In Private Letter Ruling 202509010 (released Feb. 28, 2025), the Internal Revenue Service addressed the income, gift and generation-skipping tax (GST) consequences of the termination of a “GST grandfathered trust.”
The settlor created the irrevocable trust in question for the benefit of the settlor’s grandchild (the beneficiary) prior to Sept. 25, 1985 (and no additions were made to the trust after that date), making the trust wholly GST-exempt. The trust required the trustee to pay the beneficiary a specified annuity. No other distributions are permitted during the beneficiary’s lifetime. After the beneficiary’s death, the trust provided that the annuity will be divided and paid per stirpes among the beneficiary’s living descendants, and on the death of the last survivor of 10 individuals, the trust will terminate outright in favor of the beneficiary’s then living descendants per stirpes. At the time of the ruling, the beneficiary had two living children (the current remaindermen) and four living grandchildren (the successor remaindermen). There were no predeceased descendants who left surviving descendants.
Under applicable state statutes, the beneficiary, the current remaindermen, successor remaindermen (represented by a special representative, representing minor and unborn beneficiaries), and the trustee may sign an agreement to terminate the trust. The agreement stipulated that 60 days after a favorable PLR from the IRS, the trust property will be distributed to the beneficiaries in accordance with the actuarial value of each beneficiary’s interest in the trust, to be determined by an appraisal.
GST Tax Consequences
The IRS ruled that the termination of the trust as proposed wouldn’t make the trust or any distribution from it subject to GST tax pursuant to Internal Revenue Code Section 2601.
Treasury Regulations Section 26.2601-1(b)(4)(i)(D) provides that modification of a governing instrument of a “grandfathered” (created and wholly funded prior to September 25, 1985) GST-exempt trust won’t cause an exempt trust to be subject to GST tax if the modification doesn’t shift a beneficial interest in the trust to any beneficiary who occupies a lower generation than the person or persons who held the beneficial interest prior to the modification; such a shift would occur if the modification can increase the amount of a GST or create a new GST. The IRS ruled that the proposed agreement meets the safe harbor of Treas. Regs. Section 26.2601-1(b)(4)(i)(D) because the proposed transaction wouldn’t result in such a shift, and therefore no GST tax would occur.
Gift Tax Consequences
The IRS ruled that the beneficiary’s beneficial interests, rights and expectancies would remain substantially the same before and after the trust termination under the proposed agreement, provided that the actuarial values of each beneficiary’s interest are accurately captured under the applicable appraisal. Therefore, no taxable gifts would be made under the proposed agreement.
Income Tax Consequences
The IRS ruled that the proposed agreement is a sale of the beneficiary’s and the successor remaindermen’s interests to the current remaindermen and an exchange by the current remaindermen of their interests to the other beneficiaries. Therefore, the amounts the beneficiary will receive are via sale or exchange to the current remaindermen and will be taxed as long-term capital gains under IRC Section 1222(3) because the beneficiary’s holding period in the trust exceeded one year. Similarly, amounts to be received by the successor remaindermen are amounts received via the sale or exchange of a capital asset. They would be taxed as long-term capital gains as their holding period in the trust also exceeded one year. Further, to the extent that the current remaindermen exchange property for the interests of the beneficiary and the successor remaindermen, the current remaindermen will recognize gain or loss on the property exchanged (they’ll realize an amount equal to the fair market value of the property transferred to the beneficiary and successor remaindermen).