883 / When are portions of a severed trust treated as separate trusts for GST tax purposes?

In general, portions of a trust are not to be treated as separate trusts. However, portions attributable to different transferors, substantially separate and independent shares of different beneficiaries of a trust, and trusts treated as separate trusts under state law are to be treated as separate trusts for GST tax purposes.¹ However, treatment of a single trust as separate shares for purposes of the GST tax does not permit treatment as separate trusts for purposes of filing or payment of tax, or for purposes of any other tax. Additions to, or distributions from, such a trust are allocated pro-rata among all shares unless expressly provided otherwise. In general, a separate share is not treated as such unless it exists at all times from and after creation of the trust.

Trusts created from a qualified severance are treated as separate trusts for GST tax purposes, effective for 2001 to 2009 and for tax years beginning after 2010. A qualified severance means the division of a single trust into two or more trusts under the trust document or state law if (1) the single trust is divided on a fractional basis, and (2) in the aggregate, the terms of the new trusts provide for the same succession of interests of beneficiaries as are provided in the original trust. In the case of a trust with a GST inclusion ratio of greater than zero and less than one (i.e., the trust is partially protected from the GST by allocations of the GST exemption), a severance is a qualified severance only if the single trust is divided into two trusts, one of which receives a fractional amount equal to the GST applicable fraction multiplied by the single trust’s assets. The trust receiving the fractional amount receives an inclusion ratio of zero (i.e., it is not subject to GST tax), and the other trust receives an inclusion ratio of one (i.e., it is fully subject to GST tax).²

Otherwise, severance of a trust included in the taxable estate (or created in the transferor’s will) into single shares will be recognized for GST purposes if (1) the trusts are severed pursuant to the governing instrument or state law, (2) such severance occurs (or a reformation proceeding is begun and is indicated on the estate tax return) prior to the date for filing the estate tax return (including extensions actually granted), and (3) the trusts are funded using (a) fractional interests or (b) pecuniary amounts for which appropriate adjustments are made.³

Regulations provide that a qualified severance must be done on a fractional or percentage basis; a severance based on a specific pecuniary amount is not permitted. The terms of the new trusts must provide in the aggregate for the same succession of beneficiaries. With respect to trusts from which discretionary distributions may be made on a non pro rata basis, this requirement can be satisfied even if each permissible beneficiary might be a beneficiary of only one of the separate trusts, but only if no beneficial interest is shifted to a lower generation and the time for vesting of any beneficial interest is not extended.⁴

The regulations provide that the separate trusts must be funded with property from the severed trust with either a pro rata portion of each asset or on a non pro rata basis. If funded on a non pro rata basis, the separate trusts must be funded by applying the appropriate severance fraction or percentage to the fair market value of all the property on the date of severance. The date of severance is either the date selected by the trustee or a court-imposed date of funding. The funding of the separate trusts must commence immediately, and occur within a reasonable period of time (not more than 90 days) after the date of severance.

A qualified severance is deemed to occur before a taxable termination or a taxable distribution that occurs by reason of the qualified severance. For example, a trust provides for trust income to be paid annually to grantor’s child (C) and grandchild (GC) for 10 years, remainder to C and GC or their descendants. If either dies during the trust term, income is payable to that person’s then-living descendants. The inclusion ratio for the trust is .50. The trust is severed into one trust for C and C’s descendants and one for GC and GC’s descendants. The trustee designates the trust for C as having an inclusion ratio of one, and the trust for GC as having an inclusion ratio of zero. The severance causes either a taxable termination of C’s interest in, or a taxable distribution to, GC’s trust (which is a skip person). However, the severance is deemed to occur before the GST and GC’s trust has an inclusion ratio of zero; therefore, there is no GST tax due.⁵

A trust that is partly grandfathered from GST tax can be severed into a grandfathered and a nongrandfathered trust under these rules.

Regulations provide that, for purpose of funding the separate trusts, assets must be valued without taking into consideration any discount or premium arising from the severance.⁶ For example, if the severance creates a minority interest when the separate trust receives less than the interest owned by the original trust, such a minority discount is disregarded for funding purposes.

Regulations provide that, with respect to a qualified severance of a trust with an inclusion ratio that is greater than zero and less than one, one or more resulting trusts must be funded with an amount equal to the GST applicable fraction (used to determine the GST inclusion ratio for the original trust immediately before the severance) times the value of the original trust on the date of severance. Each such resulting trust receives an inclusion ratio of zero. All other resulting trusts receive an inclusion ratio of one. If two or more trusts receive an amount equal to the applicable fraction of the original trust, the trustee can select which of the resulting trusts has an inclusion ratio of zero, and which has the inclusion ratio of one. For example, if the original trust has an applicable percentage of .50 and the trust is severed into two trusts, the trustee can select which of the two resulting trusts has an inclusion ratio of zero, and which has an inclusion ratio of one.⁷

Regulations also provide that, where a trust is severed and the severance is not qualified, the resulting trusts each receive an inclusion ratio equal to the inclusion ratio of the original trust.⁸

Further, as provided in the regulations, for purposes of the requirements that a separate share is not treated as such unless it exists at all times from and after creation of the trust, a trust is treated as created on the date of death of the grantor if the trust is fully includable in the gross estate of the grantor for estate tax purposes. Also, if the trust document requires the mandatory severance of a trust upon the occurrence of an event (not within the discretion of any person), the resulting trusts will be treated as separate trusts for GST tax purposes. The resulting trusts each receive an inclusion ratio equal to the inclusion ratio of the original trust.⁹

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Planning Point: The advantage of having portions or shares of a trust treated as separate trusts is that the transferor can decide whether or not to allocate a portion of his GST tax exemption to each separate trust and the trustee can make distributions from the separate trusts in a way that minimizes GST tax.

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