[Federal Register Volume 65, Number 245 (Wednesday, December 20, 2000)]
[Rules and Regulations]
[Pages 79735-79740]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-31757]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 26

[TD 8912]
RIN 1545-AX08


Generation-Skipping Transfer Issues

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
application of the effective date rules of the generation-skipping 
transfer (GST) tax imposed under chapter 13 of the Internal Revenue 
Code (Code). These regulations provide guidance with respect to the 
type of trust modifications that will not affect the exempt status of a 
trust. In addition, these regulations clarify the application of the 
effective date rules in the case of property transferred pursuant to 
the exercise of a general power of appointment. These regulations are 
necessary to provide guidance to taxpayers so that they may properly 
determine if chapter 13 of the Code is applicable to a particular 
trust.

DATES: These regulations are effective December 20, 2000.

SUPPLEMENTARY INFORMATION:

Background

    On November 18, 1999, the Treasury Department and the IRS published 
in the Federal Register (64 FR 62997) a notice of proposed rulemaking 
(REG-103841-99) relating to the application of the GST tax provisions 
where the terms of a trust that was irrevocable before the effective 
date of the statute are changed or modified after that date. The IRS 
received comments on the notice of proposed rulemaking. In addition, a 
public hearing was held on March 15, 2000. This document adopts final 
regulations with respect to the notice of proposed rulemaking. A 
summary of the principle comments received is provided below.

[[Page 79736]]

1. The Regulatory Approach

    In general, under the effective date rules accompanying the GST 
statutory provisions, a trust that was irrevocable on September 25, 
1985, is not subject to the GST tax provisions, unless a GST transfer 
is made out of corpus added to the trust after that date. Section 
1433(b)(2)(A) of the Tax Reform Act of 1986 (TRA), Public Law 99-514 
(100 Stat. 2085, 2731), 1986-3 (Vol. 1) C.B. 1, 634. Such trusts are 
hereinafter referred to as exempt trusts for GST tax purposes. The 
proposed regulations provide a number of safe harbors with respect to 
changes that can be made to the terms of an exempt trust that will not 
result in the loss of exempt status.
    Commentators argued that the approach set forth in the proposed 
regulations is inconsistent with the statutory effective date 
provisions. They contend that, under the TRA, with the exception of 
additions to principal, modifications or other actions with respect to 
a trust should not affect the trust's exempt status. Rather, any change 
should have GST tax consequences only if the change subjects the trust 
principal to a current gift tax. In that case, the individual making 
the gift will be treated, to the extent of the gift, as the transferor 
of the trust for GST tax purposes and the trust, to the extent of the 
gift, will be subject to the GST tax regime.
    This approach was not adopted. The statutory effective date 
provision protects generation-skipping trusts that were irrevocable 
before the GST tax was enacted and presumably could not be changed to 
avoid the imposition of the tax. The Treasury Department and the IRS 
believe that the approach adopted in the regulations is consistent with 
Congressional intent to protect these trusts and that most of the 
modifications that will not affect the exempt status of a trust will be 
covered by the safe harbors in the final regulations.

2. Trustee Discretionary Actions

    Under the proposed regulations, where there is a distribution of 
trust principal from an exempt trust to a new trust, the new trust will 
be an exempt trust if the terms of the governing instrument of the old 
trust authorize the trustee to make distributions to the new trust 
without the consent or approval of any beneficiary or court and the 
terms of the new trust do not extend the time for vesting of any 
beneficial interest in the trust beyond the applicable perpetuities 
period.
    In response to comments, the final regulations clarify that the 
retention of property in a continuing trust, as well as the 
distribution of property to a new trust, will not cause loss of exempt 
status, assuming the requirements of the regulations are satisfied.
    In response to comments, the final regulations provide that 
distribution to a new trust or retention in a continuing trust will not 
cause the loss of exempt status, even if the governing instrument does 
not specifically authorize the action, if state law, at the time the 
exempt trust became irrevocable, permitted such distribution or 
retention in a continuing trust.
    One comment suggested that the final regulations provide that a 
discretionary distribution that otherwise satisfies the regulatory 
requirements should not cause the trust to lose exempt status if the 
trustee, although not required to do so, seeks approval of a court or 
the trust beneficiaries before taking action. This change was deemed 
unnecessary. An action that satisfies the requirements of the 
regulations will not cause loss of exempt status even if, for whatever 
reason, the trustee seeks a court's or a beneficiary's approval of such 
action.
    Comments suggested that the period for measuring the appropriate 
perpetuities period for the new trust should be the date the original 
trust became irrevocable under local law. The comments noted that the 
perpetuities period is properly measured from the date the trust 
becomes irrevocable, which is not always the date the trust was created 
(the date referenced in the proposed regulations). The regulations have 
been revised accordingly.

3. Settlements and Judicial Constructions

    Under the proposed regulations, a court-approved settlement of a 
bona fide issue regarding the administration of the trust or the 
construction of terms of the trust will not cause the trust to lose 
exempt status if the settlement is the product of arm's length 
negotiations, and the settlement is within the range of reasonable 
outcomes under the governing instrument and applicable state law. A 
judicial construction of a governing instrument resolving an ambiguity 
in the terms of the instrument or correcting a scrivener's error will 
not cause loss of exempt status if the judicial action involves a bona 
fide issue, and the construction is consistent with applicable state 
law that would be applied by the highest court of the state.
    One comment suggested that the standard applicable for recognition 
of settlement agreements should also apply for court decrees, such that 
one standard would govern both actions. Thus, the commentator suggested 
that a settlement agreement or court decree should be binding on the 
Service (and not cause loss of exempt status) if the result is within 
the range of reasonable outcomes and the agreement or court decision is 
the product of adversarial proceedings. The suggestion was not adopted. 
The standard applied in the regulations for court decrees was 
enunciated by the Supreme Court in Commissioner v. Estate of Bosch, 387 
U.S. 456 (1967), and has been continuously and repeatedly applied by 
the IRS and the courts. The adoption of a different standard at this 
time is not appropriate.
    Another comment addressing the rule for settlements stated that the 
requirement that the settlement fall within the range of reasonable 
outcomes under the governing instrument and state law could be read to 
deny protection to a settlement that reaches a result that a court 
could not reach. However, the purpose of this rule is not to restrict 
safe harbor protection to only those settlements that reach the result 
a court could reach if the issue was litigated. Rather, the rule is 
intended to afford the parties a greater degree of latitude to settle a 
case than would be available if a court had to decide the issue. Thus, 
a settlement ``within the range of reasonable outcomes'' would include 
a compromise that reflects the parties' assessment of their relative 
rights and the strengths and weaknesses of their respective positions. 
The settlement need not (and it is anticipated that in most cases it 
would not) resolve the issue in the same manner as a court decision on 
the merits. Language has been added to the final regulations 
emphasizing this point. On the other hand, as illustrated in the 
preamble to the proposed regulations, a settlement that, for example, 
creates beneficial interests that did not exist under a reasonable 
interpretation of the instrument will not satisfy the regulations.
    One comment suggested that the scope of the judicial construction 
rule should be expanded to cover not only ambiguities and scrivener's 
error, but any request for court instructions or any similar 
proceedings such as requests to modernize the trust instrument, or 
adapt the instrument to unforeseen changed circumstances. This 
suggestion was not adopted. The Treasury Department and the IRS believe 
that these and similar actions are properly addressed under the safe-
harbor ``shift in beneficial interest'' rule provided in the 
regulations, and a separate category to address these items is not 
needed.

4. Other Changes

    Under the proposed regulations, a modification that does not 
satisfy the

[[Page 79737]]

regulatory rules for trustee distributions, settlements, and 
constructions will not cause a trust to lose exempt status, if the 
modification does not shift a beneficial interest in the trust to any 
beneficiary who occupies a lower generation (as defined in section 
2651) than the person or persons who held the beneficial interest prior 
to the modification, and 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.
    Comments suggested that the regulations should provide additional 
guidance on when a modification shifts a beneficial interest in a 
trust. In response to these comments, the final regulations provide 
that a modification to an exempt trust will result in a shift in 
beneficial interest to a lower generation beneficiary if the 
modification can result in an increase in a GST transfer or create a 
new GST transfer. To determine whether a modification of an irrevocable 
trust will shift a beneficial interest in a trust to a beneficiary who 
occupies a lower generation, the effect of the instrument on the date 
of the modification is measured against the effect of the instrument in 
existence immediately before the modification. If the effect of the 
modification cannot be immediately determined, it is deemed to shift a 
beneficial interest in the trust to a beneficiary who occupies a lower 
generation (as defined in section 2651) than the person or persons who 
held the beneficial interest prior to the modification.
    In conjunction with this change, the final regulations remove 
Example 7 contained in Sec. 26.2601-1(b)(2)(vii)(B). This example had 
illustrated the transition rule contained in Sec. 26.2601-1(b)(2) for 
generation-skipping transfers under wills or revocable trusts executed 
before October 22, 1986. Under this rule, the GST tax does not apply to 
transfers made under a will or revocable trust executed before October 
22, 1986, if the decedent dies before January 1, 1987, and the 
instrument is not amended after October 21, 1986, in any respect that 
results in the creation of, or increase in the amount of, a generation-
skipping transfer. In Example 7, trust income is to be distributed 
equally, for life, to A, B, and C who are skip persons assigned to the 
same generation. The trust is amended to increase A's share of the 
income. The example concludes that the trust is subject to GST tax 
because the amendment increases the amount of the generation-skipping 
transfers to be made to A. The amendment to the trust, however, does 
not increase the amount of a generation-skipping transfer when viewed 
in the aggregate. The amendment merely shifts an interest from one 
beneficiary to another beneficiary assigned to the same generation. 
Example 7 in Sec. 26.2601-1(b)(4)(i)(E) considers a substantially 
similar fact pattern involving a trust that is irrevocable on or before 
September 25, 1985, and concludes that the modification will not result 
in an increase in a generation-skipping transfer.
    The standard contained in Sec. 26.2601-1(b)(2) (relating to wills 
and revocable trusts executed before October 22, 1986) is similar to 
the standard contained in Sec. 26.2602-1(b)(4)(i)(D)(relating to a 
modification to a trust that was irrevocable on September 25, 1985). 
The Treasury Department and the IRS believe that the two provisions 
should be applied in a consistent manner. Therefore, Example 7 in 
Sec. 26.2601-1(b)(2)(vii)(B) has been eliminated.
    In response to comments, the final regulations specify that changes 
that are administrative in nature (such as a change in the number of 
trustees) will not cause the trust to lose its exempt status. An 
example has been added illustrating this point.
    Several comments indicated that many states have adopted, or are 
considering adopting, section 104 of the Revised Uniform Principal and 
Income Act. Unif. Principal and Income Act Sec. 104, 7B U.L.A. 141 
(1997) (Act). The Act allows a trustee to adjust between principal and 
income to the extent necessary to produce an equitable result, if the 
trustee invests and manages trust assets pursuant to the state's 
prudent investor statute and the trustee is unable to administer the 
trust fairly and reasonably under the general statutory rules governing 
the allocation of income and principal. In addition, the comments noted 
that some state legislatures are contemplating revising their state 
principal and income act to define trust income as a unitrust amount (a 
fixed percentage of the trust principal determined annually). The 
comments suggested that the regulations provide additional safe harbors 
to the effect that the administration of an exempt trust pursuant to a 
state statute adopting the Act, or the conversion of an income interest 
to a unitrust interest pursuant to a court order or a state statute 
redefining trust income, would not cause the trust to lose exempt 
status.
    A guidance project considering the tax consequences of these state 
law changes in a broader context is currently under consideration. 
Accordingly, these regulations do not specifically address this issue. 
However, two examples have been added to the regulations illustrating 
circumstances under which a trust will not lose exempt status where an 
income interest is converted to an interest that pays the greater of 
trust income or a unitrust amount, and a trust is modified to allow 
allocation of capital gain to income.
    In response to a comment, the facts presented in Sec. 26.2601-
1(b)(4)(i)(E) Example 5, have been changed to clarify that after the 
trusts are partitioned, if either beneficiary should die without 
descendants surviving, the principal of their partitioned trust will 
pass to the other partitioned trust.

5. Effective Dates and Other Matters

    Comments requested clarification regarding the status of exempt 
trusts that were modified or subject to other actions (for example, 
judicial constructions or settlements) prior to the effective date of 
these regulations, December 20, 2000. The IRS will not challenge the 
exempt status of a trust that was, prior to December 20, 2000, subject 
to any trustee action, judicial construction, settlement agreement, 
modification, or other action, if the action satisfies the requirements 
of the regulations.
    Finally, with respect to the deletion of Sec. 26.2601-
1(b)(2)(vii)(B) Example 7, discussed above, the IRS will not follow 
that example when applying the rule in Sec. 26.2601-1(b)(2).

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 
6) do not apply to these regulations, and therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Internal Revenue Code, the notice of proposed rulemaking preceding 
these regulations was submitted to the Small Business Administration 
for comment on its impact on small business.

Drafting Information

    The principal author of these regulations is James F. Hogan, Office 
of the Chief Counsel, IRS. Other personnel from the IRS and the 
Treasury Department participated in their development.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 26 is amended as follows:

[[Page 79738]]

PART 26--GENERATION-SKIPPING TRANSFER TAX REGULATIONS UNDER THE TAX 
REFORM ACT OF 1986

    Par. 1. The authority citation for part 26 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. In Sec. 26.2600-1, the table is amended under Sec. 26.2601-
1 by revising the entry for paragraph (b)(4) and adding an entry for 
paragraph (b)(5) to read as follows:


Sec. 26.2600-1  Table of contents.

* * * * *


Sec. 26.2601-1.  Effective dates.

* * * * *
    (b) * * *
* * * * *
    (4) Retention of trust's exempt status in the case of 
modifications, etc.
    (5) Exceptions to additions rule.
* * * * *

    Par. 3. Section 26.2601-1 is amended as follows:
    1. Adding four sentences to the end of paragraph (b)(1)(i).
    2. Paragraph (b)(2)(vii)(B) is amended by revising the heading, 
removing Example 7, and redesignating Examples 8 and 9 as Examples 7 
and 8, respectively.
    2. Redesignating paragraph (b)(4) as paragraph (b)(5).
    3. Adding a new paragraph (b)(4).
    4. Paragraph (c) is amended by adding a new sentence to the end of 
the paragraph.
    The additions read as follows:


Sec. 26.2601-1  Effective dates.

* * * * *
    (b) * * * (1) * * * (i) * * * Further, the rule in the first 
sentence of this paragraph (b)(1)(i) does not apply to a transfer of 
property pursuant to the exercise, release, or lapse of a general power 
of appointment that is treated as a taxable transfer under chapter 11 
or chapter 12. The transfer is made by the person holding the power at 
the time the exercise, release, or lapse of the power becomes 
effective, and is not considered a transfer under a trust that was 
irrevocable on September 25, 1985. See paragraph (b)(1)(v)(B) of this 
section regarding the treatment of the release, exercise, or lapse of a 
power of appointment that will result in a constructive addition to a 
trust. See Sec. 26.2652-1(a) for the definition of a transferor.
* * * * *
    (2) * * *
    (vii) * * *
    (B) Facts applicable to Examples 6 through 8.
* * * * *
    (4) Retention of trust's exempt status in the case of 
modifications, etc.--(i) In general. This paragraph (b)(4) provides 
rules for determining when a modification, judicial construction, 
settlement agreement, or trustee action with respect to a trust that is 
exempt from the generation-skipping transfer tax under paragraph 
(b)(1), (2), or (3) of this section (hereinafter referred to as an 
exempt trust) will not cause the trust to lose its exempt status. The 
rules contained in this paragraph (b)(4) are applicable only for 
purposes of determining whether an exempt trust retains its exempt 
status for generation-skipping transfer tax purposes. The rules do not 
apply in determining, for example, whether the transaction results in a 
gift subject to gift tax, or may cause the trust to be included in the 
gross estate of a beneficiary, or may result in the realization of 
capital gain for purposes of section 1001.
    (A) Discretionary powers. The distribution of trust principal from 
an exempt trust to a new trust or retention of trust principal in a 
continuing trust will not cause the new or continuing trust to be 
subject to the provisions of chapter 13, if--
    (1) Either--
    (i) The terms of the governing instrument of the exempt trust 
authorize distributions to the new trust or the retention of trust 
principal in a continuing trust, without the consent or approval of any 
beneficiary or court; or
    (ii) at the time the exempt trust became irrevocable, state law 
authorized distributions to the new trust or retention of principal in 
the continuing trust, without the consent or approval of any 
beneficiary or court; and
    (2) The terms of the governing instrument of the new or continuing 
trust do not extend the time for vesting of any beneficial interest in 
the trust in a manner that may postpone or suspend the vesting, 
absolute ownership, or power of alienation of an interest in property 
for a period, measured from the date the original trust became 
irrevocable, extending beyond any life in being at the date the 
original trust became irrevocable plus a period of 21 years, plus if 
necessary, a reasonable period of gestation. For purposes of this 
paragraph (b)(4)(i)(A), the exercise of a trustee's distributive power 
that validly postpones or suspends the vesting, absolute ownership, or 
power of alienation of an interest in property for a term of years that 
will not exceed 90 years (measured from the date the original trust 
became irrevocable) will not be considered an exercise that postpones 
or suspends vesting, absolute ownership, or the power of alienation 
beyond the perpetuities period. If a distributive power is exercised by 
creating another power, it is deemed to be exercised to whatever extent 
the second power may be exercised.
    (B) Settlement. A court-approved settlement of a bona fide issue 
regarding the administration of the trust or the construction of terms 
of the governing instrument will not cause an exempt trust to be 
subject to the provisions of chapter 13, if--
    (1) The settlement is the product 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. A settlement that results in a compromise 
between the positions of the litigating parties and reflects the 
parties' assessments of the relative strengths of their positions is a 
settlement that is within the range of reasonable outcomes.
    (C) Judicial construction. A judicial construction of a governing 
instrument to resolve an ambiguity in the terms of the instrument or to 
correct a scrivener's error will not cause an exempt trust to be 
subject to the provisions of chapter 13, 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 highest court of the state.
    (D) Other changes. (1) A modification of the governing instrument 
of an exempt trust (including a trustee distribution, settlement, or 
construction that does not satisfy paragraph (b)(4)(i)(A), (B), or (C) 
of this section) by judicial reformation, or nonjudicial reformation 
that is valid under applicable state law, will not cause an exempt 
trust to be subject to the provisions of chapter 13, if the 
modification does not shift a beneficial interest in the trust to any 
beneficiary who occupies a lower generation (as defined in section 
2651) than the person or persons who held the beneficial interest prior 
to the modification, and 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.
    (2) For purposes of this section, a modification of an exempt trust 
will result in a shift in beneficial interest to a lower generation 
beneficiary if the modification can result in either an increase in the 
amount of a GST transfer or the creation of a new GST transfer.

[[Page 79739]]

To determine whether a modification of an irrevocable trust will shift 
a beneficial interest in a trust to a beneficiary who occupies a lower 
generation, the effect of the instrument on the date of the 
modification is measured against the effect of the instrument in 
existence immediately before the modification. If the effect of the 
modification cannot be immediately determined, it is deemed to shift a 
beneficial interest in the trust to a beneficiary who occupies a lower 
generation (as defined in section 2651) than the person or persons who 
held the beneficial interest prior to the modification. A modification 
that is administrative in nature that only indirectly increases the 
amount transferred (for example, by lowering administrative costs or 
income taxes) will not be considered to shift a beneficial interest in 
the trust.
    (E) Examples. The following examples illustrate the application of 
this paragraph (b)(4). In each example, assume that the trust 
established in 1980 was irrevocable for purposes of paragraph 
(b)(1)(ii) of this section and that there have been no additions to any 
trust after September 25, 1985. The examples are as follows:

    Example 1. Trustee's power to distribute principal authorized 
under trust instrument. In 1980, Grantor established an irrevocable 
trust (Trust) for the benefit of Grantor's child, A, A's spouse, and 
A's issue. At the time Trust was established, A had two children, B 
and C. A corporate fiduciary was designated as trustee. Under the 
terms of Trust, the trustee has the discretion to distribute all or 
part of the trust income to one or more of the group consisting of 
A, A's spouse or A's issue. The trustee is also authorized to 
distribute all or part of the trust principal to one or more trusts 
for the benefit of A, A's spouse, or A's issue under terms specified 
by the trustee in the trustee's discretion. Any trust established 
under Trust, however, must terminate 21 years after the death of the 
last child of A to die who was alive at the time Trust was executed. 
Trust will terminate on the death of A, at which time the remaining 
principal will be distributed to A's issue, per stirpes. In 2002, 
the trustee distributes part of Trust's principal to a new trust for 
the benefit of B and C and their issue. The new trust will terminate 
21 years after the death of the survivor of B and C, at which time 
the trust principal will be distributed to the issue of B and C, per 
stirpes. The terms of the governing instrument of Trust authorize 
the trustee to make the distribution to a new trust without the 
consent or approval of any beneficiary or court. In addition, the 
terms of the governing instrument of the new trust do not extend the 
time for vesting of any beneficial interest in a manner that may 
postpone or suspend the vesting, absolute ownership or power of 
alienation of an interest in property for a period, measured from 
the date of creation of Trust, extending beyond any life in being at 
the date of creation of Trust plus a period of 21 years, plus if 
necessary, a reasonable period of gestation. Therefore, neither 
Trust nor the new trust will be subject to the provisions of chapter 
13 of the Internal Revenue Code.
    Example 2. Trustee's power to distribute principal pursuant to 
state statute. In 1980, Grantor established an irrevocable trust 
(Trust) for the benefit of Grantor's child, A, A's spouse, and A's 
issue. At the time Trust was established, A had two children, B and 
C. A corporate fiduciary was designated as trustee. Under the terms 
of Trust, the trustee has the discretion to distribute all or part 
of the trust income or principal to one or more of the group 
consisting of A, A's spouse or A's issue. Trust will terminate on 
the death of A, at which time, the trust principal will be 
distributed to A's issue, per stirpes. Under a state statute enacted 
after 1980 that is applicable to Trust, a trustee who has the 
absolute discretion under the terms of a testamentary instrument or 
irrevocable inter vivos trust agreement to invade the principal of a 
trust for the benefit of the income beneficiaries of the trust, may 
exercise the discretion by appointing so much or all of the 
principal of the trust in favor of a trustee of a trust under an 
instrument other than that under which the power to invade is 
created, or under the same instrument. The trustee may take the 
action either with consent of all the persons interested in the 
trust but without prior court approval, or with court approval, upon 
notice to all of the parties. The exercise of the discretion, 
however, must not reduce any fixed income interest of any income 
beneficiary of the trust and must be in favor of the beneficiaries 
of the trust. Under state law prior to the enactment of the state 
statute, the trustee did not have the authority to make 
distributions in trust. In 2002, the trustee distributes one-half of 
Trust's principal to a new trust that provides for the payment of 
trust income to A for life and further provides that, at A's death, 
one-half of the trust remainder will pass to B or B's issue and one-
half of the trust will pass to C or C's issue. Because the state 
statute was enacted after Trust was created and requires the consent 
of all of the parties, the transaction constitutes a modification of 
Trust. However, the modification does not shift any beneficial 
interest in Trust to a beneficiary or beneficiaries who occupy a 
lower generation than the person or persons who held the beneficial 
interest prior to the modification. In addition, the modification 
does not extend the time for vesting of any beneficial interest in 
Trust beyond the period provided for in the original trust. The new 
trust will terminate at the same date provided under Trust. 
Therefore, neither Trust nor the new trust will be subject to the 
provisions of chapter 13 of the Internal Revenue Code.
    Example 3. Construction of an ambiguous term in the instrument. 
In 1980, Grantor established an irrevocable trust for the benefit of 
Grantor's children, A and B, and their issue. The trust is to 
terminate on the death of the last to die of A and B, at which time 
the principal is to be distributed to their issue. However, the 
provision governing the termination of the trust is ambiguous 
regarding whether the trust principal is to be distributed per 
stirpes, only to the children of A and B, or per capita among the 
children, grandchildren, and more remote issue of A and B. In 2002, 
the trustee files a construction suit with the appropriate local 
court to resolve the ambiguity. The court issues an order construing 
the instrument to provide for per capita distributions to the 
children, grandchildren, and more remote issue of A and B living at 
the time the trust terminates. The court's construction resolves a 
bona fide issue regarding the proper interpretation of the 
instrument and is consistent with applicable state law as it would 
be interpreted by the highest court of the state. Therefore, the 
trust will not be subject to the provisions of chapter 13 of the 
Internal Revenue Code.
    Example 4. Change in trust situs. In 1980, Grantor, who was 
domiciled in State X, executed an irrevocable trust for the benefit 
of Grantor's issue, naming a State X bank as trustee. Under the 
terms of the trust, the trust is to terminate, in all events, no 
later than 21 years after the death of the last to die of certain 
designated individuals living at the time the trust was executed. 
The provisions of the trust do not specify that any particular state 
law is to govern the administration and construction of the trust. 
In State X, the common law rule against perpetuities applies to 
trusts. In 2002, a State Y bank is named as sole trustee. The effect 
of changing trustees is that the situs of the trust changes to State 
Y, and the laws of State Y govern the administration and 
construction of the trust. State Y law contains no rule against 
perpetuities. In this case, however, in view of the terms of the 
trust instrument, the trust will terminate at the same time before 
and after the change in situs. Accordingly, the change in situs does 
not shift any beneficial interest in the trust to a beneficiary who 
occupies a lower generation (as defined in section 2651) than the 
person or persons who held the beneficial interest prior to the 
transfer. Furthermore, the change in situs does not extend the time 
for vesting of any beneficial interest in the trust beyond that 
provided for in the original trust. Therefore, the trust will not be 
subject to the provisions of chapter 13 of the Internal Revenue 
Code. If, in this example, as a result of the change in situs, State 
Y law governed such that the time for vesting was extended beyond 
the period prescribed under the terms of the original trust 
instrument, the trust would not retain exempt status.
    Example 5. Division of a trust. In 1980, Grantor established an 
irrevocable trust for the benefit of his two children, A and B, and 
their issue. Under the terms of the trust, the trustee has the 
discretion to distribute income and principal to A, B, and their 
issue in such amounts as the trustee deems appropriate. On the death 
of the last to die of A and B, the trust principal is to be 
distributed to the living issue of A and B, per stirpes. In 2002, 
the appropriate local court approved the division of the trust into 
two equal trusts, one for the benefit of A and A's issue and one for 
the benefit of B and B's issue. The trust for A and A's issue 
provides that the trustee has the discretion to distribute trust 
income and principal to A and A's issue in such amounts as the 
trustee

[[Page 79740]]

deems appropriate. On A's death, the trust principal is to be 
distributed equally to A's issue, per stirpes. If A dies with no 
living descendants, the principal will be added to the trust for B 
and B's issue. The trust for B and B's issue is identical (except 
for the beneficiaries), and terminates at B's death at which time 
the trust principal is to be distributed equally to B's0 issue, per 
stirpes. If B dies with no living descendants, principal will be 
added to the trust for A and A's issue. The division of the trust 
into two trusts does not shift any beneficial interest in the trust 
to a beneficiary who occupies a lower generation (as defined in 
section 2651) than the person or persons who held the beneficial 
interest prior to the division. In addition, the division does not 
extend the time for vesting of any beneficial interest in the trust 
beyond the period provided for in the original trust. Therefore, the 
two partitioned trusts resulting from the division will not be 
subject to the provisions of chapter 13 of the Internal Revenue 
Code.
    Example 6. Merger of two trusts. In 1980, Grantor established an 
irrevocable trust for Grantor's child and the child's issue. In 
1983, Grantor's spouse also established a separate irrevocable trust 
for the benefit of the same child and issue. The terms of the 
spouse's trust and Grantor's trust are identical. In 2002, the 
appropriate local court approved the merger of the two trusts into 
one trust to save administrative costs and enhance the management of 
the investments. The merger of the two trusts does not shift any 
beneficial interest in the trust to a beneficiary who occupies a 
lower generation (as defined in section 2651) than the person or 
persons who held the beneficial interest prior to the merger. In 
addition, the merger does not extend the time for vesting of any 
beneficial interest in the trust beyond the period provided for in 
the original trust. Therefore, the trust that resulted from the 
merger will not be subject to the provisions of chapter 13 of the 
Internal Revenue Code.
    Example 7. Modification that does not shift an interest to a 
lower generation. In 1980, Grantor established an irrevocable trust 
for the benefit of Grantor's grandchildren, A, B, and C. The trust 
provides that income is to be paid to A, B, and C, in equal shares 
for life. The trust further provides that, upon the death of the 
first grandchild to die, one-third of the principal is to be 
distributed to that grandchild's issue, per stirpes. Upon the death 
of the second grandchild to die, one-half of the remaining trust 
principal is to be distributed to that grandchild's issue, per 
stirpes, and upon the death of the last grandchild to die, the 
remaining principal is to be distributed to that grandchild's issue, 
per stirpes. In 2002, A became disabled. Subsequently, the trustee, 
with the consent of B and C, petitioned the appropriate local court 
and the court approved a modification of the trust that increased 
A's share of trust income. The modification does not shift a 
beneficial interest to a lower generation beneficiary because the 
modification does not increase the amount of a GST transfer under 
the original trust or create the possibility that new GST transfers 
not contemplated in the original trust may be made. In this case, 
the modification will increase the amount payable to A who is a 
member of the same generation as B and C. In addition, 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. Therefore, the trust as modified will not be subject to the 
provisions of chapter 13 of the Internal Revenue Code. However, the 
modification increasing A's share of trust income is a transfer by B 
and C to A for Federal gift tax purposes.
    Example 8. Conversion of income interest into unitrust interest. 
In 1980, Grantor established an irrevocable trust under the terms of 
which trust income is payable to A for life and, upon A's death, the 
remainder is to pass to A's issue, per stirpes. In 2002, the 
appropriate local court approves a modification to the trust that 
converts A's income interest into the right to receive the greater 
of the entire income of the trust or a fixed percentage of the trust 
assets valued annually (unitrust interest) to be paid each year to A 
for life. The modification does not result in a shift in beneficial 
interest to a beneficiary who occupies a lower generation (as 
defined in section 2651) than the person or persons who held the 
beneficial interest prior to the modification. In this case, the 
modification can only operate to increase the amount distributable 
to A and decrease the amount distributable to A's issue. In 
addition, 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. Therefore, the trust will not be subject to 
the provisions of chapter 13 of the Internal Revenue Code.
    Example 9. Allocation of capital gain to income. In 1980, 
Grantor established an irrevocable trust under the terms of which 
trust income is payable to Grantor's child, A, for life, and upon 
A's death, the remainder is to pass to the A's issue, per stirpes. 
Under applicable state law, unless the governing instrument provides 
otherwise, capital gain is allocated to principal. In 2002, the 
trust is modified to allow the trustee to allocate capital gain to 
the income. The modification does not shift any beneficial interest 
in the trust to a beneficiary who occupies a lower generation (as 
defined in section 2651) than the person or persons who held the 
beneficial interest prior to the modification. In this case, the 
modification can only have the effect of increasing the amount 
distributable to A, and decreasing the amount distributable to A's 
issue. In addition, 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. Therefore, the trust will not be 
subject to the provisions of chapter 13 of the Internal Revenue 
Code.
    Example 10. Administrative change to terms of a trust. In 1980, 
Grantor executed an irrevocable trust for the benefit of Grantor's 
issue, naming a bank and five other individuals as trustees. In 
2002, the appropriate local court approves a modification of the 
trust that decreases the number of trustees which results in lower 
administrative costs. The modification pertains to the 
administration of the trust and does not shift a beneficial interest 
in the trust to any beneficiary who occupies a lower generation (as 
defined in section 2651) than the person or persons who held the 
beneficial interest prior to the modification. In addition, 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. Therefore, the trust will not be subject to the provisions of 
chapter 13 of the Internal Revenue Code.

    (ii) Effective date. The rules in this paragraph (b)(4) are 
applicable on and after December 20, 2000.
* * * * *
    (c) * * * The last four sentences in paragraph (b)(1)(i) of this 
section are applicable on and after November 18, 1999.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: December 7, 2000.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 00-31757 Filed 12-19-00; 8:45 am]
BILLING CODE 4830-01-P