Transfer Tax Implications of Trust Investment in Limited Partnership

March 23, 2009

On January 9, 2009, the Internal Revenue Service released Private Letter Rulings 200902008, 200902009, and 200902010 addressing the gift and generation-skipping transfer tax consequences of the investment in limited partnerships by generation-skipping transfer (“GST”) tax grandfathered trusts.

In each of these three letter rulings, husband and wife had, prior to September 25, 1985, created an irrevocable trust for the benefit of a grandson (the “Trusts”). The grandson is the sole beneficiary of his trust during his lifetime. The Trustees of the Trusts are a corporate bank and two individuals.

The governing state law gives trustees discretion to invest and reinvest trust property as they consider proper. State law also provides that a trustee may exercise any powers necessary or appropriate to carry out the purposes of the trust. These powers are similar to those granted to a trustee under the Uniform Trust Code.

Each grandson is also the sole beneficiary of a number of other trusts. The Trustees of each grandson’s other trusts placed the marketable securities held in these trusts in a custodian account with Financial Services Corporation (“FSC”) in order to have integrated reporting of asset performance, both individually for each trust and in the aggregate for all of the grandson’s trusts.

The Trustees desired to include the marketable securities of the Trusts in this integrated reporting. However, legal counsel for the corporate trustee advised that the Comptroller of the Currency requires the trustee to maintain custody of the trust assets. In order to allow the trust assets to be included in the FSC reporting, the Trustees formed a wholly-owned LLC. The Trustees contributed the trust’s marketable securities to a newly-formed limited partnership in exchange for a 99.9% limited partner interest. The LLC owned a 0.1% general partner interest in the partnership. The partnership then placed its assets in a custody account with FSC.

The rulings specify that the Partnership Agreement and the LLC Agreement will be amended to require the partnership to distribute (1) the “net cash from operations” and (2) amounts sufficient to allow any partner that is a trust to make any distributions required by the applicable trust instrument of such trust. Net cash from operations will be treated as being equivalent to net income under state law.

The parties requested rulings that the formation of the partnership will not be a taxable gift for gift tax purposes and will not cause the trust to be subject to GST tax.

The IRS granted each of the requested rulings and concluded that the operation and management of the trust assets would not result in a shift of any beneficial interest in the trust to any beneficiary who occupies a generation lower than the persons holding the beneficial interests prior to the distribution and would not extend the time for vesting of any beneficial interest in the trusts beyond the period provided for in the trust agreements. The IRS further concluded that the operation and management of the trust assets would not cause the trusts to lose their exempt status for GST tax purposes, and the receipt of partnership interests by the trusts would not be treated as additions to the trusts for GST tax purposes.

Finally, the IRS concluded that the operation and management of the trust assets would not cause any beneficiary of the trusts to have made a taxable gift for federal gift tax purposes under section 2501.

The IRS has in the past issued similar rulings on the effect of a trust’s investment in a partnership or LLC. In PLR 200346008, the IRS ruled that the investment of trust assets in an LLC would not cause the trusts to lose their GST tax exempt status. The LLC Operating Agreement in PLR 200346008, similar to the Partnership and LLC Agreements in the three rulings described above, also required that the LLC distribute at least all of the net income of the LLC, such amount to be determined as though the LLC were a trust. The rulings do not explain the inclusion of these LLC or partnership distribution requirements. The Trustees may have required them in order to avoid a later claim that they invested in entities that could trap income and prevent the trust beneficiaries from receiving the income to which they otherwise would have been entitled. Alternatively, in discussions with the taxpayers, the IRS may have required such distribution provisions in order to issue the ruling. Similar distribution requirements can also be found in Private Letter Rulings 200531008, 200531009 and 200531010. In planning, careful attention should always be given to distribution provisions and the definition of income.

McGuireWoods Fiduciary Advisory Services

Our Fiduciary Advisory Services assists financial institutions in a wide array of areas in which questions or concerns may arise. For further information on the private letter rulings discussed above or our practice, please contact the authors.

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