In the event that an existing trust in Montgomery County has an inclusion ratio of less than 1 but greater than zero, and discretionary distributions can be made to both skip persons and non-skip persons, the issue arises as to whether the trust can be severed to create 2 separate trusts -- one with an inclusion ratio of 0.0 and one with an inclusion ratio of 1.0. Prior to the EGTRRA, it was nearly impossible to sever trusts with a fractional inclusion ratio without giving both resulting trusts the same inclusion ratio that belonged to the original trust. If a trust was only partially exempt from the GST tax, it was the IRS position that any separation of the trust would cause all resulting trusts to have the same fractional exemption from the GST tax.
The problem was significantly alleviated by the enactment of IRC Section 2642(a)(3) as part of the 2001 Tax Act. That section provides that a trust can be divided into a fully exempt portion, and a fully non-exempt portion, so long as the division is a “qualified severance”. The section defines a qualified severance as a division of a single trust and the creation (by any means available under the governing instrument or under local law) of two or more trusts if:
1) the single trust was divided on a fractional basis, and
2) the terms of the new trusts, in the aggregate, provide for the same succession of interests of beneficiaries as are provided in the original trust.
Further, the severance of a partially exempt trust to be a qualified severance, the trust must be severed in a way that creates one trust with a GST inclusion ratio of 0.0 and one trust with a GST inclusion of a ratio of 1.0.
It is important to note that the statute requires division on a fractional basis (if you are confused at this point, call your Montgomery County estate lawyer), rather than using a pecuniary amount. However, this does not require that each new trust receive a proportionate ownership of each underlying asset, so long as the funding of the post-severance trusts uses fair market values at the time of distribution.
Similarly, the need for the trusts to provide the same succession interests does not mean that each trust must function with identical beneficiaries to the severed trust. But, how does one sever a trust where there is a spray power which could theoretically end up assisting only one family line if not severed (i.e. because of the possibility that one beneficiary could have significant distribution for education, medical costs, etc.)? The proposed regulations permit the severance of such a trust along family lines. Attention should also be given to Proposed Treas. Reg. Section 26.2642-1(a), which requires rounding of the applicable severance fraction to the nearest one-thousandth (.001). Do not use pecuniary amounts to define the severance, and do not use fractions when presenting the severance (i.e. use .333 rather than ⅓).
The reporting of a qualified severance is to be made via the filing of IRS Form 706-GS(T), which is a pre-existing form that is used to report Taxable Terminations of trusts. As a result, the form is not designed to address the qualified severance issue. Therefore, tax preparers should print “Qualified Severance” at the top of the form, and attach a notice that provides the following regarding the trust: name and identity of the trust being severed, the name of the transferor, the date of the creation of the trust being severed, the EIN of the trust being severed, and the inclusion ratio prior to severance.