IRS Notice 2016-16: Safe Harbors for GST Trusts

Treasury regulations provide guidance for trustees and beneficiaries of irrevocable trusts, clarifying how certain changes can be made without jeopardizing a trust’s favorable tax status. Many older trusts benefit from being “grandfathered” or exempt from the Generation-Skipping Transfer (GST) tax, a federal tax imposed on transfers to beneficiaries more than one generation younger than the person who created the trust. This exemption is valuable, as the GST tax is a flat 40 percent tax applied in addition to any applicable estate or gift taxes.

To address uncertainty when trustees need to update a trust’s terms, the regulations establish “safe harbors.” These are specific sets of rules that, if followed, guarantee that a trust modification or a “decanting” of trust assets will not cause the trust to lose its GST exemption.

Preserving GST Exemption in Trust Modifications

Trust modifications often become necessary to address administrative issues or clarify ambiguous language. These changes might be accomplished through a court order or a non-judicial settlement agreement among the beneficiaries. Treasury regulations provide a safe harbor ensuring that such a modification will not terminate a trust’s GST-exempt status, provided it adheres to strict limitations.

A requirement under the safe harbor is that the modification must not shift a beneficial interest in the trust to a beneficiary who is in a lower generation than the person who held the interest before the change. For instance, a modification could not redirect an interest intended for a child to a grandchild. This rule prevents changes that would effectively skip a generation of taxation that the original trust structure contemplated.

The modification also must not extend the time for the vesting of any beneficial interest beyond the period specified in the original trust. Vesting refers to the point at which a beneficiary’s right to an asset becomes legally secure and unconditional. For example, if a trust dictates that a beneficiary’s interest vests at age 30, a modification cannot push that date to age 40. This provision prevents the use of modifications to unduly prolong the trust’s existence and delay the transfer of assets, which could otherwise be used to circumvent transfer tax rules.

These rules apply to changes that are administrative in nature, such as updating trustee provisions, as well as more substantive changes approved by a court. As long as the modification stays within these two primary constraints, the trust’s GST-exempt status will be preserved. This allows trustees to make necessary adjustments to irrevocable trusts without triggering adverse tax consequences.

Safe Harbors for Trust Decanting

Trust decanting is the process of a trustee using their discretionary power to distribute assets from an existing trust (the “first trust”) into a new trust (the “second trust”) with updated terms. This action is often used to modernize an old trust, add a special needs provision, or change the trust’s administrative location. IRS guidance provides specific safe harbors for decanting to ensure it is not used to improperly avoid GST tax.

The guidance addresses different types of decanting. One path involves a “qualified severance,” where a single GST-exempt trust is divided into two or more separate trusts. As long as the severance complies with the relevant regulations, the resulting trusts will retain the same GST-exempt status as the original trust. This is often done to create separate trusts for different family branches or to segregate assets with different investment horizons.

For decantings that are not qualified severances, a different safe harbor applies. The requirement is that the decanting cannot result in a change that would have been impermissible under the modification safe harbor. This means the combined terms of the first and second trusts must not shift a beneficial interest to a lower-generation beneficiary or extend the vesting period for any interest. By adhering to these guidelines, trustees can decant trust assets without risking the loss of GST exemption.

Actions Outside the Safe Harbors

When a trust modification or decanting does not meet the precise requirements of the established safe harbors, it does not automatically lose its GST-exempt status. Instead, the action falls into a gray area where its tax consequences become less certain. The Internal Revenue Service (IRS) will apply a more subjective “facts and circumstances” analysis based on state law and Treasury Regulations to determine the outcome.

The central question remains whether the modification or decanting improperly shifts a beneficial interest to a lower-generation beneficiary or extends the vesting period. To manage this risk, trustees can request a private letter ruling (PLR) from the IRS. A PLR is a written determination that interprets and applies tax laws to a specific set of facts, providing assurance on the tax consequences of a proposed action before it is taken.

The IRS continues to issue PLRs on the GST tax effects of trust modifications and decanting. While the safe harbors provide a clear and direct path for making changes without adverse tax effects, a PLR offers an alternative way to gain certainty. Seeking a PLR is particularly useful when a necessary modification or decanting is complex or falls outside the established safe harbor guidelines.