Sep 1, 2007 12:00 PM, Rorie M. Sherman Editor in Chief

By: Rorie M. Sherman Editor in Chief

David A. Handler, partner, and Margaret L. Hudgins, associate, in the Chicago office of Kirkland & Ellis report:

• Final and proposed qualified severance regulations issued. On July 24, 2007, the Internal Revenue Service issued final regulations regarding “qualified severances” of trusts for generation-skipping transfer tax (GST) purposes under Internal Revenue Code Section 2642(a)(3). These regulations amend and finalize the regulations issued in 2004.

  First, the severance rules contained in Treasury Regulations Section 26.2654-1(b) are not superseded by IRC Section 2642(a)(3). The former recognizes severances of testamentary trusts and revocable inter vivos trusts included in the transferor's gross estate. Such severances are necessary to fully utilize available tax benefits, and therefore must be effective retroactively to the date of death. The Section 2642(a)(3) qualified severances are effective prospectively from the date of severance and thus, only addresses severances that typically would occur after an irrevocable trust has been in existence for a period of time.

  Second, the funding of the trusts resulting from the severance must occur within a “reasonable time” from the “date of severance.” The date of severance — the date upon which the values of the trust assets are based — is selected by the trustee or is the court-imposed date of funding in the case of a local court order. Funding must be commenced immediately upon the date of severance and occur within a reasonable time (but in no event more than 90 days) after the date of severance. Treas. Regs. Sections 26.2642-6(d) and 26.2642-6(j), Example 11 demonstrate that what constitutes a “reasonable time” depends on the nature of the asset. In the case of marketable securities and cash, the transfers would have to be completed immediately after the severance date to satisfy the reasonable time requirement.

  Third, the regulations clarify that if the qualified severance itself results in a GST taxable event, the taxable event is treated as occurring immediately after the severance. Therefore, if the resulting trust that is a skip person has a zero-inclusion ratio after the severance, then no GST tax will result from the taxable event that is deemed to occur after the severance. See Treas. Regs. Sections 26.2642-6(f)(2) and 26.2642-6(j), Example 8.

  Fourth, each beneficiary's interest in the resulting trusts (collectively) must equal the beneficiary's interest in the original trust, determined by the terms of the trust instrument, or if the trust does not define their interests, on a per capita basis. For example, in the case of the severance of a discretionary trust established for the benefit of A, B, C and their descendants, with the remainder to be divided equally among those three families, this requirement is satisfied if the trust is divided into three separate trusts of equal value with one trust established for the benefit of A and A's descendants, one trust for B and B's descendants, and one for C and C's descendants. See Treas. Regs. Section 26.2642-6(d)(5)(ii). Severances based on actuarial values of beneficial interests do not qualify. See Treas. Regs. Section 26.2642-6(j), Example 3.

  Finally, in Treas. Regs. Section 26.2642-6(j), Example 10, the trust with an inclusion ratio of .60 exists for the benefit of C, which will pass in accordance with C's exercise of a testamentary limited power in favor of C's lineal descendants. However, the trust provides that if, at the time of C's death, the trust's inclusion ratio is greater than zero, then C also may appoint that fraction of the trust corpus equal to the inclusion ratio to the creditors of C's estate. The trustee severs the trust into two trusts: Trust 1 is funded with 40 percent of the assets, and Trust 2 is funded with 60 percent of the assets. Trust 1 and Trust 2 are identical to the original trust, except that upon C's death, Trust 1 is to pass in accordance with C's exercise of his testamentary limited power of appointment in favor of his lineal descendants, and Trust 2 is to pass in accordance with C's exercise of his power to appoint in favor of his descendants and creditors of his estate. The example states that the severance constitutes a qualified severance, the inclusion ratio of Trust 1 is zero and the inclusion ratio of Trust 2 is one. For those in doubt, this example implicitly recognizes that a general power of appointment, the existence of which is based on the GST-exempt status of a trust, is effective to avoid GST tax.

  On the same date, the IRS issued new proposed regulations under Section 2642. Proposed Treas. Regs. Section 26.2642-6(d)(4) states that if a qualified severance is funded on a non-pro rata basis based on the fair market value (FMV) of the assets on the date of severance, the sum of the values distributed to the resulting trusts must equal the FMV of the trust being severed. No discounts or other reductions from the value of an asset owned by the original trust, arising by reason of the division of the original trust, are permitted in funding the resulting trusts.

  Proposed Treas. Regs. Section 26.2642-6(d)(7)(ii) would allow a trust to be severed into more than two resulting trusts. One or more of the resulting trusts in the aggregate must receive that fractional share of the total value of the original trust as of the date of severance equal to the applicable fraction used to determine the inclusion ratio of the original trust.

  Further, the proposed regulations provide that trusts resulting from non-qualified severance nevertheless will be treated as separate trusts for GST tax purposes if the resulting trusts are recognized as separate trusts under applicable state law. Each resulting trust will have the same inclusion ratio immediately after the severance as the original trust immediately before the severance, but GST tax exemption may be allocated to one or more of the resulting trusts after the severance and the trusts will otherwise be treated as separate trusts for GST tax purposes.

• Trust reformation to accommodate a child born out of wedlock did not affect GST status. In Private Letter Ruling 200728033 (issued March 26, released July 13, 2007), a trust was established before Sept. 25, 1985, and therefore was grandfathered from the GST tax. By its terms, the trust was for the benefit of the grantor's “lawful issue.” Subsequently, the grantor had a grandchild born out of wedlock, and under applicable state law, that child was not considered the grantor's “lawful issue.”

  The trustee proposed filing a reformation action in state court to remove the word “lawful” from the affected provision, and requested in this letter ruling that the proposed reformation would not cause the trust to be subject to GST tax. The trustee contended that the use of the term “lawful issue” was a scrivener's error because the words “descendant” and “issue” were used in other trust provisions without being qualified by the term “lawful,” which contradicted other portions of the trust.

  The IRS determined that because there was a bona fide issue regarding the disposition of trust property and the proposed reformation was consistent with applicable state law, the reformation would not cause the trust to lose its GST-exempt status under Treas. Regs. Section 26.2601-1(b)(4)(i)(C).

• Trustee of marital trust has no duty to use an FLP. In the Matter of Galloway, a Minnesota state court held that a corporate trustee does not have a duty to transfer marketable securities held in a qualified terminable interest property (QTIP) marital trust to a family limited partnership (FLP), C5-05-200042 (Minn. 2d Dist., April 23, 2007). According to the court, to establish a breach of fiduciary duty by a trustee, a beneficiary must establish four elements: (1) the existence of a duty; (2) breach of such duty; (3) a showing that the breach of duty proximately caused damages; and (4) damages.

  The court determined that it would be difficult to create an FLP that would achieve the desired valuation discounts while still satisfying the trustee's fiduciary duties. Based on that finding as well as expert testimony that it was rare that a QTIP trust invested in an FLP, the court held that the trustee could not be held to a standard requiring investment in an FLP.

  Moreover, the court held that the trustee's failure to create an FLP was not the proximate cause of the estate taxes, and that there were no damages because the reduction in the value of the assets transferred to the FLP would have been greater than the reduction in estate tax liability.

• IRC Section 674 trumps Section 678 (again, and again). In PLR 200730011 (issued April 25, 2007), the IRS has once again held, in a letter ruling, that IRC Sections 671-677 trumps Section 678. That is, a trust that is otherwise taxable to a beneficiary under Section 678 will not be so taxable if it is taxable to the grantor under Sections 671 through 677. In this ruling, the beneficiary had the right to withdraw amounts contributed to the trust, up to the annual exclusion amount. However, because the trust was taxable to the grantor under Section 674, the grantor is treated as the owner of “the entire Trust 1 … under §§ 674(a) and 678(b).”

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