Trust conversion is nontaxable and not self-dealing but gives no new deduction

Plain-English summary

A split-interest trust proposed adding a substitution power that would convert it from a nongrantor trust to a grantor trust. The power would be held in a nonfiduciary capacity by the grantor's sibling, who could substitute property of equivalent value. The IRS ruled that the conversion itself would not be treated as a taxable transfer of the trust property back to the grantor. It also ruled that the conversion was not self-dealing because a sibling is not a family member treated as a disqualified person under section 4946. The IRS denied the requested charitable deduction because the conversion did not involve a new transfer of property to the grantor trust.

Ruling snapshot

• Question: Would converting the trust to grantor-trust status create a taxable transfer, cause self-dealing, or generate a new charitable deduction?
• Outcome: mixed
• Key authorities: IRC §§ 170, 671, 675(4), 4941, 4946, and 4947(a)(2); Rev. Ruls. 77-402 and 85-13; Rev. Proc. 2007-45

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201730017 Third Party Communication: None
Release Date: 7/28/2017 Date of Communication: Not Applicable
Index Number: 1001.02-00, 4941.00-00,
170.01-00 Person To Contact:
---------------------------, ID No. ---------------
---------------------- -----------------
------------------------------------- Telephone Number:
-------------------------------------------- ----------------------
------------------------------------------- Refer Reply To:
CC:PSI:B03
PLR-133443-16
Date:
May 01, 2017

LEGEND

Trust = ----------------------

----------------------------------

Grantor = ----------------------

Date 1 = --------------------

Agreement = -----------------------

-

Article = ------------

Charity = --------------------------------

--------------------------------------------------------

----------------------------------------

X = --------------

State = ----------
2
PLR-133443-16

Substitutor = ---------------------------------

Dear -------------------:

This is in response to your letter dated October 19, 2016, and subsequent
correspondence submitted on behalf of Trust, requesting rulings regarding the
conversion of Trust from a nongrantor trust to a grantor trust.

                                                 FACTS

The information submitted states that on Date 1, Grantor, as settlor and initial trustee,
created Trust pursuant to Agreement. Agreement provides that until the X anniversary
of the initial contribution date, an amount equal to the annuity amount will be distributed
to Charity. Trust represents that it was previously allowed income tax deductions
pursuant to § 642(c)(1) for the amounts of gross income included in the annuity amount
each year.

Trust is seeking to amend Agreement to delete and replace Article pursuant to the laws
of State. The amended Article permits the Substitutor to have the power, exercisable at
any time in a nonfiduciary capacity (within the meaning of § 675(4)), without the
approval or consent of any person in a fiduciary capacity, to acquire or reacquire Trust
principal by substituting other property of an equivalent value, determined as of the date
of such substitution. Substitutor is not a trustee of Trust. Substitutor and Grantor are
siblings.

In connection with the aforementioned amendment, Grantor seeks the following rulings:
(1) The conversion of Trust from a nongrantor trust to a grantor trust (assuming the
Substitutor is found to hold the substitution power in a nonfiduciary capacity) is not a
taxable transfer of property held by Trust to Grantor as settlor for income tax purposes;
(2) The conversion of Trust from a nongrantor trust to a grantor trust is not an act of
self-dealing that would result in a tax under § 4941; and (3) The conversion of Trust
from a nongrantor trust to a grantor trust would result in an income tax charitable
deduction for Grantor in the year of conversion under § 170.

                                       LAW AND ANALYSIS

Ruling Request 1

Section 671 of the Internal Revenue Code provides that where it is specified in
subpart E that the grantor or another person shall be treated as the owner of any portion
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of a trust, there then shall be included in computing the taxable income and credits of
the grantor or the other person those items of income, deductions, and credits against
tax of the trust that are attributable to that portion of the trust to the extent that such
items would be taken into account under chapter 1 of the Code in computing taxable
income or credits against the tax of an individual.

Section 675(4) provides, in part, that the grantor shall be treated as the owner of any
portion of a trust over which the grantor has a power of administration exercisable in a
nonfiduciary capacity by any person without the approval or consent of any person in a
fiduciary capacity. For purposes of § 675(4), the term “power of administration” includes
a power to reacquire the trust corpus by substituting other property of an equivalent
value.

Rev. Rul. 77-402, 1977-2 C.B. 222, holds that when the grantor and owner of a trust
which holds a partnership interest subject to liabilities renounces all grantor trust powers
over that trust during life, the grantor is treated as having transferred the interest, and
will recognize gain or loss. The ruling states that the result would also be the same if the
trust were treated as a grantor trust by reason of powers exercisable by a party other
than the grantor and ceased to be a grantor trust upon the release or renunciation of
those powers by such other party or upon the expiration or lapse of such powers.

Rev. Rul. 85-13, 1985-1 C.B. 184, holds that a grantor who acquired the corpus of a
trust in exchange for an unsecured promissory note was considered to have indirectly
borrowed the trust corpus resulting in grantor trust treatment. As a result, the transfer of
trust assets to the grantor was not a sale for federal income tax purposes and the
grantor did not acquire a cost basis in the assets of the trust. The ruling concluded that
the grantor became the owner of the trust corpus which he had indirectly borrowed and
thus was taxable on the trust's income and, as the deemed owner of the trust assets,
could not engage in a transaction with the trust that would be respected for income tax
purposes. It did not conclude that the grantor realized the amount of the indirect
borrowing or any portion of that amount as income.

Rev. Rul. 77-402 concludes that the lapse of grantor trust status during the grantor-
owner’s life may have income tax consequences, but does not impose such
consequences on a non-grantor trust that becomes a grantor trust. Rev. Rul. 85-13
describes the income tax effects of a non-grantor trust becoming a grantor trust, which
effects did not include the realization or recognition of any income by the grantor-owner
by reason of the conversion. Given the lack of authority imposing such consequences,
we conclude that the conversion of Trust from a non-grantor trust to a grantor trust will
not be a transfer of property to Grantor from Trust under any income tax provision.

Ruling Request 2
PLR-133443-16 4

Section 4947(a)(2), provides in relevant part, that in the case of a trust which is not
exempt from tax under § 501(a), not all of the unexpired interests in which are devoted
to one or more of the purposes described in § 170(c)(2)(B), and which has amounts in
trusts for which a deduction was allowed under § 170 (or other charitable deduction
provisions), §4941 shall apply as if such trust were a private foundation.

Section 4941 imposes an excise tax, paid by the disqualified person, on each act of
self-dealing between a private foundation and a disqualified person for each year in the
taxable period, and requires correction of the act of self-dealing.

Section 4941(d)(1)(E), provides that an act of self-dealing includes any direct or
indirect transfer to, or for the use by or for the benefit or, of a disqualified person of the
income or assets of a private foundation.

Section 4946(a) provides definitions and rules with respect to a disqualified person with
respect to a private foundation. A disqualified person includes in part, a substantial
contributor to the foundation, a foundation manager, or a family member.

Section 4946(d) defines that members of family for purposes of §4946(a)(1), includes
only the individuals spouse, ancestors, children, grandchildren, great grandchildren, and
the spouses of children, grandchildren, and great grandchildren.

Rev. Proc. 2007-45, 2007-2 C.B. 89, section 8.09(1) provides in part, that the exercising
of a power to substitute trust assets as described in § 675(4) may result in an act of self-
dealing under § 4941.

Currently Trust is a split interest trust described in § 4947(a)(2) and is subject to the
self-dealing rules described in § 4941. In order for an act of self-dealing under § 4941 to
occur, the act needs to occur between a disqualified person as described in § 4946 and
a private foundation.

The Substitutor is not considered a disqualified person under § 4946(a) because
Substitutor, as a sibling of Grantor, is not treated as a family member as described in
§ 4946(d). Therefore, the conversion of the trust will not be an act of self-dealing under
§ 4941, since there is no disqualified person involved.

Ruling Request 3

Section 170(a)(1) allows a federal income tax charitable deduction in the taxable year in
which the payment is made.

Section 170(f)(2)(B) provides, in part, that no deduction is allowed under § 170 for the
value of any interest in property (other than a remainder interest) transferred in trust
unless the interest is in the form of a guaranteed annuity or the trust instrument
PLR-133443-16 5

specifies that the interest is a fixed percentage distributed yearly of the fair market value
of the trust property (to be determined yearly) and the grantor is treated as the owner of
such interest for purposes of applying § 671.

Rev. Proc. 2007-45, 2007-2 C.B. 89, provides guidelines for creating charitable lead
annuity trusts including sample trust agreements as well as explanations of the various
provisions involving in these sample agreements. It also describes some tax
consequences to different actions involving these trusts. Rev. Proc. 2007-45, section
8.01(2) provides that the donor to a grantor charitable lead annuity trust may claim a
federal income tax charitable deduction under § 170(a) in the year that assets are
irrevocably transferred to the trust.

Upon the conversion of Trust from a nongrantor trust to a grantor trust, the owner of the
grantor trust can claim a federal income tax charitable deduction under § 170(a) only if
property has been transferred to the grantor trust from the nongrantor trust. Because
the conversion of Trust from a nongrantor trust to a grantor trust is not a transfer of
property held by Trust for income tax purposes, Grantor is unable to take an income tax
charitable deduction under § 170(a).

                                 CONCLUSIONS

Based on the information submitted and the representations made, we conclude that:
(1) the conversion of Trust from a nongrantor trust to a grantor trust is not a transfer of
property held by Trust to Grantor as settlor of Trust for income tax purposes; (2) the
conversion of Trust from a nongrantor trust to a grantor trust is not an act of self-dealing
that would result in a tax under § 4941 because the Substitutor is not considered a
disqualified person under § 4946(a); and (3) the conversion of Trust from a nongrantor
trust to a grantor trust would not result in an income tax charitable deduction to Grantor
in the year of conversion under § 170 .

Except as specifically set forth above, we express or imply no opinion concerning the
federal tax consequences of the facts described above under any other provision of the
Code. Specifically, this ruling is limited solely to the conversion of the trust, and we are
providing no opinion as to whether an act of self- dealing as described in § 4941 may
occur upon the exercise of the power to substitute assets as described in § 675(4). See
Section 8.09 of Rev. Proc. 2007-45. Furthermore, we express no opinion regarding the
federal gift tax consequences of the proposed transaction. Specifically, we are not
ruling on whether the proposed conversion will have any gift tax consequences to
Grantor.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides
that it may not be used or cited as precedent.
PLR-133443-16 6

The ruling contained in this letter is based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the ruling request, it is subject to verification on examination.

Pursuant to a power of attorney on file with this office, a copy of this letter is being sent
to Trust's authorized representatives.

                                Sincerely,



                                Bradford R. Poston
                                Senior Counsel, Branch 3
                                Office of the Associate Chief Counsel
                                (Passthroughs & Special Industries)

Enclosures (2)
Copy for § 6110 purposes
Copy of this letter