Donald Kozusko
Summary
Guidance on private trust companies was recently proposed by the U.S. tax authorities to address whether family ownership and participation in the governance of a trust company that is serving as trustee of the family's trusts would trigger unintended and adverse wealth transfer tax and income tax results. Fortunately, as now proposed the guidance would alleviate many of the severe restrictions on a family-owned trust company that tax advisors have imposed in the past in order to avoid the risk of major adverse tax results in administering family trusts.
As the draft ruling itself suggests, this guidance bears wider implications because it should be consistent with the standards applied in more common kinds of collective family efforts to administer trusts, those in which siblings or other family members serve as co-trustees or serve on distribution committees outside of a private trust company.
Generally speaking, under this proposed revenue ruling, family members would be free to participate in determining how and when a family trust made distributions if certain "firewall" restrictions are adopted and adhered to in decision-making. These restrictions allow more family participation than some tax advisers had previously thought advisable, since authoritative guidance was lacking and the stakes were high. The firewalls in the proposed ruling would prohibit the individual who personally made a gift to the trust in question or anyone who could ever benefit from its distributions, and that person's spouse, from participating in any distribution decisions for that particular trust. In addition, for income tax purposes only, certain kinds of distribution decisions cannot be approved by "related or subordinate" parties as defined by the proposed ruling.
This revenue ruling is being proposed in draft in order to solicit comments from interested tax advisors on these questions, and in addition, comments on whether to devise different rules for trusts holding life insurance and closely-held stock. The draft guidance will hopefully become more specific and practical in this process. The framework for progress is now in place but important gaps and obstacles still reside in the details. The process for replacing decision-makers inside the private trust company needs further attention, and the proposed firewall restrictions are still much too broad, though an improvement over prior practice. The firewalls are especially troublesome for trust beneficiaries; a beneficiary of a trust, and that person's spouse, cannot vote on any distributions from that trust, even if made to someone else; this restriction would often disqualify the entire family, or most members, from participating at all in any distribution decisions since family trusts in this context typically provide for sprinkling distributions, contingent remainders, and more than one generation. Thus, as currently drafted, these rules are more restrictive than those in other contexts, so the choice of a PTC would not be tax neutral. The restrictions would not achieve the stated purpose of the ruling, which is to provide tax sensitive limits for distribution decisions made through a private trust company that are no more, and no less, restrictive than applied to family members who take direct responsibility, such as members of an unincorporated committee or individual trustees.
This comment process should be fruitful because the draft evidences the willingness of U.S. tax authorities to reject expansive tax theories that would have effectively banned useful participation by family members in trust distribution decisions. This orientation supports modern trust law reforms that allow families to take more responsibility for their own wealth management, avoiding dependency on commercial trust providers, unskilled friends, or a succession of outside professionals when deciding essentially personal and family issues.
Guidance Strikes a Favorable Note
The Internal Revenue Service and the Treasury Department have now proposed to issue a revenue ruling that would put to rest at least some of the tax concerns that arise in connection with the use of a family-owned trust company (also known as a "private trust company" or "PTC").
Such a ruling would also alleviate corresponding concerns arising in analogous family decision-making arrangements that are much more common than PTCs.
Factual Context of Proposed Ruling
The proposed favorable ruling set forth in Notice 2008-63 at 2008-31 IRB (7/11/2008) deals with two illustrative fact situations that differ only in whether the tax-relevant restrictions are imposed on the PTCs distribution decisions by the local statutory law or by the PTC's organizational documents. In both situations, parents (A and B) have three adult children (C, D, and E) who are each married with children. The parents made gifts in separate trusts for the primary benefit of each of their children and for each of their grandchildren, and their children have similarly established separate trusts for their respective descendants. Each of these trusts:
Trusts later funded exclusively by one parent (A) in 2008 (the "2008 Trusts") are similar except that one trust was established for each family branch, (e.g., A and A's descendants) and discretionary distributions can be sprinkled among those several beneficiaries; also the PTC was the original trustee. These 2008 trusts are especially pertinent to the ruling on completed gifts, the generation-skipping tax ruling dealing with post-1985 trusts, and the income tax ruling on grantor trust status for trusts with sprinkling distribution powers.
The shares of the PTC are owned entirely by the family -- by the parents (A and B) and one child (E) and various family trusts. One parent (A) and two children (C and D) are officers and directors of the PTC and serve on the discretionary distributions committee of the PTC. The third child (E) is an employee and manager of the PTC.
"Firewall" Restrictions on the PTC
Restrictions on the PTC require that:
Note that the composition of the membership of the DDC is not restricted, but that a member who is a beneficiary cannot decide upon distributions to himself or herself - or upon distributions to another beneficiary from the same trust.
These restrictions (which might be called "recusal restrictions") are complemented by supporting restrictions on the PTC providing that:
This last restriction relates to the question of who is a "related or subordinate" party for purposes of the tax analysis, explicitly on the income tax issues but implicitly on the wealth transfer tax issues as well in view of the use of this term in Rev. Rul. 95-58 as discussed below. It refers to control over employees, the tax analysis later indicates that the DDC members are not considered employees in that capacity, and yet the DDC may include members who are otherwise serving as employees.
These "firewall" restrictions - the recusal and supporting restrictions -- are imposed by applicable PTC statutes in situation one in the ruling; in situation two, they are imposed by the PTC's organizational documents and cannot be waived or changed except by a special amendment committee. This committee must act by a majority of its members and a majority of its members must be individuals who are not:
This fact pattern does not show how vacancies in the DDC are filled, and whether members of the DDC can be removed. Presumably a traditional corporate process would be followed; changes would be made by the officers, subject to oversight by the board of directors, or by the board directly. Yet this gap in the factual description lends uncertainty to the import of the ruling as to control of succession.
As to the restriction that limits how many members of the amendment committee may be individuals who are related or subordinate to a shareholder, note that the income tax part of the proposed ruling later concludes that those who serve inside the PTC are not for that reason subordinate to the shareholders as to distribution decisions, due to the firewall restrictions, and this reasoning would seem to apply equally to decisions on firewall amendments.
Issues in the Proposed Ruling
The issues involve the estate, gift and generation-skipping tax and the "grantor trust" status of the trust under the income tax. In each of these issues the question is whether certain tax results that are presumably adverse and unintended will apply if the PTC serves as trustee of the trusts, even though the PTC's process for distribution decisions is subject to the restrictions described above:
(1) will the value of the trust assets be included in the grantor's gross estate under IRC Sections 2036(a) and 2038(a) concerning retained control?
(2) will the value of the trust assets be included in a beneficiary's gross estate under section 2041 concerning powers of appointment?
(3) will the gifts be incomplete for gift tax purposes?
(4) will any trust that is exempt from generation-skipping tax under the effective date rule of section 2601 for old trusts lose its "grandfather" protection, or will a trust to which the exemption has been allocated lose that exemption in whole or in part?
(5) will the grantor or beneficiary of a trust be treated as the owner of trust income under IRC Sections 671 through 678?
Given the very broad firewall restrictions imposed on the PTC in the ruling, the answer should be self-evident, at least as to the first four questions, which involve wealth transfer tax issues. No taxable control exists.
Why then has this set of issues been unresolved for so many years?2 The answer can be traced to a potential combination of tax principles that could create serious adverse tax results on the issues addressed in the proposed ruling. If the IRS were to pursue these theories, the downside risk could include estate taxes that would strip away the principal value of old established trusts, or a delayed gift tax on values that grew substantially after transfers were made in trust, or unintended personal income taxes on family members who funded trusts with the expectation that the trust would pay its own income taxes.
Why These Issues?
It's not biophysics, or even rocket science, but the U.S. estate and wealth transfer tax system has become quite complex. A handful of fundamentally simple concepts gradually propagate subtle distinctions and interrelationships when applied to the wide variety of circumstances in which assets can be owned, gifted and inherited. Moreover, professional experience in the field as an advisor or tax administrator first builds proficiency, and then delivers the reward of the intellectual satisfaction gained from mastering complex issues. Long standing exposure to this environment, however, desensitizes the expert to the practical burdens that these concepts and questions impose on mere mortals toiling in the everyday field of tax and asset management. Unrealistic extensions of tax logic seem pure and satisfying in the parallel universe inhabited by tax experts, however much everyone else needs clear directives.
Driven by theory, this process brought us to the issues now addressed by Notice 2008-63. The private trust company concept, and more common forms of collective family decision-making for trusts, gradually ran into trouble as the law evolved over the last two or three decades and eventually posed a very troublesome response to the question of when control becomes the equivalent of taxable ownership.
Control as Taxable Ownership under the Wealth Transfer Taxes
It's easiest to understand the issue by focusing on the estate tax, where the law is the most developed. The analysis follows a comparable path under the gift and generation-skipping tax.
Existing Estate Tax Law
The estate tax applies to property owned at death and to property previously gifted if its benefits are still controlled at death, usually through trusts that grant to trustees or others the power to determine who gets paid and when. Simple enough. The retained power to "control", however, includes more than a currently effective, personal power:
(1) Replacement Power. The right to elect to take control has long been treated as equivalent to control under the estate tax. John Doe is attributed the powers of the trustee if he has an unrestricted right to choose to become trustee though he may never become trustee. 3
(2) Shared Control. In many circumstances, it is clear that shared control is equivalent to full control under the estate tax. With certain exceptions, John Doe's estate is taxed even if the power is subject to another's consent, such as that of a co-trustee. 4
(3) Reciprocal Transfers. Reciprocal transfers can now lead to retained control under the estate tax. The reciprocal transfer doctrine originated in cases where the transferors held beneficial interests in the trust gifts made by each other but then the doctrine was extended to reciprocal powers as well. If John Doe cannot control a trust that he established but can control one established by Jane Doe, and Jane can control John's trust, the powers will be uncrossed if both trusts were established at the same time, and John and Jane will each be considered in control of his or her respective trust. Call it attribution due to reciprocal transfers. Proof of intent to act in concert is not necessary; the courts have decided that crossed powers (or benefits) created by transferors are equivalent in substance to powers (or benefits) personally retained by each donor over the funds he or she gifted.5
(4) Reciprocal Replacement Powers. It further appears that reciprocal rights to elect to take control could be equivalent to direct control, combining the first and third rules in this list, since there is nothing in either rule that dictates that the application of one excludes the other.
Generally speaking, ownership that is attributed under the estate tax would create analogous results under the gift and generation-skipping tax.
Open Estate Tax Questions
These four rules cover a large universe of possible circumstances. What remains?
These four rules cover a large universe of possible circumstances. What remains?
(1) Restricted Replacement Powers. The Internal Revenue Service in Rev Rul. 95-58 indicated by negative implication that a power to remove and replace a trustee or other decision-maker with a "related or subordinate" party6 is the equivalent of power to name oneself. The 1995 ruling did not concede that attribution should apply only to persons who could appoint themselves as replacements, but instead sanctioned a power that prohibited a replacement that was related or subordinate under income tax rules. This deliberate limitation in the facts of the ruling is well known to estate planners and provides a safe harbor for replacement powers in practice. But such a distinction based on the characteristics of a third-party replacement would extend the scope of attribution without any definitive support from any existing statute, regulation, or court ruling. The IRS announced Rev. Rul. 95-58 only after it lost twice when trying to convince the courts that attribution should apply even when the trust required the replacement to be an independent third-party. Other than the fact that one of the trust documents at issue used the "related or subordinate" language, nothing in those court cases lost by the IRS supports the notion that the definition of those terms under the income tax rules is the criteria intended by the Code for determining attribution for estate tax purposes. 7 The 1995 ruling has been frequently criticized.
(2) Shared Replacement Powers. Rev. Rul. 95-58 does not address a shared power, but only one exercisable without the consent of any other party. So a tax attack by the IRS on a shared power is not foreclosed by the ruling if the replacement need not be independent. 8
(3) Mirror Powers Without a Reciprocal Transfer. Can mirror powers cause attribution for wealth transfer tax purposes without a reciprocal transfer?
(4) Shared Mirror Powers ("Group Powers"). Finally, we return to the private trust company context where we usually find powers that are both shared and mirror powers, as we have used those terms.
Open Income Tax Issues
The ruling also addresses certain income tax issues that take on a strange dynamic in the context of a private trust company. In explaining how the grantor trust rules, which attribute trust income based on powers held by grantors or beneficiaries, would be applied to PTCs, the proposed ruling divides the analysis and the related Internal Revenue Code sections into two categories. The first category is handled with dispatch in the ruling; the second requires much more analysis:
(1) All issues except Section 674. In the first category, the firewall restrictions on the PTC as described above are sufficient to "render the identity of the trustee irrelevant" so that "none of the grantors or beneficiaries" of the family trusts in question "will be treated as an owner of those trusts or any portion thereof under sections 673, 675, 676, 677 or 678 solely by reason of their ownership and management of, or employment by, PTC." The firewalls prevent any element of the PTC context from producing a different result than would apply if individuals served directly as trustees. This conclusion is accompanied by the usual qualification that whether section 675 (dealing with administrative powers held in a non-fiduciary capacity) could cause grantor trust treatment is ultimately a question of fact involving the operation of the trustee and the trusts. This part of the proposed ruling is not surprising and speaks for itself.
(2) Section 674 and "related or subordinate" decision-makers. The proposed ruling concludes that whether section 674 will cause grantor attribution of trust income depends upon whether the PTC structure permits certain kinds of distribution decisions as described in section 674 (such as broad "sprinkling" powers) to be made by a "related or subordinate" party who is "subservient to the wishes of the grantor," all as defined in IRC section 672. Thus, as described in detail below, the income tax analysis turns on the application of this "related or subordinate" terminology to the PTC structure.
Proposed Ruling on the Issues
On every issue the proposed ruling would hold that having the PTC serving as trustee does not - standing alone - cause the threatened bad result because the firewalls prevent a family member from deciding on distributions from a trust of which that person or the person's spouse is the grantor or a beneficiary:
However, the proposed ruling is not a solid green light. The proposed ruling requires materially broader restrictions than the law requires to achieve a favorable result on wealth transfer taxes. In addition, the income tax part of the ruling places potentially troublesome limits on the composition of the DDC, which may in turn complicate the succession process for the DDC that would be needed to avoid wealth transfer tax issues. In all events, more explicit and practical guidance is needed even though the basic framework of the ruling marks clear progress over the prior practice.
Wealth Transfer Tax Implications of the Ruling
The proposed guidance dispels the worst fears of an expansive adverse wealth transfer tax treatment premised on family collaboration. The proposed guidance does not find taxable attribution for wealth transfer tax purposes in what are described above as "group powers". Without mentioning these expansive theories of tax risk by name, the proposed ruling takes an approach that indicates that:
(1) the replacement power boundary drawn by Rev. Rul. 95-58 is not being imposed on shared powers, and
(2) the reciprocal transfer doctrine is not being extended to powers that mirror each other but are not held by transferors, i.e., where there is no reciprocal transfer.
It is, for example, quite clearly stated in the proposed ruling that estate tax inclusion will not apply (1) on the death of the PTC shareholders by reason of shareholding, (2) on the death of an officer, director, employer, manager, or DDC member by reason of that service, or (3) by reason of the PTC serving as the trustee. It is also stated that the result would not change if the PTC were solely owned by one family member alone.
Furthermore, family collaboration in the form of other arrangements involving group or mirror powers, such as in distribution committees, should also be tax neutral under wealth transfer taxes. The critical facts of the proposed ruling involve a distribution committee. The PTC structure surrounds this committee in the facts of the ruling, but the favorable aspects of the ruling that focuses on the workings of the committee could stand on its own and reach the same favorable result if the PTC wrapper were not present.
Nonetheless, the proposed ruling needs significant improvements on wealth transfer tax issues due to the comment process, both in articulating the legal constraints on replacing decisions-makers inside the PTC and in narrowing the recusal firewalls for distribution decisions.
Replacement Powers over Decision-Makers: Improvements Needed
Unfortunately the ruling leaves open a significant gap in providing reassurance on wealth transfer tax issues because the power to remove and replace members of the DDC, or to replace directors who can change the DDC, is not expressly considered. Thus the possible risk of taxation due to indirect influence on DDC succession is not foreclosed by the ruling as now drafted, e.g., can a sequential or joint power to replace DDC members ever cause attribution, and if so, how and when? Hopefully the final ruling will address this succession question explicitly:
Recusal Firewalls in Distribution Decisions: Improvements Needed
As to wealth transfer taxes, the final ruling should clarify or revise the recusal restrictions on the following matters, in order to achieve tax neutrality for the PTC, that is, consistency with the standards applied to decision-makers acting outside of the PTC format, whether as individual co-trustees or committee members:
Summary
Guidance on private trust companies was recently proposed by the U.S. tax authorities to address whether family ownership and participation in the governance of a trust company that is serving as trustee of the family's trusts would trigger unintended and adverse wealth transfer tax and income tax results. Fortunately, as now proposed the guidance would alleviate many of the severe restrictions on a family-owned trust company that tax advisors have imposed in the past in order to avoid the risk of major adverse tax results in administering family trusts.
As the draft ruling itself suggests, this guidance bears wider implications because it should be consistent with the standards applied in more common kinds of collective family efforts to administer trusts, those in which siblings or other family members serve as co-trustees or serve on distribution committees outside of a private trust company.
Generally speaking, under this proposed revenue ruling, family members would be free to participate in determining how and when a family trust made distributions if certain "firewall" restrictions are adopted and adhered to in decision-making. These restrictions allow more family participation than some tax advisers had previously thought advisable, since authoritative guidance was lacking and the stakes were high. The firewalls in the proposed ruling would prohibit the individual who personally made a gift to the trust in question or anyone who could ever benefit from its distributions, and that person's spouse, from participating in any distribution decisions for that particular trust. In addition, for income tax purposes only, certain kinds of distribution decisions cannot be approved by "related or subordinate" parties as defined by the proposed ruling.
This revenue ruling is being proposed in draft in order to solicit comments from interested tax advisors on these questions, and in addition, comments on whether to devise different rules for trusts holding life insurance and closely-held stock. The draft guidance will hopefully become more specific and practical in this process. The framework for progress is now in place but important gaps and obstacles still reside in the details. The process for replacing decision-makers inside the private trust company needs further attention, and the proposed firewall restrictions are still much too broad, though an improvement over prior practice. The firewalls are especially troublesome for trust beneficiaries; a beneficiary of a trust, and that person's spouse, cannot vote on any distributions from that trust, even if made to someone else; this restriction would often disqualify the entire family, or most members, from participating at all in any distribution decisions since family trusts in this context typically provide for sprinkling distributions, contingent remainders, and more than one generation. Thus, as currently drafted, these rules are more restrictive than those in other contexts, so the choice of a PTC would not be tax neutral. The restrictions would not achieve the stated purpose of the ruling, which is to provide tax sensitive limits for distribution decisions made through a private trust company that are no more, and no less, restrictive than applied to family members who take direct responsibility, such as members of an unincorporated committee or individual trustees.
This comment process should be fruitful because the draft evidences the willingness of U.S. tax authorities to reject expansive tax theories that would have effectively banned useful participation by family members in trust distribution decisions. This orientation supports modern trust law reforms that allow families to take more responsibility for their own wealth management, avoiding dependency on commercial trust providers, unskilled friends, or a succession of outside professionals when deciding essentially personal and family issues.
The proposed guidance takes a positive step towards allowing modern trust decision-making for family trusts
Guidance Strikes a Favorable Note
The Internal Revenue Service and the Treasury Department have now proposed to issue a revenue ruling that would put to rest at least some of the tax concerns that arise in connection with the use of a family-owned trust company (also known as a "private trust company" or "PTC").
Such a ruling would also alleviate corresponding concerns arising in analogous family decision-making arrangements that are much more common than PTCs.
• As explained by this author in a previous column in "Reciprocal Trust Doctrine Threatens Family Decision-making,"1 if the scope of certain tax principles were expanded to raise tax concerns for PTCs, that result would implicate other trust arrangements as well where more than one family member serves as trustee or where committees that decide upon distributions include family members.
• Importantly, the stated goal of the proposed ruling is to treat the PTC as tax neutral so that the tax rules applicable to family members involved in PTCs are no more and no less restrictive than would apply to the same individuals making trust decisions without the PTC. Also, the core of the favorable tax analysis in the ruling turns on the decision-making process of the distribution committee inside the PTC and the analysis would reach the same result without the surrounding PTC wrapper. Thus, other arrangements with individuals serving as trustee or on distribution committees should be protected by the proposed ruling and ideally that would be expressed in the final ruling.
Factual Context of Proposed Ruling
The proposed favorable ruling set forth in Notice 2008-63 at 2008-31 IRB (7/11/2008) deals with two illustrative fact situations that differ only in whether the tax-relevant restrictions are imposed on the PTCs distribution decisions by the local statutory law or by the PTC's organizational documents. In both situations, parents (A and B) have three adult children (C, D, and E) who are each married with children. The parents made gifts in separate trusts for the primary benefit of each of their children and for each of their grandchildren, and their children have similarly established separate trusts for their respective descendants. Each of these trusts:
• can distribute income or principal under a discretionary standard for the primary beneficiary during his or her life;
• grants the primary beneficiary (e.g., C as to a trust funded by A) a broad but special power of appointment (i.e., not taxable under IRC Section 2041);
• allows the grantor (or if not living, the primary beneficiary) to fill a trustee vacancy by naming someone other than himself or herself;
• becomes managed by the PTC as trustee when the original third-party bank trustee resigns.
Trusts later funded exclusively by one parent (A) in 2008 (the "2008 Trusts") are similar except that one trust was established for each family branch, (e.g., A and A's descendants) and discretionary distributions can be sprinkled among those several beneficiaries; also the PTC was the original trustee. These 2008 trusts are especially pertinent to the ruling on completed gifts, the generation-skipping tax ruling dealing with post-1985 trusts, and the income tax ruling on grantor trust status for trusts with sprinkling distribution powers.
The shares of the PTC are owned entirely by the family -- by the parents (A and B) and one child (E) and various family trusts. One parent (A) and two children (C and D) are officers and directors of the PTC and serve on the discretionary distributions committee of the PTC. The third child (E) is an employee and manager of the PTC.
"Firewall" Restrictions on the PTC
Restrictions on the PTC require that:
• a discretionary distributions committee ("DDC") must be organized and operated to determine all discretionary distributions by the PTC (i.e., all distributions that are not required by the trust document or applicable law); and
• no member of the DDC may participate on such distribution decisions for trusts as to which that member or the member's spouse is a grantor or a beneficiary or owes an obligation of support to a beneficiary of the trust.
Note that the composition of the membership of the DDC is not restricted, but that a member who is a beneficiary cannot decide upon distributions to himself or herself - or upon distributions to another beneficiary from the same trust.
These restrictions (which might be called "recusal restrictions") are complemented by supporting restrictions on the PTC providing that:
• any more restrictive provision in the trust document cannot be overridden by the governing PTC statute or organizational documents;
• express or implied reciprocal agreements between family members regarding discretionary distribution decisions by the PTC are prohibited;
• only officers and managers of the PTC may participate in employment decisions relating to PTC personnel.
This last restriction relates to the question of who is a "related or subordinate" party for purposes of the tax analysis, explicitly on the income tax issues but implicitly on the wealth transfer tax issues as well in view of the use of this term in Rev. Rul. 95-58 as discussed below. It refers to control over employees, the tax analysis later indicates that the DDC members are not considered employees in that capacity, and yet the DDC may include members who are otherwise serving as employees.
These "firewall" restrictions - the recusal and supporting restrictions -- are imposed by applicable PTC statutes in situation one in the ruling; in situation two, they are imposed by the PTC's organizational documents and cannot be waived or changed except by a special amendment committee. This committee must act by a majority of its members and a majority of its members must be individuals who are not:
• related or subordinate to any shareholder of the PTC (as defined in Internal Revenue Code Section 672(c)); or
• family members (broadly including A, B and each child and other descendant of A and B, and spouses and former spouses of any of these persons).
This fact pattern does not show how vacancies in the DDC are filled, and whether members of the DDC can be removed. Presumably a traditional corporate process would be followed; changes would be made by the officers, subject to oversight by the board of directors, or by the board directly. Yet this gap in the factual description lends uncertainty to the import of the ruling as to control of succession.
As to the restriction that limits how many members of the amendment committee may be individuals who are related or subordinate to a shareholder, note that the income tax part of the proposed ruling later concludes that those who serve inside the PTC are not for that reason subordinate to the shareholders as to distribution decisions, due to the firewall restrictions, and this reasoning would seem to apply equally to decisions on firewall amendments.
Issues in the Proposed Ruling
The issues involve the estate, gift and generation-skipping tax and the "grantor trust" status of the trust under the income tax. In each of these issues the question is whether certain tax results that are presumably adverse and unintended will apply if the PTC serves as trustee of the trusts, even though the PTC's process for distribution decisions is subject to the restrictions described above:
(1) will the value of the trust assets be included in the grantor's gross estate under IRC Sections 2036(a) and 2038(a) concerning retained control?
(2) will the value of the trust assets be included in a beneficiary's gross estate under section 2041 concerning powers of appointment?
(3) will the gifts be incomplete for gift tax purposes?
(4) will any trust that is exempt from generation-skipping tax under the effective date rule of section 2601 for old trusts lose its "grandfather" protection, or will a trust to which the exemption has been allocated lose that exemption in whole or in part?
(5) will the grantor or beneficiary of a trust be treated as the owner of trust income under IRC Sections 671 through 678?
Given the very broad firewall restrictions imposed on the PTC in the ruling, the answer should be self-evident, at least as to the first four questions, which involve wealth transfer tax issues. No taxable control exists.
Why then has this set of issues been unresolved for so many years?2 The answer can be traced to a potential combination of tax principles that could create serious adverse tax results on the issues addressed in the proposed ruling. If the IRS were to pursue these theories, the downside risk could include estate taxes that would strip away the principal value of old established trusts, or a delayed gift tax on values that grew substantially after transfers were made in trust, or unintended personal income taxes on family members who funded trusts with the expectation that the trust would pay its own income taxes.
Why the fuss? Complex tax concepts can breed questions that seem to defy the forces of common sense.
Why These Issues?
It's not biophysics, or even rocket science, but the U.S. estate and wealth transfer tax system has become quite complex. A handful of fundamentally simple concepts gradually propagate subtle distinctions and interrelationships when applied to the wide variety of circumstances in which assets can be owned, gifted and inherited. Moreover, professional experience in the field as an advisor or tax administrator first builds proficiency, and then delivers the reward of the intellectual satisfaction gained from mastering complex issues. Long standing exposure to this environment, however, desensitizes the expert to the practical burdens that these concepts and questions impose on mere mortals toiling in the everyday field of tax and asset management. Unrealistic extensions of tax logic seem pure and satisfying in the parallel universe inhabited by tax experts, however much everyone else needs clear directives.
Driven by theory, this process brought us to the issues now addressed by Notice 2008-63. The private trust company concept, and more common forms of collective family decision-making for trusts, gradually ran into trouble as the law evolved over the last two or three decades and eventually posed a very troublesome response to the question of when control becomes the equivalent of taxable ownership.
Control as Taxable Ownership under the Wealth Transfer Taxes
It's easiest to understand the issue by focusing on the estate tax, where the law is the most developed. The analysis follows a comparable path under the gift and generation-skipping tax.
Existing Estate Tax Law
The estate tax applies to property owned at death and to property previously gifted if its benefits are still controlled at death, usually through trusts that grant to trustees or others the power to determine who gets paid and when. Simple enough. The retained power to "control", however, includes more than a currently effective, personal power:
(1) Replacement Power. The right to elect to take control has long been treated as equivalent to control under the estate tax. John Doe is attributed the powers of the trustee if he has an unrestricted right to choose to become trustee though he may never become trustee. 3
(2) Shared Control. In many circumstances, it is clear that shared control is equivalent to full control under the estate tax. With certain exceptions, John Doe's estate is taxed even if the power is subject to another's consent, such as that of a co-trustee. 4
(3) Reciprocal Transfers. Reciprocal transfers can now lead to retained control under the estate tax. The reciprocal transfer doctrine originated in cases where the transferors held beneficial interests in the trust gifts made by each other but then the doctrine was extended to reciprocal powers as well. If John Doe cannot control a trust that he established but can control one established by Jane Doe, and Jane can control John's trust, the powers will be uncrossed if both trusts were established at the same time, and John and Jane will each be considered in control of his or her respective trust. Call it attribution due to reciprocal transfers. Proof of intent to act in concert is not necessary; the courts have decided that crossed powers (or benefits) created by transferors are equivalent in substance to powers (or benefits) personally retained by each donor over the funds he or she gifted.5
(4) Reciprocal Replacement Powers. It further appears that reciprocal rights to elect to take control could be equivalent to direct control, combining the first and third rules in this list, since there is nothing in either rule that dictates that the application of one excludes the other.
Generally speaking, ownership that is attributed under the estate tax would create analogous results under the gift and generation-skipping tax.
Open Estate Tax Questions
These four rules cover a large universe of possible circumstances. What remains?
These four rules cover a large universe of possible circumstances. What remains?
(1) Restricted Replacement Powers. The Internal Revenue Service in Rev Rul. 95-58 indicated by negative implication that a power to remove and replace a trustee or other decision-maker with a "related or subordinate" party6 is the equivalent of power to name oneself. The 1995 ruling did not concede that attribution should apply only to persons who could appoint themselves as replacements, but instead sanctioned a power that prohibited a replacement that was related or subordinate under income tax rules. This deliberate limitation in the facts of the ruling is well known to estate planners and provides a safe harbor for replacement powers in practice. But such a distinction based on the characteristics of a third-party replacement would extend the scope of attribution without any definitive support from any existing statute, regulation, or court ruling. The IRS announced Rev. Rul. 95-58 only after it lost twice when trying to convince the courts that attribution should apply even when the trust required the replacement to be an independent third-party. Other than the fact that one of the trust documents at issue used the "related or subordinate" language, nothing in those court cases lost by the IRS supports the notion that the definition of those terms under the income tax rules is the criteria intended by the Code for determining attribution for estate tax purposes. 7 The 1995 ruling has been frequently criticized.
(2) Shared Replacement Powers. Rev. Rul. 95-58 does not address a shared power, but only one exercisable without the consent of any other party. So a tax attack by the IRS on a shared power is not foreclosed by the ruling if the replacement need not be independent. 8
• Generally speaking, a shared power could mean a power exercisable only by joint consent (e.g., the agreement of three parties) or a power exercisable only by sequential consent (e.g., A can appoint B who can appoint C, who then decides the question).
• A power exercisable by a company, such as a private trust company, often involves both kinds of powers; for example, shareholders A, B and C (joint powers) can elect a board of directors who in turn names a trust officer, who in turn exercises a power over a distribution (thus A, B and C jointly have a sequential power to affect, however remotely, the trust officer's decision).
• Given the necessary involvement of multiple parties, whether jointly or sequentially or both, it should be readily apparent that the replacement "power" is significantly diluted when it is not a sole power to change a decision-maker.
• Since, as described in paragraph (1) above, imposing an adverse tax result based on a sole replacement power is already questionable when the powerholder cannot appoint himself or herself, it should be self-evident that taxation cannot be based on attributing powers to someone who holds only a shared replacement power. Nevertheless, favorable guidance on this point from tax authorities would ease concerns, given the severity of the adverse tax results that might be claimed.
(3) Mirror Powers Without a Reciprocal Transfer. Can mirror powers cause attribution for wealth transfer tax purposes without a reciprocal transfer?
• By "mirror powers" we mean powers that parallel each other but were not created by the power holders, so there is no foundation for a conclusion that the holders created interrelated powers, intentionally or otherwise.
• For example, if John can control a trust that benefits Jane, by exercising powers that would cause an estate tax if held by Jane herself, and if Jane similarly can control a trust that benefits John, will each of those mirror powers of control be attributed to the other person and thus create an estate tax even if the trusts in question were not established by either John or Jane but instead by their mother? There is no hard line of authority that prevents this result, but no support for it either. Existing non-binding guidance by the IRS indicates what should be the result: no attribution. On at least two occasions, the IRS has concluded in private letter rulings that the reciprocal transfer doctrine does not apply.9
• While it is hard to see how the mere existence of similar powers held by family members (or any one else) for the benefit of other family members creates a reciprocal transfer, it has been suggested that the mirror powers invite cross-trading of favorable conduct (i.e., trading votes) and thus should be considered the equivalent of reciprocal transfers and taxed accordingly, whether or not there is evidence of vote trading, or, for that matter, any exercise of these powers at all, which may be simply powers to make principal distributions that are rarely or never used. 10
• Again, favorable guidance would be helpful to quiet the threat, however remote, of a bad result.
(4) Shared Mirror Powers ("Group Powers"). Finally, we return to the private trust company context where we usually find powers that are both shared and mirror powers, as we have used those terms.
• As noted above in paragraph (2) above, trust company governance naturally involves shared powers, i.e., shareholders vote for directors who in turn name officers. Also, family-owned trust companies typically administer multiple trusts that raise the issue of mirror powers without a reciprocal transfer, as described in paragraph (3) above. Powers in these family trusts appear to be reciprocal only if one ignores crucial facts. The trusts are often established at different times, so the powers are not interrelated when created; and the transferors may even be deceased or not otherwise involved in PTC decisions.
• So what might be called "group powers" do not meet the criteria of the reciprocal transfer doctrine; collaboration among beneficiaries does not constitute reciprocal transfers. If, however, these group powers were to be treated as if created by reciprocal transfers, and particularly if shared replacement powers are treated as equivalent to the sole powers addressed in Rev. Rul. 95-58, then this expansive application of tax principles would lead to the conclusion that no family member can participate in the PTCs distribution decisions or vote on selecting those who do make those decisions, without an unacceptable risk of an estate tax.
• Under this expansive theory, which seems to have no limits, it would not be sufficient to recuse the person who funded or benefits from the particular trust in question at any given time since all family beneficiaries and grantors are treated as engaging in reciprocal trading of control over each other's trusts simply because they are family members and chose to make collective decisions. In this world of PTCs, family members would always trade votes but for these tax restrictions, in-laws are cherished, and siblings are never rivals.
• Thus, acting with extreme caution in view of the tax dollars at risk and willing to tolerate wholesale limitations on family members in PTC governance, a certain number of taxpayers sought and accepted private letter rulings on these issues for their PTCs. These rulings imposed such broad recusal restrictions on family participation in distribution decisions that in effect no family member served on the distribution committees, and family ownership of the PTC was also limited in various ways.11 Several years ago these requests prompted the IRS to consider offering more authoritative and comprehensive guidance.
• Ironically, following this path gives non-family members a key role in the family trust company, dilutes family privacy, and creates distinctions that defy common sense. Under traditional estate tax law John Doe can decide by his own vote (one man, one vote) whether he needs distributions to maintain the life style to which he has grown accustomed - - a so-called ascertainable standard under Code section 2041(b) - -without his power causing adverse wealth tax consequences. Under the restricted PTC, however, he cannot vote as one family member among many on whether his niece needs a distribution in her "best interests."
• The proposed guidance now considers whether such sweeping limitations are necessary, and concludes they are not. Generally speaking, for wealth transfer tax purposes the proposal would disqualify from participation in distribution decisions the grantors and beneficiaries of the particular trust in question, and their spouses. Of course, comments on the proposed ruling are expected to address whether this narrower prohibition is still excessive.
Open Income Tax Issues
The ruling also addresses certain income tax issues that take on a strange dynamic in the context of a private trust company. In explaining how the grantor trust rules, which attribute trust income based on powers held by grantors or beneficiaries, would be applied to PTCs, the proposed ruling divides the analysis and the related Internal Revenue Code sections into two categories. The first category is handled with dispatch in the ruling; the second requires much more analysis:
(1) All issues except Section 674. In the first category, the firewall restrictions on the PTC as described above are sufficient to "render the identity of the trustee irrelevant" so that "none of the grantors or beneficiaries" of the family trusts in question "will be treated as an owner of those trusts or any portion thereof under sections 673, 675, 676, 677 or 678 solely by reason of their ownership and management of, or employment by, PTC." The firewalls prevent any element of the PTC context from producing a different result than would apply if individuals served directly as trustees. This conclusion is accompanied by the usual qualification that whether section 675 (dealing with administrative powers held in a non-fiduciary capacity) could cause grantor trust treatment is ultimately a question of fact involving the operation of the trustee and the trusts. This part of the proposed ruling is not surprising and speaks for itself.
(2) Section 674 and "related or subordinate" decision-makers. The proposed ruling concludes that whether section 674 will cause grantor attribution of trust income depends upon whether the PTC structure permits certain kinds of distribution decisions as described in section 674 (such as broad "sprinkling" powers) to be made by a "related or subordinate" party who is "subservient to the wishes of the grantor," all as defined in IRC section 672. Thus, as described in detail below, the income tax analysis turns on the application of this "related or subordinate" terminology to the PTC structure.
A comprehensive framework...but more work is needed
Proposed Ruling on the Issues
On every issue the proposed ruling would hold that having the PTC serving as trustee does not - standing alone - cause the threatened bad result because the firewalls prevent a family member from deciding on distributions from a trust of which that person or the person's spouse is the grantor or a beneficiary:
• No estate tax would apply, either to the grantor or the beneficiary's estate
• Gifts would be complete
• No effect on generation-skipping
• No income tax attributed to the grantor or beneficiary
However, the proposed ruling is not a solid green light. The proposed ruling requires materially broader restrictions than the law requires to achieve a favorable result on wealth transfer taxes. In addition, the income tax part of the ruling places potentially troublesome limits on the composition of the DDC, which may in turn complicate the succession process for the DDC that would be needed to avoid wealth transfer tax issues. In all events, more explicit and practical guidance is needed even though the basic framework of the ruling marks clear progress over the prior practice.
Wealth Transfer Tax Implications of the Ruling
The proposed guidance dispels the worst fears of an expansive adverse wealth transfer tax treatment premised on family collaboration. The proposed guidance does not find taxable attribution for wealth transfer tax purposes in what are described above as "group powers". Without mentioning these expansive theories of tax risk by name, the proposed ruling takes an approach that indicates that:
(1) the replacement power boundary drawn by Rev. Rul. 95-58 is not being imposed on shared powers, and
(2) the reciprocal transfer doctrine is not being extended to powers that mirror each other but are not held by transferors, i.e., where there is no reciprocal transfer.
It is, for example, quite clearly stated in the proposed ruling that estate tax inclusion will not apply (1) on the death of the PTC shareholders by reason of shareholding, (2) on the death of an officer, director, employer, manager, or DDC member by reason of that service, or (3) by reason of the PTC serving as the trustee. It is also stated that the result would not change if the PTC were solely owned by one family member alone.
Furthermore, family collaboration in the form of other arrangements involving group or mirror powers, such as in distribution committees, should also be tax neutral under wealth transfer taxes. The critical facts of the proposed ruling involve a distribution committee. The PTC structure surrounds this committee in the facts of the ruling, but the favorable aspects of the ruling that focuses on the workings of the committee could stand on its own and reach the same favorable result if the PTC wrapper were not present.
Nonetheless, the proposed ruling needs significant improvements on wealth transfer tax issues due to the comment process, both in articulating the legal constraints on replacing decisions-makers inside the PTC and in narrowing the recusal firewalls for distribution decisions.
Replacement Powers over Decision-Makers: Improvements Needed
Unfortunately the ruling leaves open a significant gap in providing reassurance on wealth transfer tax issues because the power to remove and replace members of the DDC, or to replace directors who can change the DDC, is not expressly considered. Thus the possible risk of taxation due to indirect influence on DDC succession is not foreclosed by the ruling as now drafted, e.g., can a sequential or joint power to replace DDC members ever cause attribution, and if so, how and when? Hopefully the final ruling will address this succession question explicitly:
• Presumably a favorable result is intended as to family ownership of the PTC. A sole shareholder can have some indirect impact on the succession (at least sequentially as described above by changing the directors who then may or may not change the DDC), and yet the ruling states that ownership by a single family shareholder is not considered an obstacle to avoiding adverse tax results if the firewalls are in place; indeed in the income tax analysis, due to the firewall restrictions, family ownership of the PTC is not considered "significant" from the viewpoint of voting control over distributions, as discussed below.
• This does not mean that other more direct means of control by grantors and beneficiaries are permitted in DDC succession, and unfortunately, does not mean that the ruling provides guidance as to where the law draws the line. The guidance is intended to be tax neutral, which includes preventing the grantor or beneficiary from using a PTC to control distributions in a way that could not be accomplished outside of a PTC. Unfortunately, even outside the PTC context the standards for replacement powers are not clear if one gives any weight to the related or subordinate concept of Rev. Rul. 95-58, while also recognizing what it lacks in supporting authority and convincing logic.
• Moreover, a prior comment on these PTC issues argued convincingly that trying to apply the concept of the 1995 ruling to the PTC context serves to emphasize the inherent weakness of that concept.12 The distinction between a power to choose my close friend but not my brother as a trustee seems on its face to be a dubious ground for deciding whether to tax away half of my net worth. If it then becomes necessary to apply the "related or subordinate" language of the grantor income tax rules to PTCs owned by families and acting through employees, the concept truly becomes wrapped around the axle, or at least the org chart. The proposed ruling makes progress by finding that the firewall restrictions can be used to wall off family share ownership from the scope of the related or subordinate language. But the square peg still will not fit in the round hole. Certainly a grantor or beneficiary should not be able to hold a unilateral right and avoid attribution simply because the power is exercised inside a PTC. Yet, as we will see in the income tax analysis, the application of the related or subordinate language to a PTC remains an exercise in confusion and hair-splitting. The proposed ruling, for example, considers an employee of the PTC (organized as a corporation) to be a related or subordinate party to a grantor or beneficiary who serves as an officer and director, which would cause the use of a corporate PTC to expand further the category of related or subordinate parties, but not so for a PTC organized as a partnership or LLC. In short, there must be a better place to draw these lines for wealth transfer tax purposes, and the impractical results generated by the "related or subordinate" concept should prompt consideration of taking the step that the 1995 ruling did not, which is to return to the statement in the estate tax regulations and base attribution only on a power to name oneself.
• In all events, as discussed above, the 1995 ruling simply does not speak to shared replacement powers, much less to those mirrored within a group. The guidance in the proposed ruling should make it clear that there is no intention to extend this debate beyond a unilateral power to replace a decision-maker.
Recusal Firewalls in Distribution Decisions: Improvements Needed
As to wealth transfer taxes, the final ruling should clarify or revise the recusal restrictions on the following matters, in order to achieve tax neutrality for the PTC, that is, consistency with the standards applied to decision-makers acting outside of the PTC format, whether as individual co-trustees or committee members:
• Restriction on participation by spouses of grantors and beneficiaries. Presumably this restriction is relevant only for the income tax part of the ruling, and for that matter, only for attributing trust income to the grantor since a beneficiary can be attributed trust income only by reason of a power of withdrawal solely exercisable by the beneficiary. Unlike under IRC section 672(e) of the grantor sections of the income tax rules, there is no automatic attribution between spouses as to wealth transfer taxes.13If the spouse's recusal is intended to be required only for certain income tax issues in the ruling, that distinction should be made clear in the final ruling. If spouses are not given a voice and a vote, this restriction would be considered much more than a mere inconvenience in many families where spouses and surviving spouses command respect and manage transitions of money and values to younger generations.• Restriction on participation by a beneficiary on distributions to others from same trust. Distributions that would not benefit the beneficiary personally would not be completely restricted if the beneficiary were serving as an individual trustee (and the beneficiary was not also a transferor)14. Yet the recusal restrictions in the PTC would apply to decisions on distributions to others. The final ruling should drop this part of the recusal (or at least offer a very narrowly focused solution to whatever was the perceived abuse or tax risk). This is not a small matter. Family trusts typically include multiple family members as beneficiaries, such as through "pot" trusts, multi-generational dynasty trusts, and alternative remainders; and by fishing with such a wide net, the recusal provision raises many interpretive issues for trusts with powers of appointment, charitable beneficiaries, and contingent and conditional interests. If this restriction were applied literally, it would often disqualify all or most family members from participating in distribution decisions by PTCs, a result that would be completely at odds with the purpose of the proposed ruling to treat PTCs as tax neutral, no more restricted than individual fiduciaries.
• Restriction on participation by grantors. The recusal restrictions preclude express or implied reciprocal agreements. This seems too limited because it requires, apparently, a finding of an agreement (and seems merely to duplicate state trust and corporate law on the duty of loyalty). Under established case law, if transferors cross their powers of control in reciprocal fashion when making gifts in trust, it would not be necessary to find an agreement - - bargained for "quid pro quo" - - in order to apply the reciprocal transfer doctrine; it is enough that the grantors ended up with the equivalent of such an exchange of powers. The final ruling could make it clearer that reciprocal use of the PTC when creating and funding trusts should have the same effect even if there is no express or implied quid pro quo. Possibly the guidance could address this by illustrating and explaining what was intended by the prohibition of "implied" reciprocal agreements.
Income Tax Implications of the Ruling
The income tax part of the proposed ruling involves more subtle issues and proposes more limits on decision-making bodies in PTCs. As noted earlier, the question is whether the grantor will be attributed trust income if the PTC structure involves decision-making by a "related or subordinate" party under section 674:• It is assumed for purposes of this discussion that the trusts in question include sufficiently broad distribution discretion that section 674 would be controlling; that is, section 674 would attribute income to the grantor if the powers were exercised by such a "related or subordinate" party who is "subservient" to the grantor as defined in section 672.
• First, the tax analysis in the proposed ruling concludes that family stock ownership does not cause "related or subordinate" characterization under section 672. This part of the analysis is straightforward. The firewall restrictions discussed above make the voting control of the PTC irrelevant. Under the relevant language of section 672, the PTC structure cannot involve a "corporation....in which the stockholdings of the grantor and the trust are significant from the viewpoint of voting control." Even if the PTC were solely owned by a single family member/grantor, this sole voting control is not "significant" because the firewall restriction on the PTC prevents the voting control of the stock from providing any control over the distributions made by the PTC and the employees of the PTC. 15
• However, the proposed ruling then looks inside the PTC and turns troublesome. What is described as a "partial look-through" analysis is used to test the real decision-makers - the DDC members -- under a tax neutral screen, as if those DDC members served as individual trustees in making those decisions. The point is to see whether the role of the DDC under the recusal restrictions, which protects against control by shareholders, could nonetheless allow the actual distribution decisions to be controlled by "related or subordinate" parties serving as members of the DDC.
• That step by itself seems quite logical and necessary. Yet the next step of the analysis bears close attention, since the use of the corporate form actually affects whether PTC personnel are characterized as "related or subordinate" under section 672. Under section 672(c) this tainted category includes "a subordinate employee of a corporation in which the grantor is an executive." Applying this language the proposed ruling concludes that all DDC members who are also serving as employees would be, or at least could be, "related or subordinate" and "subservient" parties to a grantor under section 672 whenever the grantor is a director and/or officer of the PTC. Under the facts at hand, the proposed ruling thus finds that grantors A, C, D, and E are caught by section 672 (although it does not specifically address the "subservient" question). The ruling excludes B from this result because B is not an officer or director or manager16.
This interpretation of the "subordinate employee" language is unfortunate because, among other reasons, it does not apply evenly to PTCs organized not as corporations but as limited liability companies or partnerships. The final guidance could take a more practical alternative path and conclude that the firewall restrictions preclude a finding that DDC members are "subordinate employees" or preclude a finding that they are "subservient to the wishes of the grantor" for these purposes17.
• This enabling alternative would require revising the supporting restrictions in the firewall to deal more specifically with the executive-employee relationship in view of the "subordinate" and "subservient" language of section 672. As proposed the firewall does not prevent an officer from controlling the terms of employment of an employee who sits on the DDC and thus votes on distributions from a trust of which that officer is the grantor; for such cases, the firewall restrictions can be revised, for example, to disqualify the relevant employee members of the DDC from voting only when such officer-funded trusts are at issue. The current draft of the proposed ruling does not address whether and how such refinements in the recusal restrictions could be made effective.
• However the employee question is resolved, note that family members are still effectively precluded from voting on DDC questions involving trust distributions if, as related or subordinate parties, their participation as individual trustees would lead to undesired attribution of trust income to a related grantor. Presumably the cure here can be additional specific recusal provisions so family membership on the DDC need not be kept at minority levels for all trusts in order to avoid the "related or subordinate" language for certain trusts.
• These kinds of refinements in the final ruling would respond to the reality that this ruling is expected to be relied upon to provide guidance on how to construct tax-protected governance, without requiring much extrapolation if any from its stated facts. Most PTCs have no reason to engage a wide variety of outside professionals and other unrelated parties in their governance of family trust distributions, so any tax mandates on committee voting membership should be narrowly confined to the relevant tax sensitive decisions. Sample recusal guidance is needed.
In sum the ruling would apply the grantor trust rules in a tax neutral way to PTCs and conclude that nothing in the firewalled PTC triggers the grantor trust rules, with one important exception -- a need under section 674 to test the "related or subordinate" definition of section 672 at the DDC level where real decision-making resides, as if the committee members were individual trustees. The ruling then needs more detailed related treatment of the membership composition of the DDC and firewall restrictions. On a positive note, the ruling concludes with conviction that family ownership of PTC voting shares does not by itself cause parties inside the PTC to be related or subordinate, reasoning that the firewall restrictions preclude shareholders from having "significant" and "relevant" voting control.
Not a solid green light... Caution still required.
Summary: Room for improvement
The proposed ruling offers a remarkably thorough and thoughtful framework for resolving these issues, but needs improvement in its critical details in order to offer workable rules and achieve its goal of treating PTCs as tax neutral. In addition to adding favorable commentary for a comparable distribution committee standing alone outside a PTC (i.e., created by the trust document rather than the PTC and state law), the final ruling should as explained above:• make it clear that reciprocal use of the PTC's powers when creating and funding trusts should have the same effect on grantors whether or not there was an intended exchange or quid pro quo that constitutes an "agreement" and make it clear that a prohibition against reciprocal agreements could be just as effective if imposed by state trust law rather than by express PTC provisions;
• make it clear that, for wealth transfer tax purposes, the DDC can be appointed and changed by any combination of decisions, including joint or sequential powers as described above, as long as a grantor or beneficiary does not have a sole power to change the decision-maker in a manner that would cause attribution in a context where a PTC is not involved; and in this connection the relevance of the "related or subordinate party" standard for wealth transfer taxes in either context should be reconsidered;
• articulate why a spouse of a grantor or beneficiary should be precluded from participating in the DDC decisions for that trust, so it is clear that this restriction is relevant only for the grantor's income tax purposes, and thus would be totally unnecessary, for example, if the grantor were deceased;
• delete the restriction that precludes a beneficiary from acting on decisions on distributions to others;
• further articulate how the membership of the DDC could include employees of the PTC and family members without triggering income tax attribution of trust income to grantors if certain kinds of refinements are made in the firewall restrictions described in the proposed ruling.
Conclusion
The proposed guidance represents a step forward on the path to providing practical rules that allow family decision-making over family trusts without undue complexity and tax risk. Assuming important holes in the guidance will be repaired with workable solutions, and the firewalls tailored to put PTCs on a "level tax playing field" with individual fiduciaries, the resolution is close at hand for the tax issues arising from a family's collective management of its trusts through PTCs, individual co-trustees, family committees and similar governance methods and means.
1Published at http://www.wealthstrategiesjournal.com/Issue_2006_11/2006 and cited hereinafter as "Family Decision-making."
2This issue first became evident in private letter ruling requests in 2001 and has been commented on in professional journals since at least 2002. D. Kozusko and M. Padgett, Private Trust and Protector Companies: How Much Family Control? 43 Tax Man. Memo. No. 22 (Nov. 4, 2002) (hereinafter referred to as "Family Control").
3Treas. Reg. 20.2036-1(b)(3), 20.2038-1(a)(3), and 20.2041-1(b)(1).
4IRC Sections 2036(a) and 2038(a); Treas. Reg. 2511-2(e). A classic exception would be a power that requires the consent of someone with an adverse interest in its exercise.
5This complex subject is explained in more detail in "Family Decision-making" and in "Family Control."
6Rev. Rul. 95-58 (1995-2 CB 191). The facts in the ruling dealt only with a power that precludes the naming of a related or subordinate as a replacement, and it revokes a prior ruling that found attribution even when the power was so restricted.
7"Family Control" and Comments to Office of Chief Counsel on Family-owned Trust Companies by McGuire Woods, LLP, Feb. 27, 2006 (hereinafter "McGuire Woods"), p. 11-13.
8Note that in the absence of Rev. Rul. 95-58 and the prior rulings it revokes or modifies, one could have concluded, by negative inference, that any power that did not allow the power holder to appoint himself or herself was not going to be challenged, because the regulations only spoke of attribution in the context of such broader powers. But that favorable expectation of the IRS position was dispelled by these later rulings.
9PLR 9451049 and then a series of five related rulings (PLR 200748008, 200748011 to 13 and 200748016) ruled favorably; but see PLR 9235025.
10See PLR 9235025. For a full discussion, see "Family Decision-making."
11See "Family Decision-making" as to the recommendations of the New York State Bar Association and "Family Control" at p. 13-16 and McGuire Woods at p. 4-6 for a more detailed discussion of the private letter rulings.
12McQuire Woods p. 11-13.
13For example, under IRC Section 2041 the grantor's spouse could hold a special power of appointment over the grantor's trust without triggering an estate tax as long as the power is not exercisable in favor of the spouse, the spouse's estate or creditors, or to discharge the spouse's legal obligation of support.
14See Treas. Reg. 25.2514-1(b)(2) (power of appointment); Treas. Reg. 25.2514-3(b) (adverse party consent); and for trustee distributions to others, see Treas. Reg. 25.2511-1(g)(2)(ascertainable standard). The mere holding by a beneficiary of a power to benefit others is not a taxable power of appointment, and its exercise should not be a gift unless it is equivalent to a transfer of all or part of the beneficiary's own interest. Treas. Reg. 25.2514-3(e)(Ex. 3); PLR 8535020; PLR 9451049; W. Culp and M. Richardson, Lifetime Special Powers of Appointment Offer Unique Planning Opportunities, Estate Planning Journal (Oct. 2006).
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