Generation-skipping Transfer Issues

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 26 [TD 8912] RIN 1545-AX08

TITLE: Generation-skipping Transfer Issues

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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.

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 effectve 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 rule provided in the
regulations,

and a separate category to address these items is not needed. Other
Changes nder the proposed regulations, a modification that does
notsatisfy the 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 §26.2601-1(b)(2)(vii)(B). This example
had illustrated the transition rule contained in §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
§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 §26.2601-1(b)(2) (relating to wills
and revocable trusts executed before October 22, 1986) is similar to
the standard contained in §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
§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 § 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 §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 §26.2601- 1(b)(2)(vii)
(B) Example 7, discussed above, the IRS will not follow that example
when applying the rule in §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:

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 §26.2600-1, the table is amended under
§26.2601-1 by revising the entry for paragraph (b)(4) and
adding an entry for paragraph (b)(5) to read as follows:
§26.2600-1 Table of contents.

* * * * *

§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: §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 §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 B

(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.16 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.
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 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's 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.22 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 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.23 (b)(1)(i) of this
section are applicable on and after November 18, 1999.

Robert E. Wenzel
Deputy Commissioner of Internal Revenue.

Approved: 12-7-00

Jonathan Talisman
Acting Assistant Secretary of the Treasury.

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