In Private Letter Ruling 201613007 (released March 25, 2016), the Internal Revenue Service addressed five issues related to an irrevocable trust, which a grantor created for his benefit and for the benefit of permissible beneficiaries. A corporate trustee was the sole trustee, charged with distributing net income and principal to permissible beneficiaries in the following three ways: 1) under a grantor’s consent power, in which the grantor would give his written consent, and a majority of the distribution committee members would direct the income or principal; 2) under a unanimous member power, in which all of the distribution committee members would direct the net income; and 3) under a grantor’s sole power, in which the grantor would direct the principal for any beneficiaries’ health, education, maintenance or support. Any net income that wasn’t distributed was to be added to the principal.
The Distribution Committee
Under the terms of the trust, at all times, at least two adult permissible beneficiaries must serve on the distribution committee; the grantor couldn’t be a committee member. The distribution committee was initially made up of three permissible beneficiaries, all whom served in a nonfiduciary capacity. If a vacancy on the committee would arise, it was to be filled in the following order: grantor’s father, grantor’s son, grantor’s daughter. On the grantor’s death, the distribution committee would cease to exist.
The trust would terminate on the grantor’s death, and under the grantor’s will (the grantor’s testamentary power), the balance would be distributed to any person, other than grantor’s estate, creditors or estate’s creditors. If there was a default under this testamentary power, the balance would be divided into equal shares and distributed outright or in trust to individuals that the grantor named.
Ruling 1: Computation of Taxable Income
The IRS first addressed whether, for as long as the distribution committee existed, any portion of the trust’s income, deductions and credits against tax would be included in computing the grantor’s or distribution committee members’ taxable income, deductions and credits. After analyzing Internal Revenue Code Sections 671, 674, 676, 677 and 678, the IRS ruled that neither the grantor nor the distribution committee members were the “owners” of any portion of the trust. Thus, portions of the trust’s income, deductions and tax credits wouldn’t be included in the grantor’s or committee members’ taxable income. The IRS, however, deferred ruling whether the grantor was an “owner” of a portion of the trust under IRC Section 675, instead stating that such a determination under that IRC section must await an examination of the federal tax returns of the parties involved.
Under IRC Section 671, wherever it’s specified in the IRC that a grantor or other person is considered the “owner” of a portion of a trust, then the income, deductions and credits against tax attributable to that portion of the trust is considered in computing the taxable income and credits of the grantor or other person. IRC Section 673(a) treats the grantor as the owner of a portion of a trust in which he has a reversionary interest in either the corpus or income, if, as of the inception of that portion of the trust, the value of that interest is more than 5 percent of the value of such portion. Under IRC Section 674(a), the grantor is the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or income is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party. “Adverse party” refers to any person with a substantial beneficial interest in a trust that would be adversely affected by the exercise or nonexercise of a power (IRC Section 672(a)).
Section 674(b) states that Section 674(a) doesn’t apply to: a power to distribute corpus to a beneficiary, provided that the power is limited by a reasonably definite standard set forth in the trust; and a power exercisable only by will, except for the grantor’s power to appoint by will the trust income that accumulated in the grantor’s or nonadverse party’s discretion, without the consent of any adverse party.
IRC Section 676(a) provides that a grantor is the owner of a portion of a trust if, at any time, a power to revest in the grantor title to such portion is exercisable by the grantor or a nonadverse party. Similarly, IRC Section 677(a) treats a grantor as the owner of a portion of a trust if the income may be distributed to the grantor or their spouse; held for future distribution to the grantor or their spouse; or applied to pay premiums for insurance policies on the grantor or their spouse. And, IRC Section 678(a) provides that a person other than the grantor is the owner of any portion of a trust with respect to which: (1) such person has a power exercisable solely by him or herself to vest the corpus or the income in him or herself, or (2) such person previously partially released/modified such power and after the release/modification retains control as would subject a grantor of a trust to treatment as the owner. Because none of the committee members had a power exercisable solely by himself to vest trust income or corpus in himself, none of them were owners under Section 678(a), and portions of the trust’s income, deductions and tax credits wouldn’t be included in their taxable income.
Under IRC Section 675, however, a grantor is the owner of a portion of a trust if, under the trust’s terms or circumstances attendant to its operation, administrative control is exercisable primarily for the grantor’s benefit rather than the beneficiaries’ benefit. Although in this case, the IRS found that none of the trust’s terms would cause administrative control to be considered exercisable primarily for the grantor’s benefit, it was a question of fact as to whether the circumstances attendant to the operation of trust would cause administrative control to be exercisable primarily for the grantor’s benefit. As such, it deferred making a ruling on this issue until it analyzed the parties’ federal income tax returns.
Rulings 2 and 3: Completed Gifts
The IRS next addressed whether the grantor’s contribution of property to the trust was a completed gift for federal gift tax purposes and whether a distribution of trust property by the distribution committee to the grantor was a completed gift for any member of the distribution committee and thus subject to federal gift tax. The IRS ruled that neither the grantor’s contributions to the trust nor the committees’ distributions to the grantor were completed gifts subject to federal gift tax.
Under IRC Section 2511(a), gift tax applies whether a transfer is in trust or otherwise; whether a gift is direct or indirect; and whether the property is real, personal, tangible or intangible. Treasury Regulations Section 25.2511-2(b) provides that a gift is complete when a donor parts with dominion and control so as to leave him or her with no power to change the disposition of the property transferred. If a donor reserves any power of the disposition of property, the gift may be incomplete, partially complete or partially incomplete, depending on the facts of the case. Thus, the IRS must closely examine every case in which property is subject to a reserved power.
A gift is incomplete in every instance in which a donor reserves power to revest beneficial title in him or herself; it’s also incomplete when a donor reserves power to name new beneficiaries or change the interests of the beneficiaries, unless that power is a fiduciary one, limited by a fixed or ascertainable standard (Treas. Regs. Section 25.2511-2(c)). A donor possesses power over transferred property if such power is exercisable with any person not having a substantial adverse interest in the disposition of the transferred property (Treas. Regs. Section 25.2511-2(e)). Under Treas. Regs. Section 25.2511-2(g), if a donor transfers property to himself as trustee (or to him/herself and another person who lacks a substantial adverse interest, as trustee) and retains no beneficial interest in the property except for fiduciary powers, the exercise/nonexercise of which is limited by a fixed or ascertainable standard, the donor has made a completed gift. As such, gift tax will apply to the value of the transferred property.
In this instance, because of the grantor’s consent power over the trust principal, the IRS considered whether the distribution committee members had a substantial adverse interest over the trust property. The distribution committee members weren’t takers in default of the property; rather, they were co-holders of the power. Moreover, the distribution committee would cease on the grantor’s death. Thus, the members didn’t have interests adverse to the grantor under Treas. Regs. Section 25.2511-(2)(e), and the grantor possessed the power to distribute income and principal to any beneficiary.
Moreover, the grantor had the power to change the interests of the beneficiaries under his sole power over the trust principal. This reserved power rendered any transfer to be wholly incomplete for federal gift tax purposes. In addition, the grantor’s testamentary power was considered a retention of dominion and control under Treas. Regs. Section 25.2511-2(b)(2); therefore, any transfer of trust property was incomplete for federal gift tax purposes. On his death, the fair market value of the trust property would thus be included in the grantor’s gross estate for federal estate tax purposes.
Finally, the distribution committee members’ unanimous power over the income wasn’t a condition precedent to the grantor’s powers; the grantor still retained control over trust income. Thus, the transfer of property wasn’t complete with respect to the income interest for federal gift tax purposes.
Rulings 4 and 5: Distribution Committee
Lastly, the IRS analyzed whether distributions by the committee members to the beneficiaries (other than the grantor) were completed gifts subject to federal gift tax and whether the committee members possessed a general power of appointment (GPOA) over the trust so as to make the trust property includible in any committee member’s gross estate. The IRS concluded that distributions to beneficiaries weren’t completed gifts subject to federal gift tax, and the committee members didn’t possess a GPOA.
The IRS determined that the powers held by the distribution committee members under the grantor’s consent power were powers exercisable only in conjunction with the grantor. Under IRC Section 2514(b) (which provides that the exercise or release of a GPOA created after Oct. 21, 1942 is a transfer of property by the individual possessing such power) and IRC Section 2041(a)(2) (which provides that the value of the gross estate includes the value of all property to the extent of any property with respect to which the decedent has at the time of death a GPOA created after Oct. 21, 1942 or with respect to which the decedent has at any time exercised or released such a power by a disposition which is of such nature that if it were a transfer or property owned by the decedent, such property would be includible in the decedent’s gross estate), the distribution committee didn’t possess a GPOA by virtue of the grantor’s consent power. Moreover, the committee’s unanimous member powers weren’t GPOAs under Sections 2514(b) and 2041(a)(2) and as such, weren’t includible in any of the distribution committee members’ gross estates. Any distribution made from the trust to any beneficiary (other than the grantor), pursuant to the grantor’s consent power and the unanimous member powers, weren’t gifts from the distribution committee members. Rather, they were gifts from the grantor.