IRS Issues Proposed Ruling on Private Trust Companies

By James Beavers, J.D., LL.M., CPA

The IRS is seeking comments from the public on a proposed ruling regarding the use of family-owned private trust companies (PTCs) as trustees of trusts.

Fact Patterns in the Proposed Ruling

The proposed ruling presents two situations. Situation 1 involves a PTC formed under laws of a state that has enacted a PTC statute. Situation 2 involves a PTC formed in a state without a PTC statute.

Facts common to both situations: In both situations, A and B, who are husband and wife, have three children, C, D, and E. All of the children are married, and each has children. A and B have established separate irrevocable trusts for each of their children and grandchildren, and C, D, and E have established irrevocable trusts for their respective descendants. Each child or grandchild of A and B is the primary beneficiary of the trust established for that child or grandchild. Each trust receives contributions only from the person who created the trust, all grantors and beneficiaries are U.S. persons, and no trust is a foreign trust.

Each trust instrument provides the trustee with discretionary authority to distribute income and/or principal to the primary beneficiary of the trust during the primary beneficiary’s lifetime. Each trust also provides the primary beneficiary with the testamentary power to appoint the trust corpus to or for the benefit of one or more family members (other than the primary beneficiary) and/or one or more charitable organizations. In addition, each trust provides that the grantor, or the primary beneficiary if the grantor is not living, may appoint a successor trustee other than himself or herself if the current trustee either resigns or is no longer able to fulfill the duties of trustee. Each trust provides that the trust will terminate no later than 21 years after the death of the last to die of certain designated individuals living at the time of the creation of the trust.

In addition to the provisions of the trust agreement, under the state statute in situation 1 and the governing documents of the PTC in situation 2:

1. Discretionary distributions are defined as permissible distributions that are not mandated in the trust instrument or by applicable law.

2. There are no restrictions on who may serve on the PTC’s discretionary distribution committee (DDC), but no member of the DDC may participate in the activities of the DDC with regard to any trust of which that DDC member or his or her spouse is a grantor, or any trust of which that DDC member or his or her spouse is a beneficiary.

3. A DDC member may not participate in the activities of the DDC with respect to any trust with a beneficiary to whom that DDC member or his or her spouse owes a legal obligation of support.

4. Only officers and managers of the PTC may participate in decisions regarding personnel of the PTC (including the hiring, discharge, promotion, and compensation of employees).

5. Nothing in the state statute or in the PTC’s governing documents may override a more restrictive provision in the trust instrument of a trust for which the PTC is acting as a trustee.

6. No family member may enter into any reciprocal agreement, express or implied, regarding discretionary distributions from any trust for which the PTC is serving as a trustee.

Additional facts in situation 1: The state statute provides that any PTC formed under the statute must create a DDC and delegate to the DDC the exclusive authority to make all decisions regarding discretionary distributions from each trust for which it serves as trustee.

In 2008, the family formed a corporation that is a PTC under the statute. The PTC’s governing documents created a DDC; they do not restrict who may serve on the DDC. The family owns all of the stock in the PTC, either outright or through trusts and/or other entities. A, C, and D are officers of the PTC and serve on its board of directors. A, C, and D also serve on the DDC. B and E own shares of the PTC, but neither is on the DDC and neither is an officer or director of the PTC. E is a manager and employee of the PTC.

Additional facts in situation 2: In 2008, the family formed a corporation that is a PTC in a second state for the specific purpose of acting as the trustee for the various trusts established by members of the family. The family owns all of the stock in the PTC, either outright or through trusts and/or other entities. The PTC’s governing documents create a DDC and delegate to the DDC the exclusive authority to make all decisions regarding discretionary distributions from each trust for which it serves as trustee.

The PTC’s governing documents also provide for the creation of an amendment committee, a majority of whose members must always be individuals who are neither members of the family nor persons related or subordinate (as described in Sec. 672(c)) to any shareholder of the PTC. The amendment committee will have the sole authority to make any changes to the PTC’s governing documents regarding the creation, function, or membership of the DDC or of the amendment committee itself, the provisions delegating exclusive authority regarding personnel decisions to the officers and managers, and the prohibition of reciprocal agreements between the family’s members.

F, G, and A are the initial members of the amendment committee. F and G are not members of the family, are not employed by the PTC, and are not otherwise related or subordinate to any member of the family as defined in Sec. 672(c). A, C, and D are officers of the PTC. A, C, D, F, and G serve on the PTC’s board of directors. A, C, and D also serve on the DDC. B and E own shares of the PTC, but neither is on the DDC and neither is an officer or director of the PTC. E is a manager and employee of the PTC.

Events subsequent to formation in both situations 1 and 2: In both situations, subsequent to the PTC’s formation, X, a financial institution that had been the trustee of each of the trusts since their inception, resigned and the PTC was appointed as the successor trustee of each trust. In addition, A created and transferred property to three additional irrevocable trusts (the 2008 trusts), one for the primary benefit of each of A’s children (C, D, and E) and that child’s descendants. The terms of each of the 2008 trusts are the same as those described above, except these trusts provide that the trustee has discretionary authority to distribute income and/or principal to any one or more beneficiaries during the beneficiary’s life. Each 2008 trust receives contributions only from A. The PTC will serve as the initial trustee of each of the 2008 trusts.

Proposed Holdings

The proposed ruling states under the facts in both situation 1 and situation 2 that:

1. Neither the appointment nor the service of the PTC as the trustee of a family trust described in situation 1 or situation 2 will alone cause the value of the trust assets to be included in a grantor’s gross estate under Secs. 2036(a) or 2038(a).

2. Neither the appointment nor the service of the PTC as the trustee of a family trust described in situation 1 or situation 2 will alone cause the value of the trust assets to be included in a beneficiary’s estate under Sec. 2041.

3. Neither the appointment nor the service of the PTC as the trustee of the trusts in which the trustee has the discretionary power to distribute income and/or principal to the grantor’s child or descendants in situation 1 or situation 2 will alone cause the grantor’s transfer to that trust to be deemed an incomplete gift under Sec. 2511, or any distribution from the trust to be a gift by any DDC member.

4. Neither the appointment nor the service of the PTC as trustee of a family trust in situation 1 and situation 2 will alone affect the exempt status of that trust if the trust is otherwise exempt from the GST tax under Regs. Sec. 26.2601-1(b)(1)(i), or change the inclusion ratio of a trust.

5. Neither the appointment nor the service of the PTC as the trustee of a family trust in either situation 1 or situation 2 will alone cause any grantor or beneficiary of that trust to be treated as the owner of that trust or any portion thereof under Secs. 673, 676, 677, or 678. Whether any grantor is treated as an owner of the trust or any portion thereof under the Sec. 675 rules regarding administrative powers is a question of fact, the determination of which must be deferred until the federal income tax returns of the parties involved have been examined. Whether any grantor is treated as an owner of the trust or any portion thereof under the Sec. 674 rules regarding powers of appointment will depend on the particular powers of the trustee and may depend on the proportion of the members of the DDC with authority to act with regard to that trust who are related to or subordinate to the grantor. For purposes of this determination, the ownership of voting stock of the PTC will not be considered significant under Sec. 672(c) for purposes of determining if someone is a related or subordinate party.

The conclusions regarding the tax consequences of the PTC as trustee of the family trusts would not change even if (1) in situation 2, F and/or G also serve on the board of directors; (2) any of the discretionary distributions are made under a reasonably definite external standard provided in the trust instrument; or (3) a single family member was the sole owner of the PTC. Distribution powers subject to such a standard will generally not cause the grantor or beneficiary to be treated as the owner of a trust or any portion of a trust under Secs. 674 and 678, unless a grantor or spouse of a grantor is the trustee, regardless of the terms of the state statute or the existence of the amendment committee.

Reflections

In March 2006, the AICPA submitted comments to the IRS regarding the consequences of using a PTC as the trustee of a trust. The proposed ruling largely follows the suggestions made in those comments, allowing, without adverse tax consequences, a grantor or beneficiary of a trust of which a PTC is the trustee to serve on a DDC of the PTC as long as the grantor or beneficiary does not participate in the activities of the DDC with regard to any trust of which that DDC member or his or her spouse is a grantor or beneficiary and otherwise allowing family members to participate in the management of a PTC and be owners of the PTC.

—Notice 2008-63, 2008-31 I.R.B. 261.

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