Income Beneficiaries of Older Trusts Should Consider Making Unitrust Election

In a recent private letter ruling (15529705), the IRS has confirmed that a generation skipping transfer (GST) tax grandfathered trust will not lose its exemption if a court modifies the trust to permit the income beneficiary to receive unitrust payments.

The facts for the ruling are as follows. Taxpayer creates a testamentary trust (a trust in his/her will) that specifies that when the taxpayer dies the trust will pay income to taxpayer’s surviving spouse and upon spouse’s demise the trust will pay all income to the taxpayer’s children and, upon the childrens’ demise, to the childrens’ descendants.

The taxpayer and the taxpayer’s spouse die. The taxpayer’s children now want to petition the court to permit the trust to pay the children unitrust payments, rather than fixed payments. Unitrust payments are payments equal to a percentage of the trust assets (typically between 2% and 5%).

Absent a unitrust payout the trust would continue to pay all income to the trust beneficiaries. Income typically only refers to interest payments and dividends – not capital gains or gains associated with sell of investments. If there is no unitrust provision, the current income beneficiary (as opposed to future income beneficiaries, such as the taxpayer’s children’s descendants in this case) may prefer that the trustee invest primarily in income producing assets.

The problem with this is that investing a substantial portion of the trust assets in interest/dividend bearing investments will, as the argument goes, diminish the value of the trust assets over time because investments which have typically under performed capital gain assets, such as stocks.
In other words, the trustee may be able to maximize the value of the trust assets if he or she can invest a larger portion of the trust assets in stocks, grow the trust assets for the future beneficiaries.

Unitrust payments eliminate this conflict of interest between current income beneficiaries (such as the taxpayer’s children) and the future income beneficiaries (such as the taxpayer’s children’s descendants).

If the trust document does not provide for unitrust payments (or provide the trustee with the discretion to opt to start paying unitrust payments), the current income beneficiary (with the consent of the future income beneficiaries) must ask a court to alter the trust so that such payments can be made. This type of court intervention is very common, as the unitrust concept is relatively new compared to the age of a majority of trusts that exist today.

The problem addressed in this letter ruling arises when a trust was created before September 1985, the date that the generation skipping transfer (GST) tax was enacted. The GST tax only impacts trusts created after this date. Trusts created (and that were irrevocable) before this date are grandfathered or exempt from the GST tax.

So the question answered by this letter ruling is whether a GST tax exempt trust would lose its exemption if the court changed the trust to provide for unitrust payments. The IRS said that it would not.

Given this ruling, beneficiaries of older trusts should contact their estate planning attorneys to review whether they should modify their trusts to provide for unitrust payments.