Use of irrevocable trusts is common in a number of planning scenarios – tax planning, estate planning, business succession, Medicaid qualification, asset protection, etc. Just like there are several reasons irrevocable trusts are created, there can be reasons why a trust may be terminated before the expiration of the term stated in the trust agreement.[1] While it has always been permissible to modify or terminate a trust, the widespread adoption of the Uniform Trust Code has made trust termination much more streamlined.[2]
Just because something can be done does not always mean it should be done. One reason why early trust terminations should not be taken lightly is the potential income tax consequences. Trusts typically consist of current and remainder beneficiaries. The current beneficiaries are those who may receive current distributions, whether mandatory or discretionary. Remainder beneficiaries are those who may receive distributions after the interests of the current beneficiaries terminate. There may be multiple levels of remainder beneficiaries.
For example, a parent may establish a trust for their child providing that the child receives all income for life with the trust terminating at the child’s death in favor of the child’s children (i.e. the settlor’s grandchildren). If any grandchild has predeceased with their own children, then those great-grandchildren will take. Here, the current beneficiary is the child. The remainder beneficiaries are the grandchildren and great-grandchildren. Among the classes of remainder beneficiaries (grandchildren and great-grandchildren), the interests of the grandchildren are actuarily more valuable than those of the great-grandchildren since a grandchild would need to predecease their parent for a great-grandchild to take under the trust.
In these and similar situations, trust terminations often result in distributions among these various classes of beneficiaries based on the actuarial value of their interests in the trust corpus. Those terminations are referred to as a trust “commutation.” As stated above, these commutations are typically easy to accomplish under state law, may satisfy the needs of the beneficiaries, and should avoid transfer tax consequences.[3] However, income tax consequences must be considered. Several tax authorities show how trust commutations can result in income tax consequences.[4]
Background: Is a Beneficiary’s Interest in a Trust a Property Interest or Contract Right?
The basis for the IRS’ stance on trust terminations is founded in a decision of the United States Supreme Court. In Blair v. Commissioner,[5] the U.S. Supreme Court found that a beneficiary’s right to receive income from a trust is not merely a contractual right to future payments. Rather, it is a present “equitable interest in the corpus of the property.”
This analysis was further supported by the Second Circuit Court of Appeals in the McAllister opinion.[6] In McAllister, to settle family litigation, the current beneficiary with a life interest in a trust agreed to accept a lump sum in exchange for her interest. This beneficiary reported the distribution as creating a capital loss. The IRS argued that the entire proceeds should be taxed as ordinary income. The beneficiary argued she sold a capital asset below the actuarial value of her interest, thereby generating a capital loss. Citing to Blair, the Second Circuit held the commutation to constitute the sale of a capital asset with gain or loss determined with reference to the beneficiary’s basis in her interest (remanding to the Tax Court to analyze and compute). The IRS later acquiesced in this result.[7]
The Zero Basis Rule: IRC § 1001(e)
Under basic tax principles, a taxpayer only pays tax on the gain from the sale or exchange of a capital asset. That gain is the excess of the amount realized over their cost basis in the property.[8] In the context of a trust, the “uniform basis” rules generally provide that the trust’s total basis is shared among all beneficiaries according to their actuarial interests.[9] Were this rule to apply to commutations, then the McAllister analysis would allow beneficiaries to allocate that basis to offset gain (or create loss subject to any related party limitations) by their share of the unitary basis in trust assets.
However, in 1969, IRC § 1001(e) was added to create an exception for “term interests.”[10] This section provides that when a taxpayer disposes of a life interest or a term of years in property, the portion of the adjusted basis determined under the uniform basis rules (IRC §§ 1014, 1015, or 1041) must be disregarded. In effect, this means the income beneficiary’s basis is $0. As such, for example, if a current beneficiary receives $1 million as their actuarial share of a terminated trust, the IRS views the entire $1 million as a taxable capital gain with no basis available to offset the liability in spite of the otherwise applicable unitary basis rules.
An exception to this outcome applies when there is a sale or other disposition “which is part of a transaction in which the entire interest in property is transferred to any person or persons”[11] with regulations stating that the sale must be to a “third person or two or more other persons.”[12] From the rulings issued, it seems clear the IRS does not consider a commutation as satisfying this exception.[13]
PLRs 201932001 and 202509010
The IRS has issued private letter rulings dealing with the application of these rules. In a series of near-identical rulings, PLRs 201932001 through 201932010, the IRS analyzed a trust termination facilitated by a nonjudicial settlement agreement. The parties, the income beneficiary (G2), the current remaindermen (G3), and the successor remaindermen (G4), agreed to split the trust assets actuarially.
The IRS ruled that this transaction was a deemed sale where G2 and G4 sold their interests to G3. Under § 1001(e), G2 was denied any basis, resulting in a taxable gain on the full value of the distribution received. G4 recognized gain but was able to offset income tax by their share of basis in trust assets since their interests were not “term interests.” Also, the IRS also ruled that while G3 (the “buyers”) did not recognize gain on their own receipt of assets, the transaction triggered capital gains for G3 as a result of exchanging their share of appreciated assets to acquire interests of the G2 and G4.
More recently, the IRS issued PLR 202509010 which comes to the same conclusion. Despite the termination being court-approved and based on expert valuations of the beneficiaries’ interests, the IRS held that the “zero-basis rule” applied to the income beneficiary’s share, turning what the family intended as a tax-neutral simplification into a significant income tax event.
Modifications or Decantings
The danger of unintended tax consequences is not limited to terminations/commutations. The deemed sale risk also haunts trust modifications and decantings. The IRS relies on the “materially different” standard established in Cottage Savings.[14] If a modification or decanting provides legal interests of the beneficiaries considered “materially different” than before, the IRS may argue that the beneficiaries have exchanged their old interests for new ones. Such an exchange could trigger capital gains recognition even if no cash changes hands.
Alternatives to Avoid Gain[15]
Before proceeding with a commutation, beneficiaries and their advisors should evaluate alternatives that may achieve the desired flexibility without triggering income tax:
- Gifting or Disclaiming Interests: An income beneficiary could gift or disclaim their interest to the remaindermen. While this may have gift tax implications, it may avoid the deemed sale capital gain recognition.[16]
- Maintaining the Trust Structure: Rather than terminating the trust, it can often be modified to allow for more flexible principal distributions while remaining intact until its natural expiration with caution to avoid “materially different” terms as discussed above. Then, the trust could be allowed to terminate by its own terms (such at the death of the current beneficiary) which would not trigger these income tax consequences. Within this context, a trust may be severed into separate trusts for the beneficiaries should that be desirable. This may also provide continuing asset protection benefits.
- The § 1001(e)(3) “Entire Interest” Exception: The zero-basis rule is waived if the entire interest in the trust property is transferred to a third party in a single transaction. If the life tenant and the remaindermen join together to sell the trust’s assets to an outside buyer, they are permitted to use their respective portions of the uniform basis to offset any gain.
Conclusion
While the desire to simplify trust administration, resolve disputes among beneficiaries, or otherwise make adjustments to irrevocable trusts, tax law and recent IRS rulings make it clear that the path to trust termination is not as straightforward as state law may indicate. Tax consequences must be considered. The application of IRC § 1001(e) can transform a sound planning strategy into a costly tax event. Trust beneficiaries and their professional advisors must carefully weigh the intended benefits of termination against the very real risk of a “zero-basis” capital gain trap.
[1] While there can be income tax consequences of terminating trusts under its own terms, I will not discuss those here. Some of the relevant concepts, although discussed in the context of estates, was raised in Gray Edmondson, “What are the Income Tax Consequences of Bequests?,” Oct. 31, 2024, https://esapllc.com/income-tax-consequences-of-bequests-2024/.
[2] See, e.g., Uniform Trust Code §§ 111 and 411-417.
[3] I note here that transfer tax consequences are beyond the scope of this writing. However, some of the authorities cited herein address transfer tax considerations which will be important in many trust terminations. Note that actuarial values received by the parties may be important to avoid transfer tax consequences. See CCA 202352018 and McDougall v. Commissioner, 163 T.C. 5 (2024).
[4] Some IRS authorities in this context cite to Rev. Rul. 69-486. In that Revenue Ruling, a non-pro rata distribution of trust assets among the beneficiaries, when neither the trust nor state law authorized non-pro rata distributions, was treated as a pro rata distribution followed by a taxable sale or exchange of assets among the beneficiaries. Given that state law (see, e.g., Uniform Trust Code § 816(22)) and most trust agreements permit non-pro rata distributions, I will not address that Revenue Ruling in this writing. For additional analysis of the issues raised in this writing, see Edwin P. Morrow III, Potential Income Tax Disasters for Early Trust Terminations, LISI Estate Planning Newsletter #2753 (Oct. 9, 2019).
[5] Blair v. Commissioner, 300 U.S. 5, 13 (1937).
[6] McAllister v. Commissioner, 157 F.2d 235 (2d Cir. 1946).
[7] Rev. Rul. 72-243.
[8] IRC § 1001(a).
[9] Treas. Reg. § 1.1014-5(a).
[10] Pub.L. 91-172, Title II, § 231(c)(2), Title V, § 516(a), Dec. 30, 1969.
[11] IRC § 1001(e)(3).
[12] Treas. Reg. § 1.1001-1(f)(3); question whether this regulation exceeds the scope of Congressional authority.
[13] See, e.g., PLR 200127023 where the IRS refused to apply this exception to a commutation saying that “the entire interest in the Trust’s assets is not being sold, or otherwise disposed of, to a third party.”
[14] Cottage Savings Ass’n v. Commissioner, 499 U.S. 554 (1991). See also Treas. Reg. § 1.1001-1(a) referring to a taxable transaction being “the exchange of property for other property differing materially either in kind or in extent.”
[15] This list is not intended to be comprehensive, but rather merely some of the number of alternatives which may avoid current income tax.
[16] IRC § 102.
