New IRS position could lead to gift tax consequences in trust modifications and decantings

Taken to its somewhat illogical conclusion, Chief Counsel Advice 202352018 (issued November 28, 2023, released December 29, 2023) could lead to gift tax consequences for beneficiaries of trusts which are modified or decanted in a way that alters beneficial interests in a trust.  Modification of administrative, nondispositive trust provisions should not be affected.

In CCA 202352018, the IRS took the position that beneficiaries’ consent to a trust modification of a defective grantor trust to give the trustee the discretionary power to reimburse the settlor’s income tax payments constituted “a gift of a portion of their respective interest in income and/or principal” of the trust.  While the beneficiaries consented to the modification in the case to which the CCA applies, the CCA provides that “the result would be the same if the modification was pursuant to a state statute that provides beneficiaries with a right to notice and a right to object to the modification and a beneficiary fails to exercise their right to object.”

This is an IRS position, not a court determination.  Still, it could cause concern in cases where a trust is modified or decanted in a way that diminishes the beneficial interest of a beneficiary of the decanted trust.  If the beneficiary consents or does not object to the modification or decanting, he or she could be deemed to have made a gift of a portion of the income or principal of the trust.

Texas Trust Code Section 112.054 – the judicial modification statute – does not require the beneficiary to consent to a modification, but it does make the beneficiary a necessary party, and the beneficiary is entitled to initiate the modification action. Perhaps having the trustee initiate the proceeding and having the beneficiary file a general denial or other non-consenting response will overcome the implications of CCA 202352018.  But trustees are sometimes reluctant to initiate modification suits.  This might be a good use of a trust protector, who could direct the trustee to seek the modification, taking away the trustee’s discretion and overcoming their reluctance to proceed.

Texas Trust Code Section 112.074 – part of the Texas decanting statute – requires notice to beneficiaries of a decanting.  This might be enough to cause the CCA to apply unless the beneficiary objects to the decanting.

A combination of trusts under Texas Trust Code Section 112.057 may avoid the CCA trap because the combination must not “impair the rights of any beneficiary or adversely affect achievement of the purposes of the trust.” If a beneficiary’s rights may not be impeded, then presumably he or she will not be making a gift of a beneficial interest in the trust. 

Often the modification, decanting or combination of a trust is undertaken to solve problems with the administration of the trust, not to change the beneficial interests in the trust.  For example, a modification which changes the trustee succession provisions of a trust or changes the situs of the trust should not be affected by CCA 202352018 because the trustee remains subject to the same duties to the beneficiaries and the beneficial interests remain the same.