Final Regs. for Separate-Share Rules Issued

On Dec. 28, 1999, the IRS issued final Regs. Sec. 1.663(c)-16 on the separate-share rules that apply to estates under Sec. 663(c). With some modifications, these final regulations adopt the proposed regulations issued in January 1999.

Sec. 663(c) provides that, in determining distributable net income (DNI), when a single trust or estate has more than one beneficiary, substantially separate and independent shares of different beneficiaries of a trust (or estate) shall be treated as separate trusts. This rule ensures that beneficiaries whom the grantor or decedent intended to be treated equally are not taxed unequally, if income is accumulated for one beneficiary but not the others.

A trust's DNI is divided into separate shares allocable to each beneficiary. The amount of DNI carried out to any beneficiary (i.e., taxable to the beneficiary and deductible by the estate/trust) is limited to the DNI allocable to the beneficiary's separate share. If a trust distributes an amount in excess of a beneficiary's taxable portion of DNI, that beneficiary is not required to include more than his allocable portion of DNI in taxable income. The trust's distribution deduction is limited as well, so that it may be taxed on the portion of DNI allocable to the other beneficiaries that has not been distributed.

Practical Application

A tax adviser must first determine if separate shares exist. If an estate or trust has multiple beneficiaries, substantially separate and independent shares of different beneficiaries exist when the governing document and applicable local laws create separate economic interests in one beneficiary or class of beneficiaries, such that the economic interests of those beneficiaries are not affected by the economic interests accruing to another separate beneficiary or class of beneficiaries. The application of the separate-share rule is mandatory when separate shares exist.

The preamble to the final regulations clarifies that a separate share exists only if it includes both corpus and income attributable thereto and is independent from any other share. The Committee report for the Taxpayer Relief Act of 1997 further states "[f]or example, a separate share in an estate would exist where the decedent's will provides that all of the shares of a closely-held corporation are devised to one beneficiary and that any dividends paid to the estate by that corporation should be paid only to that beneficiary and any such dividends would not affect any other amounts which that beneficiary would receive under the will. As in the case of trusts, the application of the separate share rule is mandatory where separate shares exist." Regs. Sec. 1.663(c)-4 also states that a revocable trust for which a Sec. 645 election is made is always a separate share.

Second, a tax adviser must maintain a separate accounting for each share within a trust or estate. Regs. Sec. 1.663(c)-2 provides that a fiduciary must use a reasonable and equitable method to determine each share's value and the allocation of taxable income to each share; redeterminations in value of the separate shares must be taken into account. Thus, if an estate undergoes an audit by the Service in which the asset values are redetermined, separate shares and subsequent allocations of DNI would potentially need readjustment. This could result in amended fiduciary and individual income tax returns for all affected open years.

Third, a tax adviser needs to consider how the rules could affect current tax planning for the estate or trust under consideration. For example, a pecuniary marital bequest could be constructed to deliberately "fail" the separate-share rule, so that most or all of the income of the estate earned during the period of administration is taxable to the surviving spouse on funding of the pecuniary marital bequest. This has the effect of decreasing the surviving spouse's assets and increasing the residual portion.

Regs. Sec. 1.663(c)-4(b) provides a special exception to the separate-share rules generally applicable to pecuniary bequests. If a pecuniary bequest is not entitled to income or to share in appreciation or depreciation and the governing instrument does not provide that it is to be paid or credited in more than three installments, the pecuniary bequest is to be treated as a separate share. A tax adviser should consider having revocable trusts or wills provide that a pecuniary marital bequest is to be paid in more than three installments over a certain period of time, so that the estate's DNI will be allocable to the spouse on funding of the bequest.

From Barbara Cox, Pasadena, CA

Foreign Asset-Protection Trusts

Many high net-worth individuals should consider some sort of asset protection strategy. Having a sound plan reduces the risk of litigation and, in the event of a lawsuit, increases the likelihood of a favorable settlement. To this end, a foreign asset-protection trust is among the vehicles that can be used. However, before implementing this strategy and transferring assets to an offshore trust, it is important to understand the vehicle's basic components, as well as some of its potential limitations.

In establishing a foreign asset-protection trust, the settlor chooses a situs with favorable laws regarding such trusts (e.g., the Cayman Islands, the Bahamas, the Cook Islands or Bermuda). It is important that the jurisdiction not honor foreign judgments, thereby requiring a creditor to litigate a claim in the jurisdiction directly. Generally, the applicable fraudulent conveyance laws require "proof beyond a reasonable doubt" that an entity was established to defraud creditors before a trust will be set aside. Additionally, the fraudulent conveyance laws generally require action within a short period of time (i.e., two or three years).

Often, foreign asset-protection trusts are drafted as grantor trusts for U.S. Federal income tax purposes, due to the retention of the power to appoint either the income or principal or the retention of some reversionary interest. Thus, a trust is ignored for U.S. Federal income tax purposes, so that U.S. grantors are treated as owning the trust's assets and deriving income directly from them. In addition, many jurisdictions with favorable statutes will exempt foreign asset-protection trusts from their own tax system. A trust will normally be irrevocable, have no provisions for payment to a grantor, and, at the end of the term, the trust property will revert to the grantor's estate. Unfortunately, many prospective grantors believe that a foreign asset-protection trust will also permit the deferral or avoidance of U.S. Federal income tax. Rather, a foreign asset-protection trust will generally result in the same U.S. Federal income or estate tax consequences that would result had no trust been created.

To permit a grantor to retain some effective level of control over a trust, many favorable jurisdictions call for a special office of "protector" to be created in connection with the trust. A trust protector is given certain veto powers over trustees for distributions to beneficiaries or investment decisions, or both. A protector may also have the power to change trustees or to move a trust's location. In addition, a trust instrument will often instruct trustees to ignore any court order directed against a grantor, requiring action either to dissolve the trust or to obtain a distribution for the benefit of any creditor.

Prior to implementing a foreign asset-protection trust, the following factors should be reviewed and considered:

1. The cost associated with implementation (generally, should be no more than about $5 per year per $1,000 of assets);

2. Nature of assets to be transferred;

3. Political and economic risks that may be associated with a trust's jurisdiction;

4. Number and type of required trustees (generally, two corporate trustees and an individual trustee are required);

5. Comfort level of a grantor in placing assets into a foreign trust;

6. Experience and competence of U.S. and associated legal counsel with these matters; and

7. Fiduciary responsibilities of other parties in a trust arrangement.

In summary, a foreign asset-protection trust may be a sound basic asset-protection strategy for high net-worth individuals who may be subject to litigation (and who place value on peace of mind) to consider and potentially implement as part of an overall asset protection strategy. (For more information, see Engel, "Integrated Estate Planning with Foreign-Situs Trusts," 31 The Tax Adviser 102 (February 2000).)

From Ronald G. Wainwright, Jr., Raleigh, NC

GST Planning Opportunities

Early planning can yield great benefits with the generation-skipping transfer (GST) tax exemption. Whenever possible, a GST trust should be used for new business opportunities. First, the trust can be funded with cash; the trust can then purchase a business interest. This strategy avoids valuation challenges if the business interest appreciates rapidly and minimizes the initial GST tax-exempt allocation.

Other GST tax planning opportunities include:

1. Maximize the direct payment of college and medical expenses that are exempt from gift tax and disregarded when computing the $10,000 annual gift tax exclusion.

2. Consider making as many $10,000 annual exclusion gifts as possible. A powerful way to use the annual exclusion is to take advantage of Sec. 529 qualified state tuition programs. A grandparent may give up to $50,000 per grandchild, spread this amount over five years and shield the gift from tax by using the annual exclusion. The income on a qualified state tuition program account grows tax-free, and the grandchild is taxed when he withdraws the funds for college education expenses.

3. Use the $1 million GST tax exemption during life and focus on leveraging the transfer with assets with the greatest potential for appreciation.

Long-term GST trusts should be created for the exclusive benefit of grandchildren, if the parents can afford to forego the income. If children need trust income, consider making them discretionary (rather than mandatory) beneficiaries.

The optimal trust term to defer transfer taxes is a trust that will end on the expiration of the period established by the Rule Against Perpetuities. Alaska, Delaware and other jurisdictions that have abolished the rule make excellent jurisdictions to establish dynasty trusts, designed to build up as much trust corpus as possible for future generations.

When designing a dynasty-type trust, a trustee should have broad discretionary powers, including the power to make distributions. To optimize a transfer of wealth to future generations, a trust should purchase assets (such as a business or a home) for grandchildren's use. Senior family members should consider loaning money to a GST trust to invest in new business opportunities.

Charitable lead unitrusts (CLUTs) are also useful in GST tax-exemption planning. CLUTs are attractive, because a GST tax exemption can be allocated when the trust is funded: The GST tax exemption can be allocated only after the charity's income interest has expired for a charitable lead annuity trust. A CLUT should be considered only if it is estimated trust assets will perform at a rate of return in excess of the Sec. 7520 rate. A possible strategy to exceed the Sec. 7520 rate is to first place assets in a family limited partnership (FLP) and to contribute partnership interests to a CLUT. The Sec. 7520 rate is computed on the value of partnership interests, after any relevant discounts are considered.

The prohibitions against self-dealing apply to charitable trusts. Charitable trusts should not purchase an asset from a related party, including the grantor's FLP or closely held business. Also, the self-dealing rules apply if a beneficiary uses trust property.

From Susan Willey, Cedar Rapids, IA

Grandfathered Trust Modification Permitted

As a general rule, the generation-skipping transfer (GST) tax is applicable to certain property transfers made by a member of an older generation to one or more members of a younger generation. For example, a transfer called a direct skip may be a cash gift from a grandfather to a grandchild. A taxable distribution might be a transfer to a grandchild from a trust that a grandfather established for his children and grandchildren. Alternatively, a taxable termination may occur on the death of a father that leaves the grandchild as the sole beneficiary of a trust established by the grandfather.

The GST tax is set at the highest Federal estate tax rate (55%). For most purposes, the tax applies to property transfers made after Oct. 22, 1986. An exception is that the GST tax does not apply to transfers to (or from) an irrevocable trust created on or before Sept. 25, 1985. An irrevocable trust created before that time is said to be "exempt" or "grandfathered;" GSTs from a grandfathered trust to its beneficiaries are not subject to the GST tax. Of course, if additional assets were contributed to a grandfathered trust after Sept. 25, 1985, any subsequent distributions from the trust to "skip" persons would be subject to the GST tax in an amount proportionate to the subsequent trust contribution (as of the new contribution's date).

Many of the GST rules are complex and, for some issues, the Service has been slow to publish needed guidance. Often, the trustee of a grandfathered trust is hesitant to make minor or administrative changes to the trust, for fear that such modification may cause the trust to lose its grandfathered status. As a result, taxpayers may feel compelled to request a letter ruling (which costs $5,000) for any possible type of change to an exempt trust's terms. For example, two beneficiaries of a grandfathered trust may not agree with the trustee's investment philosophy and want the trust to be divided into two separate trusts, with the same terms but different trustees. Would such a division cause the trust to lose its grandfathered status?

Over the years, the Service has issued numerous rulings on changes that will cause a trust to lose its grandfathered status. The IRS has consistently adhered to the position that a modification to a grandfathered trust would be permitted if it did not change the quality, value or timing of any trust beneficial interest. Thus, if after a proposed modification of an exempt trust, none of the beneficial interests had changed, the Service might issue a ruling that permitted the modification.

However, cautious trustees of exempt trusts who would like to make administrative modifications do not necessarily want to depend on a ruling issued to another taxpayer on facts not exactly similar to theirs. If a change to a trust is desired, taxpayers want to be certain that the anticipated revision will not taint the trust's grandfathered status.

To address taxpayers' concerns and expressly reduce the number of ruling requests for nominal trust changes, on Nov. 18, 1999, the Service issued Prop. Regs. Sec. 26.2601-1, to clarify the so-called effective-date rules. These regulations provide guidance on the types of modifications, constructions and settlement of controversies that can be freely made to an exempt trust by a trustee, without endangering the trust's grandfathered status and without prior IRS authorization or approval.

As additional guidance on a controversial GST issue, Prop. Regs. Sec. 26.2601-1 gives the Service's position on when an exercise or lapse of a general power of appointment over an otherwise grandfathered trust results in GST tax.

Prop. Regs. Sec. 26.2601-1(b)(4) includes four basic rules for determining when a modification, a judicial construction, a settlement agreement or other trustee action can be made without prior IRS approval and without fear that the trustee's action will cause a trust to lose its exempt, grandfathered status. The rules apply only for GST tax purposes. They do not, however, apply in determining whether a trust modification might result in a taxable gift, cause a trust's assets to be included in a decedent's gross estate or cause gain or loss to be realized for income tax purposes.

The first of the four trust modification rules provides that a distribution of trust principal from an exempt trust to a new trust will not cause the new trust to lose its exempt status, if:

1. The exempt trust's terms authorize the trustee to make distributions to a new trust without the consent or approval of any beneficiary or court; and

2. The new trust's terms do not postpone the vesting of trust principal beyond the perpetuities period applicable to the original trust.

The perpetuities period is a reference to a universal trust rule known as "the Rule Against Perpetuities." In general, that rule states that the life of a trust cannot be longer than a life in being at the creation of the trust plus 21 years (plus, if necessary, a reasonable period of gestation). That rule has since been modified to include a period of no longer than 90 years. Thus, under Prop. Regs. Sec. 26.2601-1(b)(4), if a new, exempt trust can otherwise be created, its life can be stated as either no longer than a life in being at the creation of the exempt trust plus 21 years or, alternatively, no longer than 90 years from the creation of the new trust.

The second new trust modification rule states that a court-approved settlement of a bona fide controversy as to the administration of a trust or the construction of terms of the governing instrument will not cause an exempt trust to lose its status, if:

1. The settlement is a result of arm's-length negotiations; and

2. The settlement is within the range of reasonable outcomes under the governing instrument and applicable state law addressing the issues resolved by the settlement.

The third rule provides that a judicial construction of a governing instrument to resolve an ambiguity in the terms of the instrument or to correct a recorder's error will not cause an exempt trust to lose its grandfathered status, if:

1. The judicial action involves a bona fide issue; and

2. The construction is consistent with applicable state law that would be applied by the state's highest court.

The fourth and final rule provides that a modification of the governing instrument of an exempt trust by judicial reformation or by nonjudicial reformation that is valid under state law, will be permitted if:

1. The modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation (as defined in Sec. 2651) than the person who held the beneficial interest prior to the modification; and

2. The modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust.

Prop. Regs. Sec. 26.2601-1 provides seven examples to illustrate the above-mentioned rules. As a secondary matter, Prop. Regs. Sec. 26.2601-1 attempts to settle a GST controversy involving two conflicting Court of Appeals decisions, Simpson, 183 F3d 812 (8th Cir. 1999), and Peterson Marital Trust, 78 F3d 795 (2d Cir. 1996). These cases have similar facts and were concerned with the exercise or lapse or both of a general power of appointment created in a grandfathered trust. Based on Peterson Marital Trust (and its position as set out in Prop. Regs. Sec. 26.2601-1(b)(1)(v)(A)), the transfer of property pursuant to the exercise, release or lapse of a general power of appointment created in a pre-Sept. 25, 1985, trust is not a transfer under the trust but, rather, a transfer by the powerholder occurring when the exercise, release or lapse of the power becomes effective. Thus, if a grandmother holds a general power of appointment created by her deceased husband in an exempt trust, the exercise of that power in favor of a skip person will be a GST subject to the GST tax. On the other hand, if the powerholder were the son of the creator of the exempt trust, there would be no GST on the exercise, release or lapse of a general power in favor of the creator's grandchildren.

The existing regulations, as clarified by Prop. Regs. Sec. 26.2601-1, in effect state that the fact that a general power of appointment is in an exempt, grandfathered trust is irrelevant in determining whether an exercise of a general power in an exempt trust is a taxable GST.

Simpson, in a persuasive decision, holds to the contrary. It states that the exercise of the general power by the grandmother in the above example would not be a GST, due to the plain language of the enacting statute. The court pointed out that Section 1433(b)(2)(A) of the Tax Reform Act of 1986 states that the GST tax would not apply to "any generation-skipping transfer under a trust which 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."

Because these two decisions conflict, they could be appealed to the U.S. Supreme Court, which could result in a revision of this section of the regulations.

From Lee A. Dunn, New Bern, NC