IRS Rules that Conversion to Unitrust in Accordance with State Law Will Not Trigger Loss of Grandfathered Protection
July 30, 2013
Authored by: Kathy Sherby and Linsey Glosier
A recent Private Letter Ruling (PLR 201320009) issued by the Internal Revenue Service (IRS) blessed a conversion of a grandfathered Trust to a unitrust determination of income, as not causing any loss of the Trust’s generation-skipping transfer (GST) tax grandfathered protection, and not resulting in a gift or in the recognition of any gain. Here, the trust in question had been held for the benefit of the Settlor’s son, but the son had since died and the trust was now held for the benefit of three grandchildren. No additions had been made after September 25, 1985. However, the trust determined the income to be distributed to the grandchildren under the traditional method, with interest and dividends constituting trust income.
Long after the trust became irrevocable as a result of the death of the Settlor, the state in which the trust was being administered enacted legislation authorizing the conversion to a unitrust determination of income. The trustee determined that such a conversion was in the best interest of the grandchildren and sought to convert the trust to a unitrust. The state statute required that the grandchildren, who were all legally competent to act on their own behalf, to consent to the unitrust conversion. The trustee sought and the IRS ruled that the conversion did not cause a loss of the trust’s grandfathered status as exempt from GST tax, did not cause any beneficiary to be deemed to have made a taxable gift, and did not cause the trust or any beneficiary to realize capital gain so long as the trustee strictly adhered to the requirements of the new state statute in completing the conversion.
Under Treas. Reg. § 643(b)-1, whenever there is a switch in the method of determining income of a trust, if the switch is authorized by state statute and so long as the trustee follows the procedure set out in the state statute for making the switch in the method of determining income, the unitrust conversion will be respected by the Service as an authorized switch, and will not constitute a recognition event for income tax purposes or a gift for gift tax purposes.
Similarly, Treas. Reg. § 26.2601-1(b)(4)(i)(E), Example 11 sets out that the applicable state law was amended to provide that a trust determination of income could be converted to a unitrust, but required the beneficiaries to all consent to the unitrust conversion within two years of the enactment of the statute. Example 11 states that administering the trust in conformity with the statutory conversion to a unitrust would not cause the trust to lose its grandfathered protection.
Based on PLR 201320009, however, it would seem that a unitrust conversion in a fashion not specifically authorized by statute, such as by non-judicial agreement or by a court modification, would not fit within Example 11 and may not be respected by the IRS. While this may not cause a loss of GST grandfathered protection if the modification did not shift a beneficiary interest to any beneficiary who occupies a lower generation and did not extend the time for vesting of any beneficial interest in the trust, the IRS may still construe it as a recognition of income and a deemed gift by the remainder beneficiaries to the income beneficiaries.