of X's powers of appointment. The powers of appointment extend to all distributions of net income and principal from the Trust. The Article VI Trust has no assets other than the items of income and the principal distributions that it receives from Trust.

Article VIII(B) of X's will, which contains administrative provisions for the Article VI Trust, provides that any individual trustee who is at any time the sole trustee may designate a cotrustee to serve with him. V, the original individual cotrustee of the Article VI Trust, died in 1987 having been at no time the sole trustee. Therefore, V never had the opportunity to designate a successor, and since his death Bank 1 has acted alone as trustee.

X's will provides that the trustees of the Article VI Trust are to pay to or for the benefit of X's son, Y, so much of the net income and principal of the trust estate as the trustees shall from time to time determine. Payments are to be made to Y only if the trustees determine that Y is actively pursuing a worthwhile educational program at a college or university or the equivalent; has commenced a worthwhile business career, is engaged in worthwhile activities for the betterment of society, or has otherwise adopted a style or manner of life where he is accomplishing or shows promise of accomplishing productive and worthwhile goals.

Any net income or principal of the Article VI Trust that is not distributed to Y may be paid to or for the benefit of any issue of Y. In regard to issue who have not attained age twenty-one, the trustee may pay as much of the net income and principal as it determines is necessary for a beneficiary's support, maintenance, health, or education, after taking into account other resources available to the beneficiary. In connection with issue who have attained age twenty-one, the trustee may pay to said issue so much of the net income and principal as it determines is in a beneficiary's long-term interests or welfare, using the same standards as are applied to distributions to Y. To the extent that net income is not distributed to Y's issue, net income may be distributed to one or more designated charitable organizations or may be accumulated and added to principal.

The Article VI Trust will terminate upon the death of Y, at which time the entire trust property is to be distributed to the then living issue of Y, by right of representation. The trustees, however, will have the discretion in the case of any such issue whom they determine has shown a "lack of strength of character and affirmative attitude" to withhold distribution and to distribute the property withheld among the child's issue or to one or more charitable organizations.

At the present time, Trust owns a fractional (1/8th) interest in timberlands in State 2, and a portfolio of stocks, bonds and cash. The current cotrustees of Trust are Bank 1 and Y. Bank 1 is not willing to act as cotrustee of the State 2 timberlands, so that its trusteeship is limited to the investment and administration of the portfolio of stocks, bonds and cash.

Because of the limitation on Bank l's role in Trust, Y is in effect the sole trustee of the Trust's interests in timberland. The operation of the timberlands and management of timber-related assets is the only independent source of revenue providing funds to the Article VI Trust. Y, however, is not a cotrustee of the Article VI Trust. Presently, the sole trustee of the Article VI Trust is Bank 1. Accordingly, Bank 1, which has no responsibility for the management of the timberlands or timber-related assets, acts alone in administering the funds generated by those activities after they are distributed to the Article VI Trust.

In order to remedy this situation Y proposes to file a petition in the Superior Court of State 1, County of D, seeking four modifications to the terms of the Article VI Trust. The first two requested modifications are as follows:

1. The Article VI Trust would be divided into two separate trusts referred to as Article VI Trust No. 1 and Article VI Trust No. 2. Article VI Trust No. 1 would receive all distributions of net income, timber sales proceeds, and other distributions of principal from Trust which are made on or after October 1, 1996. Article VI Trust No. 2 would hold and continue to manage all income, proceeds, principal, and assets which comprise the trust estate of the Article VI Trust as of September 30, 1996, but after that date the Article VI Trust No. 2 would not receive any additional distributions of income, timber sales proceeds, or principal from Trust, which distributions are to be made to the Article VI Trust No. 1.

2. Bank 1 would continue to act as sole trustee of Article VI Trust No. 2, but would resign as trustee of Article VI Trust No. 1. Y and U would be appointed to serve as cotrustees of Article VI Trust No. 1.

The taxpayer believes that these modifications, if permitted by the Court, will increase overall efficiency of trust administration by making more coordination possible between the administration of the Trust and the administration of the Article VI Trust. Y would not only be active in the operation of the timberlands owned by Trust, but with his cotrustee, U, would be active in the administration of the funds flowing to the Article VI Trust No. 1 from the operation of those timberlands and timber-related assets. As sole trustee of Article VI Trust No. 2, Bank 1 would continue to administer all assets comprising the trust estate of the Article VI Trust as of September 30, 1996 and will not have the added burden of coordinating with Y as cotrustee of Trust responsible for the operation of the timberlands.

As described above, with respect to the Article VI Trust, an institutional trustee may not designate a cotrustee. As a result, the Article VI Trust currently lacks any provisions for the appointment of a successor trustee. If modifications #1 and #2 are made such that there will be two individuals acting as cotrustee of Article VI Trust No. 1, it is proposed that the third modification, an amendment to the Article VI No. 1 Trust, be made to enable future vacancies to be filled without the need to obtain a court order. The third requested modification which would be an amendment to Article VI Trust No. 1 would provide as follows:

3. Notwithstanding any other provision that is applicable to Article VI Trust No. 1, any individual Trustee of Article VI Trust No. 1 shall have the right to designate, subject to subsequent revocation, an individual or corporate entity and one or more alternate individuals or corporate entities to succeed him or her upon his or her death, resignation or inability to act. Said designation and any revocation thereof shall be valid only if it is made (i) by the individual while acting as a Trustee of Article VI Trust No. 1 and (ii) by an instrument in writing filed with the then-acting Trustee. Upon commencing to act as Trustee, said designee shall succeed to all powers and discretions invested in the Trustee making such designation and shall be subject to any limitations restricting the powers and discretions of the Trustee making such designation.

The fourth modification is requested in order to avert the potential inclusion of Article VI Trust No. 1 property in the gross estate of any beneficiary or contingent beneficiary who serves as a cotrustee. The amendment to Article VI Trust No. 1 would provide as follows:

4. Notwithstanding any other provision that is applicable to Article VI Trust No. 1, if at any time any beneficiary or contingent beneficiary of Article VI Trust No. 1 shall be the Trustee or a Co-Trustee thereof and, but for this paragraph, would thereby have a discretionary power with respect to the distribution of principal and/or net income of Article VI Trust No. 1 which could be exercised in favor of said Trustee and/or any person or persons to whom he owes an obligation of support an/or the creditors of either, said Trustee shall have no power or authority to exercise or participate in the exercise of any discretion to distribute or not distribute which shall directly or indirectly affect the amount of property distributable to said Trustee-beneficiary and/ or any person whom he is obligated to support and/or the creditors of either, or which shall affect the time or times at which such distributions are made. Said discretion shall be exercised exclusively by his Co-Trustee, or if at any time there is no disinterested Trustee hereunder, said Trustee-beneficiary shall petition a Court having jurisdiction over Article VI Trust No. 1 for an order appointing a disinterested third party as Co-Trustee. In its order appointing said disinterested Co-Trustee, the Court may restrict the rights, powers and privileges of the disinterested Co-Trustee thus named to the exercise of the discretions which the other Trustee may not exercise, and, if so, the disinterested Co-Trustee thus named shall have no other duty or responsibility of any kind or nature hereunder, and said disinterested Co-Trustee shall be indemnified by the trust estate of Article VI Trust No. 1 against, any loss, liability, or expense suffered or incurred by said disinterested Co-Trustee as a result of his failure to take any other actions with respect to the trust estate, specifically including, but not limited to, investigating the manner in which the trust estate is otherwise being administered and/or seeking to prevent or compel, as the case may be, other actions by the Trustee which might be considered as contrary to the terms of Article VI Trustee No. 1. The disinterested Co-Trustee may not be removed by the other Trustee hereunder, and shall continue to serve until said disinterested Co-Trustee shall resign, die or be unable to serve by reason of incapacity or incompetence.

Taxpayer requests a ruling that the above described modifications to the Article VI Trust will not cause generation-skipping transfers from the Article VI Trust, or from Article VI Trust No. 1, or from Article VI Trust No. 2 to be subject to the provisions of Chapter 13 of the Internal Revenue Code of 1986.

Section 2601 imposes a tax on every generation-skipping transfer.

Section 2611 defines the term "generation-skipping transfer" to mean (1) a taxable distribution, (2) a taxable termination, and (3) a direct skip.

Section 2612(a) provides that the term "taxable termination" means a termination (by death, lapse of time, release of power, or otherwise) of an interest in property held in a trust and thereafter only skip persons have an interest in the property.

Section 2612(b) defines the term "taxable distribution" to mean any distribution from a trust to a skip person (other than a taxable termination or a direct skip).

Section 2613(a)(1) defines the term "skip person" as including a natural person assigned to a generation that is two or more generations below the generation assignment of the transferor.

In this case the Article VI Trust provides for distributions to persons that are two or more generations below X's (the grantor's) generation. Thus, unless the trust is excepted from the generation-skipping transfer tax provisions by reason of §1433(b)(2)(A) of the Tax Reform Act of 1986 (Act), P.L. 99-514, 1986-3 (Vol. 1) C.B. 1, the distributions from the trust would be subject to the generation-skipping transfer tax.

Section 1433(b)(2)(A) of the Act and §26.2601-1(b)(1)(i) of the Generation-Skipping Transfer Tax Regulations provide that the generation-skipping transfer tax shall not apply to any generation-skipping transfer under a trust that 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 (or out of income attributable to corpus so added).

Section 26.2601-1(b)(1) (iv) provides that if an addition is made after September 25, 1985, to an irrevocable trust, which is excluded from Chapter 13 (Tax on Certain Generation-Skipping Transfers) by §1433(b)(2)(A) of the Act, a pro rata portion of subsequent distributions from (and terminations of interests in property held in) the trust is subject to the provisions of Chapter 13.

Section 26.2601-1(b)(1)(v) describes "constructive" additions to trusts in certain situations involving powers of appointment and relief from liability. Section 26.2601-1(b)(1)(v) (B) provides that the release, exercise, or lapse of a power of appointment (other than a general power of appointment as defined in §2041(b) ) is not treated as an addition to a trust if (1) the power of appointment was created in an irrevocable trust that is not subject to chapter 13 under §26.2601-1(b)(1) ; and (2) in the case of an exercise, the power or appointment is not exercised in a manner that may postpone or suspend the vesting, absolute ownership or power of alienation of an interest in property for a period, measured from the date of creation of the trust, extending beyond any life in being at the date of creation of the trust plus a period of 21 years plus, if necessary, a reasonable period of gestation (the perpetuities period).

In the present case, it has been represented that no additions have been made to the Trust or to the Article VI Trust after September 25, 1985 (other than the distributions of income, timber sales proceeds, or principal from Trust, which, under the terms of Article VI of X's will, are to pass to the Article VI Trust.) We conclude that distributions from Trust to the Article VI Trust pursuant to X's exercise in 1978 of his power of appointment are not treated as additions to the Article VI Trust within the meaning of §26.2601-1(b)(1)(v) .

A modification of a generation-skipping trust that is otherwise exempt under the 1986 Act will generally result in a loss of its exempt or "grandfathered" status if the modification changes the quality, value, or timing of any powers, beneficial interests, rights, or expectancies originally provided for under the terms of the trust.

In the proposed partition of the Article VI Trust, both the Article VI Trust No. 1 and the Article VI Trust No. 2 will have substantive terms identical to those of the original Article VI Trust. The Article VI Trust No. 1 will receive all distributions of net income, timber sales proceeds, and other distributions of principal from Trust which are made on or after October 1, 1996. The Article VI Trust No. 2 will hold and continue to manage all income, proceeds, principal, and assets which comprise the trust estate of the Article VI Trust as of September 30, 1996.

The proposed partition of the Article VI Trust will not alter the quality, value, or timing of interests under the original terms of the Article VI Trust. The proposed partition of the Article VI Trust will not confer any additional powers or beneficial interests upon any of the beneficiaries and will not create any additional generation-skipping transfers or increase the amount of generation-skipping transfers.

The second, third, and fourth proposed modifications all affect the identity and powers of the trustees of the Article VI Trust No. 1. Under the second proposed modification, Bank 1 will resign as trustee of the Article VI No. 1 Trust, and Y and U will be appointed to serve as individual cotrustees of Article VI

Trust No. 1. Under the third proposed modification any individual trustee of Article VI Trust No. 1 will have the right to designate an individual or corporate entity and one or more alternate individuals or corporate entities to succeed him or her upon his or her death, resignation or inability to act. The fourth proposed modification provides that any beneficiary or contingent beneficiary of Article VI Trust No. 1 who is a trustee or a cotrustee of the trust shall have no authority to exercise or participate in the exercise of any discretion regarding the distribution of income and principal to himself, his creditors, any person he is obligated to support, or any creditors of such person.

These three modifications constitute a change in only the administrative provisions of the trust and will not alter the quality, value, or timing of interests under the original terms of the Article VI Trust.

Based on the facts submitted and the representations made, we conclude that neither the partition of the Article VI Trust nor the modifications to the administrative provisions of Article VI No. 1 trust will affect the exempt status of the Article VI Trust, the Article VI No. 1 Trust, or the Article VI No. 2 Trust for federal generation-skipping transfer tax purposes. Provided that there are no future additions to the Trust, the Article VI No. 1 Trust, and the Article VI Trust No. 2, (other than the distributions of income, timber sales proceeds, or principal from Trust, which, under the terms of Article VI of X's will, are to pass to the Article VI Trust), distributions from the Article VI Trust, Article VI Trust No. 1 and Article VI Trust No. 2 will be exempt from the generation-skipping transfer tax.

Except as we have specifically ruled herein, we express no opinion as to the consequences of this transaction under the cited provisions or under any other provisions of the Code.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.

Sincerely yours, Assistant Chief Counsel (Passthroughs and Special Industries), Frances D. Schafer, Senior Technician Reviewer