[Federal Register Volume 69, Number 163 (Tuesday, August 24, 2004)]
[Proposed Rules]
[Pages 51967-51973]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-19352]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 26

[REG-145987-03]
RIN 1545-BC50


Qualified Severance of a Trust for Generation-Skipping Transfer 
(GST) Tax Purposes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: These proposed regulations provide guidance regarding the 
qualified severance of a trust for generation-skipping transfer (GST) 
tax purposes under section 2642(a)(3) of the Internal Revenue Code, 
which was added to the Code by the Economic Growth and Tax Relief 
Reconciliation Act of 2001 (EGTRRA). The regulations will affect trusts 
that are subject to the GST tax.

DATES: Written or electronic comments and requests for a public hearing 
must be received by November 22, 2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-145987-03), room 
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
145987-03), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the IRS 
Internet site at http://www.irs.gov/regs or via the Federal eRulemaking 
Portal at http://www.regulations.gov (IRS-REG-145987-03).

FOR FURTHER INFORMATION CONTACT: Mayer R. Samuels, (202) 622-3090 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP; 
Washington, DC

[[Page 51968]]

20224. Comments on the collection of information should be received by 
October 25, 2004. Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in this proposed regulation is in 
Sec.  26.2642-6(b). This collection of information is required by the 
IRS to identify whether a trust is exempt from the GST. This 
information will be used to determine whether the amount of tax has 
been calculated correctly. The collection of information is required in 
order to have a qualified severance. The respondents are trustees of 
trusts that are being severed.
    Estimated total annual reporting burden: 12,500 hours.
    Estimated average annual burden hours per respondent: 30 minutes.
    Estimated number of respondents: 25,000.
    Estimated annual frequency of responses: on occasion.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget. Books 
or records relating to a collection of information must be retained as 
long as their contents may become material in the administration of any 
internal revenue law. Generally, tax returns and tax return information 
are confidential, as required by 26 U.S.C. 6103.

Background

    Section 2642(a)(3) was added to the Internal Revenue Code by 
EGTRRA, Public Law 107-16 (115 Stat. 38 (2001)). Under section 
2642(a)(3), if a trust is divided into two or more trusts in a 
qualified severance, the resulting trusts will be recognized as 
separate trusts for GST tax purposes. In many cases, a qualified 
severance of a trust will facilitate the most efficient and effective 
use of the transferor's GST tax exemption. The GST tax exemption is the 
lifetime exemption applicable in determining the inclusion ratio with 
respect to the trust, which in turn determines the amount of GST tax 
imposed on any generation-skipping transfer made from the trust.
    Section 2642(a)(3) expands the options for trustees wishing to 
sever trusts by providing more time to make the severance, providing 
that severances may occur for more trusts, and providing a uniform 
system for severance. Section 2642(a)(3) was intended to supercede and 
replace Sec.  26.2654-1(b) of the Generation-Skipping Transfer Tax 
Regulations, which authorizes the recognition of severed trusts for GST 
tax purposes in limited situations involving testamentary trusts or 
inter vivos trusts that are included in the transferor's gross estate 
for estate tax purposes. That regulation does not apply to irrevocable 
inter vivos trusts that are not includible in the decedent's gross 
estate. Further, under that regulation, a severance is recognized only 
if commenced within a prescribed time period, and only if specifically 
authorized under the terms of the governing instrument or local law.
    Section 2642(a)(3)(B)(i) provides a general rule that a qualified 
severance is defined as the division of a single trust and the creation 
of two or more trusts if: (1) The single trust is divided on a 
fractional basis; and (2) the terms of the new trusts, in the 
aggregate, provide for the same succession of interests of 
beneficiaries as are provided in the original trust. Under section 
2642(a)(3)(B)(ii), if a trust has an inclusion ratio that is greater 
than zero and less than one, the trust must be severed in a specified 
manner that produces one trust that is wholly exempt from GST tax, and 
one trust that is wholly subject to GST tax. Each of the two new trusts 
created may be further divided into two or more trusts under section 
2642(a)(3)(B)(i). Under section 2642(a)(3)(C), a trustee may elect to 
sever a trust in a qualified severance at any time, and the manner in 
which the qualified severance is to be reported is to be specified by 
regulation. Section 2642(a)(3) is applicable for severances of trusts 
occurring after December 31, 2000.

Explanation of Provisions

I. Division on a Fractional Basis

    Under section 2642(a)(3), in order to constitute a qualified 
severance, the single trust must be divided on a fractional basis. 
Under the proposed regulations, each new trust must receive assets with 
a value equal to a fraction or percentage of the total value of the 
trust assets. Thus, for example, the severance of a single trust on the 
basis that one trust is to be funded with 30% of the trust assets and 
that the other trust is to be funded with the remaining 70% of the 
trust assets would satisfy this requirement. Similarly, a severance 
stated in terms of a fraction of the trust assets such that one trust 
is to receive, for example, that fraction of the trust assets the 
numerator of which is $1,500,000 and the denominator of which is the 
fair market value of the trust assets on a specified date and the 
second trust is to receive the remaining fraction, would also satisfy 
this requirement. However, the severance of a trust based on a 
pecuniary amount (for example, severance of a single trust on the basis 
that one trust is to be funded with $1,500,000, and the other trust is 
to be funded with the balance of the trust corpus) would not satisfy 
this requirement.
    The proposed regulations provide that each separate trust need not 
be funded with a pro rata portion of each asset held by the original 
trust. Rather, the separate trusts may be funded on a non pro rata 
basis (that is, where each resulting trust does not receive a pro-rata 
portion of each asset) provided that funding is based on the total fair 
market value of the assets on the date of funding. This avoids the 
necessity of dividing each and every asset on a fractional basis to 
fund the severed trusts.

II. New Trusts Must Provide for the Same Succession of Interests

    Under section 2642(a)(3)(B)(i)(II), the new trusts created as a 
result of the qualified severance must provide in the aggregate for the 
same succession of interests of beneficiaries as provided in the 
original trust. Under the regulations, the beneficiaries of each 
separate trust resulting from the severance need not be identical to 
those of the original trust. In the case of trusts that grant the 
trustee the discretionary power to make non pro rata distributions to 
beneficiaries, the separate trusts will be considered to have the same 
succession of interests of beneficiaries if the terms of the separate 
trusts are the same as the terms of the original trust, the severance 
does not shift a beneficial interest in the trust to any beneficiary in 
a lower generation (as determined under section 2651) than the person 
or persons who held the beneficial interest in the original trust, and 
the severance does not extend the time for vesting of any beneficial

[[Page 51969]]

interest in the trust beyond the period provided for in the original 
trust. This rule for discretionary trusts is intended to facilitate the 
severance of trusts along family lines.
    In this regard, the Treasury Department and the IRS recognize that 
in many cases involving discretionary trusts, when the members of two 
or more families are beneficiaries, the parties may desire to divide 
the trust along family lines so that one trust is established 
exclusively for the benefit of one family and one trust is established 
exclusively for the benefit of another family. If the inclusion ratio 
of the trust is between zero and one, section 2642(a)(3)(B)(ii) would 
ordinarily, as a practical matter, preclude the division of the trust 
along family lines because the section requires that the severance 
result in one trust with an inclusion ratio of zero and one trust with 
an inclusion ratio of one. However, under the proposed regulations, a 
similar result may be accomplished through a series of severances; that 
is, first a division of the trust based on the inclusion ratio, and 
then a division of each resulting trust along family lines.
    Finally, Sec.  26.2601-1(b)(4) of the regulations contains rules 
for determining when certain actions with respect to a non-chapter 13 
trust (a trust that was irrevocable on or before September 25, 1985) 
will not cause the trust to lose its exempt status. In particular, 
under Sec.  26.2601-1(b)(4)(i)(D)(1), a modification (including a 
severance) of a non-chapter 13 trust will not cause the trust to be 
subject to the provisions of chapter 13 if the modification does not 
(1) 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 or (2) extend the time 
for vesting of any beneficial interest in the trust beyond the period 
provided for in the original trust.
    Under the proposed regulations, the rules in Sec.  26.2601-1(b)(4) 
will continue to apply to severances (and other actions) with respect 
to trusts created on or before September 25, 1985. However, the post-
2000 severance of a trust created after September 25, 1985, will be 
governed by section 2642(a)(3) and the applicable regulations.

III. Reporting Requirements

    The proposed regulations provide that a qualified severance is to 
be reported by filing a Form 706-GS(T), ``Generation-Skipping Transfer 
Tax Return for Terminations,'' or such other form that may be published 
by the IRS in the future that is specifically designated to be utilized 
to report qualified severances. When Form 706-GS(T) is utilized, the 
filer should write ``Qualified Severance'' in red at the top of the 
return and attach a Notice of Qualified Severance to the return that 
clearly identifies the trust that is being severed and the new trusts 
created as a result of the severance. The notice must also provide the 
inclusion ratio of the trust that was severed and the inclusion ratios 
of the new trusts resulting from the severance. The return and attached 
notice must be filed even if the severance does not result in a taxable 
termination. A transition rule applies in the case of severances 
occurring before the date of publication of the final regulations.

IV. Income Tax Consequences of Severance Under the Proposed Regulations

    The proposed regulations provide that a qualified severance will 
not constitute an exchange of property for other property differing 
materially either in kind or in extent, for purposes of section 1001, 
provided that: (1) An applicable state statute or the governing 
instrument authorizes the trustee to sever the trust; and (2) if the 
separate trusts created by the severance are funded on a non pro rata 
basis, as discussed in Section I above, an applicable state statute or 
the governing instrument authorizes the trustee to fund the separate 
trusts on a non pro rata basis. If section 1001 does not apply in 
accordance with this standard, then under section 1015, the basis of 
the trust assets will be the same after the severance as the basis of 
those assets before the severance, and under section 1223, the holding 
periods of the assets distributed to the new trusts will include the 
holding period of the assets in the original trust.

V. Proposed Effective Date

    Section 2642(a)(3) supercedes the regulatory rules contained in 
Sec.  26.2654-1(b). Accordingly, under the proposed regulations, the 
applicability of Sec.  26.2654-1(b) is limited to severances occurring 
on or before December 31, 2000. The regulations under section 
2642(a)(3), as proposed, apply to severances occurring on or after the 
date of publication of the Treasury decision adopting these rules as 
final regulations. In the case of severances occurring after December 
31, 2000, and before publication of final regulations, taxpayers may 
rely on any reasonable interpretation of section 2642(a)(3) as long as 
reasonable notice concerning the severance and identification of the 
trusts involved has been given to the IRS.
    The regulations under section 1001, as proposed, apply to 
severances occurring on or after the date of publication of the 
Treasury decision adopting these rules as final regulations. However, 
taxpayers may apply the proposed regulations under section 1001 to 
severances occurring after August 24, 2004, and before publication of 
final regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations. It is hereby 
certified that the collection of information in these regulations will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based upon the fact that the collection 
of information imposed by this regulation is not significant as 
reflected in the estimated burden of information collection for, which 
is 0.5 hours per respondent, and that few trustees are likely to be 
small entities. Therefore, a Regulatory Flexibility Analysis under the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. 
Pursuant to section 7805(f) of the Internal Revenue Code, this notice 
of proposed rulemaking will be submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on its impact 
on small business.

Comments and Requests for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the substance 
of the proposed regulations, as well as on the clarity of the proposed 
rules and how they can be made easier to understand. All comments will 
be available for public inspection and copying. A public hearing will 
be scheduled if requested in writing by any person that timely submits 
written comments. If a public hearing is scheduled, notice of the date, 
time, and place for the public hearing will be published in the Federal 
Register.

Drafting Information

    The principal author of these proposed regulations is Mayer R.

[[Page 51970]]

Samuels, Office of the Associate Chief Counsel (Passthroughs and 
Special Industries), IRS. If you have any questions concerning these 
proposed regulations, please contact Mayer R. Samuels at (202) 622-
3090. Other personnel from the IRS and the Treasury Department 
participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 26

    Estate taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 26 are proposed to be amended as 
follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read, 
in part, as follows:

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

    Par. 2. In Sec.  1.1001-1, paragraph (h) is added to read as 
follows:


Sec.  1.1001-1  Computation of gain or loss.

* * * * *
    (h) Qualified severances of trusts--(1) In general. A severance of 
a trust that meets the requirements of Sec.  26.2642-6 is not an 
exchange of property for other property differing materially either in 
kind or in extent if--
    (i) An applicable state statute or the governing instrument 
authorizes the trustee to sever the trust; and
    (ii) If the separate trusts created by the severance are funded on 
a non pro rata basis as provided in Sec.  26.2642-6(b)(3), an 
applicable state statute or the governing instrument authorizes the 
trustee to fund the separate trusts on a non pro rata basis.
    (2) Effective date. This paragraph (h) applies to severances 
occurring on or after the date these regulations are published as final 
regulations in the Federal Register. Taxpayers may apply this paragraph 
(h) to severances occurring on or after August 24, 2004, and before the 
date these regulations are published as final regulations in the 
Federal Register.

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

    Par. 3. The authority citation for part 26 is amended by adding an 
entry in numerical order to read, in part, as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 26.2642-6 also issued under 26 U.S.C. 2642. * * *

    Par. 4. In Sec.  26.2600-1, the table is amended as follows.
    1. An entry for Sec.  26.2642-6 is added.
    2. The entry for Sec.  26.2654-1(b) introductory text is revised.
    3. An entry for Sec.  26.2654-1(c) is added.
    The revision and additions read as follows:


Sec.  26.2600-1  Table of contents.

* * * * *

Sec.  26.2642-6 Qualified Severance

    (a) In general.
    (b) Requirements for a qualified severance.
    (c) Time for making a qualified severance.
    (d) Irrevocable trusts.
    (e) Examples.
    (f) Effective date.
* * * * *

Sec.  26.2654-1 Certain Trusts Treated as Separate Trusts

* * * * *
    (b) Division of a trust included in the gross estate occurring 
on or before December 31, 2000.
* * * * *
    (c) Qualified severance occurring after December 31, 2000.

    Par. 5. Section 26.2642-6 is added to read as follows:


Sec.  26.2642-6  Qualified severance.

    (a) In general. If a trust is severed into two or more trusts, the 
separate trusts resulting from the severance will be treated as 
separate trusts for generation-skipping transfer tax purposes only if 
the severance is a qualified severance. In general, the rules in this 
section are applicable only for purposes of the generation-skipping 
transfer tax and are not applicable in determining, for example, 
whether the severance may result in a gift subject to gift tax, cause 
the trust to be included in the gross estate of a beneficiary, or 
result in a realization of gain for purposes of section 1001. See Sec.  
1.1001-1(h) for rules relating to whether a qualified severance will 
constitute an exchange of property for other property differing 
materially either in kind or in extent.
    (b) Requirements for a qualified severance. For purposes of this 
section, a qualified severance is a division of a single trust into two 
or more trusts that meets each of the following requirements:
    (1) The single trust is severed pursuant to the terms of the 
governing instrument, or pursuant to applicable local law.
    (2) The severance is effective under local law.
    (3) The single trust is severed on a fractional basis, such that 
each new trust is funded with a fraction or percentage of the entire 
trust. For this purpose, the fraction or percentage may be determined 
by means of a formula (for example, that fraction of the trust the 
numerator of which is equal to transferor's unused GST tax exemption, 
and the denominator of which is the fair market value of the trust 
assets on the date of severance). The severance of a trust based on a 
pecuniary amount does not satisfy this requirement. For example, the 
severance of a trust would not be a qualified severance if the trust 
was divided into two trusts, with one trust to be funded with 
$1,500,000 and the other trust to be funded with the balance of the 
original trust assets. For purposes of this paragraph, the separate 
trusts resulting from the severance may be funded with the appropriate 
fraction, percentage, or pro rata portion of each asset held by the 
undivided trust, or on a non pro rata basis. However, if funded on a 
non pro rata basis, each resulting trust must be funded by applying the 
appropriate fraction or percentage to the total fair market value of 
the trust assets as of the date of funding.
    (4) The terms of the new trusts must provide, in the aggregate, for 
the same succession of interests of beneficiaries as are provided in 
the original trust. This requirement will be satisfied if the 
beneficiaries of the separate trusts and the interests of the 
beneficiaries with respect to the separate trusts, when the separate 
trusts are viewed collectively, are identical to the beneficiaries and 
their respective beneficial interests with respect to the original 
trust before severance. With respect to trusts from which discretionary 
distributions may be made to any one or more beneficiaries on a non pro 
rata basis, this requirement will be satisfied if the terms of each of 
the separate trusts are the same as the terms of the original trust 
(even though each permissible distributee of the original trust might 
be a beneficiary of only one of the separate trusts), the severance 
does not shift a beneficial interest in the trust to any beneficiary in 
a lower generation (as determined under section 2651) than the person 
or persons who held the beneficial interest in the original trust, and 
the severance does not extend the time for vesting of any beneficial 
interest in the trust beyond the period provided for in the original 
trust.
    (5) In the case of a severance after GST tax exemption has been 
allocated to the trust as a result of an allocation, deemed allocation, 
or automatic

[[Page 51971]]

allocation pursuant to the rules contained in section 2632, if the 
trust has an inclusion ratio as defined in Sec.  26.2642-1 that is 
greater than zero and less than one, then the trust may be severed 
initially only into two trusts. One separate trust must receive that 
fractional share of the total value of all trust assets as of the date 
of funding equal to the applicable fraction, as defined in Sec.  
26.2642-1(b) and (c), with respect to the single trust immediately 
before the severance. The other separate trust must receive the balance 
of the trust assets. The trust receiving the fractional share equal to 
the applicable fraction shall have an inclusion ratio of zero, and the 
other trust shall have an inclusion ratio of one. If the applicable 
fraction with respect to the original trust is .50, then with respect 
to the two equal trusts resulting from the severance, the Trustee may 
designate which of the resulting trusts will have an inclusion ratio of 
zero and which will have an inclusion ratio of one. Each separate trust 
resulting from the severance may be further divided in accordance with 
the rules of this section.
    (6) The severance is reported by filing Form 706-GS(T), 
``Generation-Skipping Transfer Tax Return for Terminations,'' or such 
other form that may be published by the IRS that is specifically 
designated to be utilized to report qualified severances. When Form 
706-GS(T) is utilized, the filer should write ``Qualified Severance'' 
in red at the top of the return and attach a Notice of Qualified 
Severance to the return. The Notice must contain: a statement 
identifying the trust that is severed, the name of the transferor of 
the trust, the date of creation, the tax identification number, and the 
inclusion ratio with respect to the trust before severance; and a 
statement identifying each of the new trusts created as a result of the 
severance, the name and tax identification number of each new trust, 
the fraction of trust assets received by each new trust, other details 
explaining the basis for funding each new trust (a fraction of the 
total fair market value of the assets on the date of funding or a 
fraction of each asset), and the inclusion ratio of each new trust. The 
return and attached Notice must be filed by April 15th of the year 
immediately following the year during which the severance occurred or 
the last day of the period covered by an extension of time, if an 
extension of time is granted.
    (c) Time for making a qualified severance. A trust may be severed 
in a qualified severance at any time prior to the termination of the 
trust. Thus, provided that the separate trusts resulting from the 
severance continue in existence after the severance, a trust may be 
severed in a qualified severance either before or after: GST tax 
exemption has been allocated to the trust; a taxable event has occurred 
with respect to the trust; or an addition has been made to the trust. A 
qualified severance is effective at the time the trust is divided into 
two or more separate trusts. Thus, a qualified severance has no effect 
on a taxable termination as defined in section 2612(a) or a taxable 
distribution as defined in section 2612(b) that occurred prior to the 
effective date of the qualified severance.
    (d) Irrevocable trusts. See Sec.  26.2601-1(b)(4) for rules 
regarding severances and other actions with respect to trusts that were 
irrevocable on September 25, 1985.
    (e) Examples. The rules of this section are illustrated by the 
following examples:

    Example 1. Formula severance. T's will establishes a 
testamentary marital trust (Trust) that qualifies as qualified 
terminable interest property (QTIP) under section 2056(b)(7). Trust 
provides that all trust income is to be paid to T's spouse for life. 
On the spouse's death, the trust corpus is to be held in further 
trust for the benefit of T's then-living descendants. On T's date of 
death in January of 2004, T's unused GST tax exemption is 
$1,200,000, $200,000 of which T's executor will allocate to bequests 
to T's grandchildren. Prior to the due date for filing the Form 706, 
``United States Estate (and Generation-Skipping Transfer) Tax 
Return,'' for T's estate, and thus, prior to the allocation of any 
GST tax exemption with respect to Trust, T's executor, pursuant to 
applicable state law, divides Trust into two separate trusts, Trust 
1 and Trust 2. Trust 1 is to be funded with that fraction of the 
Trust assets, the numerator of which is $1,000,000, and the 
denominator of which is the value of the Trust assets as finally 
determined for federal estate tax purposes. Trust 2 is to be funded 
with the balance of the Trust assets. On the Form 706 filed for the 
estate, T's executor makes a QTIP election under section 2056(b)(7) 
with respect to Trust 1 and Trust 2 and a reverse QTIP election 
under section 2652(a)(3) with respect to Trust 1. Further, T's 
executor allocates T's available GST tax exemption to Trust 1. If 
the requirements of section 2642(a)(3) are otherwise satisfied, the 
severance constitutes a qualified severance. Accordingly, Trust 1 
and Trust 2 are treated as separate trusts, and the GST tax 
elections and GST tax exemption allocation are recognized and 
effective for generation-skipping transfer tax purposes.
    Example 2. Severance of single trust with one income 
beneficiary. T's will establishes a testamentary trust providing 
that income is to be paid to T's sister, S, for her life. On S's 
death, one-half of the corpus is to be paid to T's child, C, or to 
C's estate if C fails to survive S and one-half of the corpus is to 
be paid to T's grandchild, GC, or to GC's estate if GC fails to 
survive S. Prior to the due date for filing the Form 706, T's 
executor, pursuant to applicable state law, divides the testamentary 
trust into two separate trusts, Trust 1 and Trust 2, with each trust 
receiving 50 percent of the current value of the assets of the 
original trust. Trust 1 provides that trust income is to be paid to 
S for life with remainder to C or C's estate, and Trust 2 provides 
that trust income is to be paid to S for life with remainder to GC 
or GC's estate. Because Trust 1 and Trust 2 provide for the same 
succession of interests in the aggregate as provided in the original 
trust, the severance will constitute a qualified severance if the 
requirements of section 2642(a)(3) are otherwise satisfied. On the 
Form 706, T's executor may allocate T's available GST tax exemption 
to Trust 2.
    Example 3. Severance of discretionary trust. T's will 
establishes a testamentary trust (Trust) providing that income is to 
be paid from time to time in such amounts as the trustee deems 
advisable to T's children, A and B, and to their respective 
descendants. In addition, the trustee may distribute corpus to any 
trust beneficiary in such amounts as the trustee deems advisable. On 
the death of the last to die of A and B, the trust is to terminate 
and the corpus is to be distributed in two equal shares, one share 
to the descendants of each child, per stirpes. Prior to the due date 
for filing the Form 706, T's executor, pursuant to applicable state 
law, divides Trust into two separate trusts, Trust 1 and Trust 2. 
Trust 1 provides that income is to be paid in such amounts as the 
trustee deems advisable to A and A's descendants. In addition, the 
trustee may distribute corpus to any trust beneficiary in such 
amounts as the trustee deems advisable. On the death of A, Trust 1 
is to terminate and the corpus is to be distributed to the 
descendants of A, per stirpes, but if A dies with no living 
descendants, the principal will be added to Trust 2. Trust 2 
contains identical provisions, except that B and B's descendants are 
the trust beneficiaries and, if B dies with no living descendants, 
the principal will be added to Trust 1. Because Trust 1 and Trust 2 
provide for the same beneficiaries and the same succession of 
interests in the aggregate as provided in Trust, and because the 
severance does not shift any beneficial interest in the trust to a 
beneficiary who occupies a lower generation than the person or 
persons who held the beneficial interest in Trust, the severance 
constitutes a qualified severance if the requirements of section 
2642(a)(3) are otherwise satisfied.
    Example 4. Severance of single trust with two income 
beneficiaries. T's will establishes a testamentary trust (Trust) 
providing that Trust income is to be paid to T's children, A and B, 
for their joint lives. Upon the death of the first to die of A and 
B, the income will be paid to the survivor. At the death of the 
survivor of A and B, the corpus is to be distributed equally to T's 
grandchildren, W and X (with any then-deceased grandchild's share 
being paid to that grandchild's estate). W is A's child and X is B's 
child. Prior to the due date for filing Form 706, T's executor 
divides the testamentary trust equally into two separate trusts, 
Trust 1 and Trust 2. Trust 1 provides that trust income is to be 
paid to A for life and, on A's death, the remainder

[[Page 51972]]

is to pass to W. Trust 2 provides that trust income is to be paid to 
B for life and the remainder on B's death to X. Because Trust 1 and 
Trust 2 do not provide A and B with contingent survivor income 
interests as provided under the terms of the original trust, Trust 1 
and Trust 2 do not provide for the same succession of interests in 
the aggregate as provided in Trust. Therefore, the division is not a 
qualified severance, and Trust 1 and Trust 2 are treated as one 
trust. If, however, in this example, Trust 1 instead provides that 
trust income is to be paid to A for life and then to B (if B 
survives A), with remainder to W, and if Trust 2 instead provides 
that trust income is to be paid to B for life and then to A (if A 
survives B), with remainder to X, then Trust 1 and Trust 2 would 
provide for the same succession of interests in the aggregate as 
provided in Trust, and the severance would constitute a qualified 
severance.
    Example 5. Severance of a trust with a 50% inclusion ratio. On 
September 1, 2004, T transfers $100,000 to a trust for the benefit 
of T's grandchild, GC. On a timely filed Form 709, ``United States 
Gift (and Generation-Skipping Transfer) Tax Return,'' reporting the 
transfer, T allocates all of T's remaining GST tax exemption 
($50,000) to the trust. As a result of the allocation, the 
applicable fraction with respect to the trust is .50 [$50,000 (the 
amount of GST tax exemption allocated to the trust) divided by 
$100,000 (the value of the property transferred to the trust)]. The 
inclusion ratio with respect to the trust is .50[1-.50]. In 2006, 
pursuant to authority granted under applicable state law, the 
trustee severs the trust into two trusts, Trust 1 and Trust 2, each 
of which receives a 50 percent fractional share of the total value 
of all trust assets at that time. Because the applicable fraction 
with respect to the original trust is .50 and the trust was severed 
into two equal trusts, the trustee may designate which trust has an 
inclusion ratio of one, and which trust has an inclusion ratio of 
zero. Accordingly, in the Notice of Qualified Severance reporting 
the severance, the trustee designates Trust 1 as having an inclusion 
ratio of zero, and Trust 2 as having an inclusion ratio of one.
    Example 6. Funding of severed trusts on a non pro rata basis.  
T's will establishes a testamentary trust (Trust) for the benefit of 
T's descendants, to be funded with T's stock in Corporation A and 
Corporation B. T dies on May 1, 2004, at which time the Corporation 
A stock included in T's gross estate has a fair market value of 
$100,000 and the stock of Corporation B included in T's gross estate 
has a fair market value of $200,000. On a timely filed Form 706, T's 
executor allocates all of T's remaining GST tax exemption ($270,000) 
to Trust. As a result of the allocation, the applicable fraction 
with respect to Trust is .90 [$270,000 (the amount of GST tax 
exemption allocated to the trust) divided by $300,000 (the value of 
the property transferred to the trust)]. The inclusion ratio with 
respect to Trust is .10 [1-.90]. On August 1, 2008, when the value 
of the Trust assets totals $500,000, consisting of Corporation A 
stock worth $450,000 and Corporation B stock worth $50,000, the 
trustee severs Trust into two identical trusts, Trust 1 and Trust 2. 
The terms of the instrument severing Trust provides that Trust 1 is 
to be funded on a non pro rata basis with assets having a fair 
market value on the date of funding equal to 90% of the value of the 
Trust assets on that date, and Trust 2 is to be funded with assets 
having a fair market value on the date of funding equal to 10% of 
the value of the Trust assets on that date. Also on August 1, 2008, 
the trustee funds Trust 1 with all of the Corporation A stock and 
funds Trust 2 with all of the Corporation B stock. Accordingly, 
Trust 1 is funded with assets having a value equal to 90% of the 
value of Trust as of the date of funding, August 1, 2008, and Trust 
2 is funded with assets having a value equal to 10% of the value of 
Trust as of the date of funding. Therefore, if the requirements of 
section 2642(a)(3) are otherwise satisfied, the severance 
constitutes a qualified severance. Trust 1 will have an inclusion 
ratio of zero and Trust 2 will have an inclusion ratio of one.
    Example 7. Severance of a trust along family lines.  T dies on 
October 1, 2004. T's will establishes a testamentary trust (Trust) 
to be funded with $1,000,000. Trust income is to be paid to T's 
child, S, for S's life. On S's death, Trust is to terminate and the 
assets are to be divided equally among T's three grandchildren, GC1, 
GC2, and GC3 (or their respective descendants, per stirpes). On a 
timely filed Form 706, T's executor allocates all of T's remaining 
GST tax exemption ($300,000) to Trust. As a result of the 
allocation, the applicable fraction with respect to the trust is .30 
[$300,000 (the amount of GST tax exemption allocated to the trust) 
divided by $1,000,000 (the value of the property transferred to the 
trust)]. The inclusion ratio with respect to the trust is .70 
[1-.30]. On June 1, 2007, the trustee determines that it is in the 
best interest of the beneficiaries to sever Trust to provide a 
separate trust for each of T's three grandchildren and their 
respective families. The trustee severs Trust into two identical 
trusts, Trust 1 and Trust 2, each trust providing that trust income 
is to be paid to S, for life, and on S's death, the trust is to 
terminate and the assets are to be divided equally among GC1, GC2, 
and GC3 (or their respective descendants, per stirpes). The terms of 
the instrument severing Trust provide that Trust 1 is to receive 30% 
of the Trust assets and Trust 2 is to receive 70% of the Trust 
assets. Further, each trust is to be funded with a pro rata portion 
of each asset held in Trust. The trustee then severs Trust 1 into 
three equal trusts, Trust GC1, Trust GC2, and Trust GC3. Each trust 
is named for a grandchild of T and provides that trust income is to 
be paid to S for life, and on S's death, the trust is to terminate 
and the trust proceeds distributed to the respective grandchild for 
whom the trust is named. If that grandchild has predeceased the 
termination date, the trust proceeds are to be distributed to that 
grandchild's then-living descendants, per stirpes, or, if none, to 
the other grandchildren (or their respective then-living 
descendants, per stirpes). Each trust is to be funded with a pro 
rata portion of each Trust 1 asset. The trustee also severs Trust 2 
in a similar manner, into Trust GC1(2), Trust GC2(2), and Trust 
GC3(2). If the requirements of section 2642(a)(3) are otherwise 
satisfied, the severance of Trust into Trust 1 and Trust 2, the 
severance of Trust 1 into Trust GC1, Trust GC2, Trust GC3, and the 
severance of Trust 2 into Trust GC1(2), Trust GC2(2) and Trust 
GC3(2), constitute qualified severances. Trust GC1, Trust GC2, Trust 
GC3 will each have an inclusion ratio of zero and Trust GC1(2), 
Trust GC2(2) , and Trust GC3(2) will each have an inclusion ratio of 
one.

    (f) Effective date. (1) This section applies to severances 
occurring on or after the date that this document is published in the 
Federal Register as final regulations.
    (2) Transition rule. In the case of severances occurring after 
December 31, 2000, and before the date that this document is published 
in the Federal Register as a final regulation, taxpayers may rely on 
any reasonable interpretation of section 2642(a)(3) as long as 
reasonable notice concerning the severance and identification of the 
trusts involved has been given to the IRS. For this purpose, these 
proposed regulations are treated as a reasonable interpretation of the 
statute. For purposes of the notification requirement contained in 
Sec.  26.2642-6(b)(6), notification will be deemed timely if mailed by 
April 15th of the year immediately following the year during which the 
severance occurred or the last day of the period covered by an 
extension of time, if an extension of time is granted. For severances 
occurring between December 31, 2000, and January 1, 2004, notification 
will be deemed timely if mailed by November 22, 2004.
    Par. 6. Section 26.2654-1 is amended as follows:
    1. The paragraph heading for (b) and the introductory text of 
paragraph (b)(1) are revised.
    2. Paragraph (c) is added.
    The revision and addition reads as follows:


Sec.  26.2654-1  Certain trusts treated as separate trusts.

* * * * *
    (b) Division of a trust included in the gross estate occurring on 
or before December 31, 2000--(1) In general. If a trust that is 
included in the transferor's gross estate (or created under the 
transferor's will) is severed on or before December 31, 2000, into two 
or more trusts, the severance is recognized for purposes of chapter 13 
if--
* * * * *
    (c) Qualified severance occurring after December 31, 2000. For 
rules applicable to the severance of a trust for GST tax

[[Page 51973]]

purposes occurring after December 31, 2000, see Sec.  26.2642-6.

Deborah M. Nolan,
Acting Deputy Commissioner for Services and Enforcement.
[FR Doc. 04-19352 Filed 8-23-04; 8:45 am]
BILLING CODE 4830-01-P