IRS Rules on Proposed Trust Modification

Grantor and Spouse created an inter vivos revocable trust, and after the death of the Grantor and Spouse, the Trust was divided into two equal shares with Trust 1 going to the benefit of Son and Trust 2 for the benefit of Daughter. Son and Bank are co-trustees and the Trust is governed by State laws.

Son and Bank entered into a dispute resolution agreement concerning Trust 1.The agreement modified Trust 1 as follows:

• To provide that Son as Trustee has sole management and investment authority over Trust 1’s assets;
• To remove the requirement that Bank review and approve Son’s investment decisions, including Bank’s right to approve or disapprove a change in Trust 1’s assets;
• To address the adjustment of receipts between principal and income;
• To provide that Son invests Trust 1’s assets prudently;
• Trustee, Bank will serve as sole trustee and have sole investment authority over Trust 1’s assets. If Bank determines, due to incapacity, that Son is no longer capable of investing and managing Trust 1’s assets, Bank may request Son resign as Trustee, disregard his investment instructions, and/or take steps to remove Son as Trustee;
• To provide that granting sole investment authority to Son involves risks;
• To provide that Bank may exercise its discretion to adjust receipts between income and principal;
• To acknowledge the manner in which Bank has previously adjusted receipts between income and principal and to determine the tax treatment of receipts for prior tax years;
• To determine treatment of future distributions;
• To provide that the adjustment between principal and income fulfills Bank’s duty or impartiality between current and contingent beneficiaries and that if the Internal Revenue Service does assess any federal income, gift, estate or generation-skipping transfer tax, the tax will be assessed against the trust for such beneficiary; and
• To establish that the trustees will not be liable to the beneficiaries for their actions with respect to Trust 1’s investments and that Bank will not be liable with respect to the adjustment.

In two recent IRS rulings, PLR 201128013 and PLR 201128014, the IRS held, in part, that the proposed modification of Trust 1 and the Bank’s resulting power to adjust between principal and income would not cause a gain or loss to the trust, would not hurt the trust’s generation-skipping transfer tax exempt status, and would not cause the inclusion of any trust assets in Son’s gross estate.

Special thanks to Jim Hillhouse (WealthCounsel) for bringing this to my attention.