Trust tax-allocation settlement avoids gift, GST, and gain consequences

Plain-English summary

A trust derived from an irrevocable pre-1985 trust incurred unusually large capital gains taxes after business interests were liquidated. Its governing instrument said income should pay “all proper taxes” but did not clearly address extraordinary capital gains taxes, while state law generally charged taxes on principal receipts to principal. Current and remainder beneficiaries, including representatives for minor and unborn beneficiaries, settled the dispute by allocating one year's tax between principal and income and charging later capital gains taxes to principal. A state court approved the agreement subject to a favorable IRS ruling. The IRS found the competing claims bona fide and the negotiated allocation within a reasonable range of outcomes. Implementing the settlement would not create taxable gifts, would not end the trust's generation-skipping transfer tax grandfathering, and would not be a taxable sale or exchange producing gain or loss.

Ruling snapshot

• Question: What gift, GST, and income tax consequences follow from a court-approved settlement allocating a grandfathered trust's capital gains taxes between income and principal?
• Outcome: Approved
• Key authorities: IRC §§ 61, 1001, 2501, 2511, 2512, 2601; Treas. Reg. §§ 1.1001-1(a), 26.2601-1(b)(4)

Full text (IRS public release)

Internal Revenue Service                                      Department of the Treasury
                                                              Washington, DC 20224

Number: 201528024                                             Third Party Communication: None
Release Date: 7/10/2015                                       Date of Communication: Not Applicable
Index Number: 2601.03-01, 2501.00-00,
              1001.00-00                                      Person To Contact:
                                                              ------------------------- --------------------------
----------------------------------------------                Telephone Number:
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-----------------------------------                           Refer Reply To:
------------------------                                      CC:PSI:B04
                                                              PLR-138461-14
In Re: ----------------------------------------               Date:
                                                              March 26, 2015




Legend

Grantor                          -----------------------------------------------------------------------------------
Trust 1                          -----------------------------------------------------------------------------------
Date 1                           -----------------------------------------------------------------------------------
Son                              -----------------------------------------------------------------------------------
Son's Wife                       -----------------------------------------------------------------------------------
Year 2                           -----------------------------------------------------------------------------------
Year 3                           -----------------------------------------------------------------------------------
State                            -----------------------------------------------------------------------------------
Daughter                         -----------------------------------------------------------------------------------
Foundation                       -----------------------------------------------------------------------------------
Trust A                          -----------------------------------------------------------------------------------
Trust B                          -----------------------------------------------------------------------------------
Trust X                          -----------------------------------------------------------------------------------
Company A                        -----------------------------------------------------------------------------------
LLC A                            -----------------------------------------------------------------------------------
Company B                        -----------------------------------------------------------------------------------
Company C                        -----------------------------------------------------------------------------------
Company D                        -----------------------------------------------------------------------------------
Date 4                           -----------------------------------------------------------------------------------
State Court                      -----------------------------------------------------------------------------------
Date 5                           -----------------------------------------------------------------------------------
Trust 2                          -----------------------------------------------------------------------------------
                                 -----------------------------------------------------------------------------------
Grandchild 1                     -----------------------------------------------------------------------------------
Grandchild 2                     -----------------------------------------------------------------------------------
Grandchild 3                     -----------------------------------------------------------------------------------
Grandchild 4                     -----------------------------------------------------------------------------------
GGC 1                            -----------------------------------------------------------------------------------
PLR-138461-14                                           2

GGC 2                          -----------------------------------------------------------------------------------
GGC 3                          -----------------------------------------------------------------------------------
GGC 4                          -----------------------------------------------------------------------------------
GGC 5                          -----------------------------------------------------------------------------------
GGC 6                          -----------------------------------------------------------------------------------
GGC 7                          -----------------------------------------------------------------------------------
GGC 8                          -----------------------------------------------------------------------------------
GGC 9                          -----------------------------------------------------------------------------------
Year 6                         -----------------------------------------------------------------------------------
Year 7                         -----------------------------------------------------------------------------------
Date 8                         -----------------------------------------------------------------------------------
a                              -----------------------------------------------------------------------------------
b                              -----------------------------------------------------------------------------------
State Statute 1                -----------------------------------------------------------------------------------
State Statute 2                -----------------------------------------------------------------------------------
State Statute 3                -------------------------------------------


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

      This letter responds to your personal representative’s letter of October 3, 2014,
requesting income, gift, and generation-skipping transfer (GST) tax rulings regarding the
proposed modification of Trust 2.

        The facts and representations submitted are summarized as follows:

      Grantor created and funded Trust 1 on Date 1 for the benefit of Son, Son’s Wife,
and Son’s descendants. You represent that Trust 1 was irrevocable before September
25, 1985, and that there have been no additions, actual or constructive, since that time.
Grantor died in Year 2.

       Section A of Article I of Trust 1 provides that Son, in his capacity as initial trustee
of Trust 1, shall hold, manage, control and administer the above-described property,
and such other money and property as the Grantor may assign, deliver or bequeath to
him at any time(s) after the execution of this agreement, in trust, shall collect all the
income thereof, out of such income shall pay or provide for all proper taxes, costs,
charges and expenses of every kind imposed upon or incurred by Trust 1 (other than
those imposed upon or incurred by it upon or by reason of its termination, and other
than capital losses), and all gift taxes on whomever imposed payable to State by reason
of the execution of this agreement or by reason of any assignments, transfers, or
deliveries made by Grantor to the initial trustee at or within six months after the
execution of this agreement and thereafter shall distribute the remaining net income and
corpus of Trust as hereinafter provided.
PLR-138461-14                                 3

       Section B of Article I of Trust 1 provides, in part, that the remaining net income of
Trust 1 for each calendar quarter shall be divided into equal shares, of which there shall
be: (a) one share for Grantor’s son, Son, so long as he is living; (b) one share for
Grantor’s said Son’s Wife so long as they both are living and she is his wife; (c) one
share for each of Grantor’s said Son’s lawful children then living; and (d) one share for
the then living descendants of each of Grantor’s said Son’s lawful children then
deceased.

        Section C of Article I of Trust 1 provides that upon the death of Son, the corpus
of Trust shall be distributed to such person or persons within a class including only the
Grantor’s lineal descendants other than Son, and no other or others whatsoever,
particularly and expressly excluding from said class Son, Son’s estate, Son’s creditors,
and the creditors of his estate, and in such shares and proportions and at such time or
times and in such manner, absolutely or in trust, as Son, by his will shall appoint or
direct, but not in such a way as to postpone the final distribution of this Trust 1 beyond
the expiration of 21 years after the death of the last survivor of all of Grantor’s
descendants living at the time this agreement is executed, and any later final distribution
directed by Son shall be accelerated accordingly; or, as to all or any portion of this
Trust 1 estate not so effectively appointed by Son, this Trust 1 shall continue until the
death of the last survivor of the lawful children of Son, living at the time this agreement
is executed, and the corpus shall then be distributed free of trust per stirpes to the then
living descendants of Son; or if no such descendants are then living, then free of trust
per stirpes to the then living descendants of Grantor’s daughter, Daughter; or if none of
her descendants is then living, then to Foundation, a charitable corporation.

       On Date 4, State Court ordered that Trust 1 be separated into two separate
modified trusts with terms identical to Trust 1 except that different individuals may act as
successor trustees of each resulting trust to facilitate different investment and
management objectives. The court found that the proposed modification of Trust 1 by
reason of changed circumstances comported with the intentions of Grantor and would
have no effect upon the current or ultimate disposition of Trust 1. In addition, State
Court issued an order that authorized the initial trustee to partition Trust into two
separate trusts, Trust A and Trust B, with identical terms except that the separate trusts
may provide that different individuals may act as successor trustee of each modified
trust.

        After the partition, Son acted as trustee of Trust A and Trust B, and trustee
succession would continue to be governed by the terms of Trust 1. Son transferred all
assets from Trust 1 other than common stock of Company A to Trust A, and transferred
the common stock of Company A to Trust B. Company A is a corporation which would
later be converted into a limited liability company, LLC A. LLC A was a holding
company that owned a controlling interest in the business that had previously been
spun-off from Company B, and was later operated as Company C.
PLR-138461-14                                4

       On Date 5, Son died. In his will, Son exercised the limited testamentary power of
appointment (provided under Section C of Article I of Trust 1) over Trust B to create
Trust 2, to be held and administered as a separate trust under the terms of Trust X (a
revocable trust first established by Son in Year 3, which became irrevocable upon Son’s
death). You represent that no additions, constructive or otherwise, were made to
Trust B or Trust 2 since Date 4. Distributions from Trust 2 are governed by Trust X,
while the terms of Trust 1 continue to govern all other matters related to the
administration of Trust 2, including termination. Son’s Wife, Grandchild 1, Grandchild 2,
Grandchild 3, and Grandchild 4 are all the current income beneficiaries of Trust 2.
GGC1, GGC 2, GGC 3, GGC 4, GGC 5, GGC 6, GGC 7, GGC 8, GGC 9, and several
minors are the remainder beneficiaries of Trust 2. Trust 2 will terminate no later than 21
years after the death of the last to die of Grantor’s descendants who were living on
Date 1.

       In Year 6, LLC A sold its interest in Company C to Company D, a publicly-traded
corporation, in exchange for cash and stock in Company D. At the end of Year 6,
LLC A made a partial liquidating distribution to its members of cash received from the
sale of Company C. A portion of this partial liquidating distribution represented the
amounts that Trust 2 was entitled to receive as a preferred distribution and was
characterized by the trustee of Trust 2 as trust income. The majority of the partial
liquidating distribution was characterized by the trustee of Trust 2 as trust principal.

         In Year 7, LLC A sold its stock in Company D. In the same year, LLC A made a
final liquidating distribution to its members of cash received from the sale of stock in
Company D. This distribution was characterized by the trustee of Trust 2 as trust
principal.

       As a result of the transactions in Year 6 and Year 7, Trust 2 incurred a significant
capital gains tax, which was much greater than the annual income of Trust 2. The
dispositive tax charging provision (Tax Charging Provision) for Trust 2, which is
contained in Trust 1, solely states that the trustee shall collect all the income from
Trust 1 and out of such income the trustee shall pay or provide for “all proper taxes.”
The trustee believes the language of Trust 1 is ambiguous and incomplete regarding
whether the capital gains taxes due as a result of the transactions in Year 6 and Year 7
should be paid from Trust 2 income or Trust 2 principal.

        As a result of the ambiguous language and the lack of specific direction
regarding payment of taxes for capital gains in the Tax Charging Provision, the trustee
of Trust 2 petitioned State Court to construe the Tax Charging Provision to determine
how the capital gains tax payment should be charged against Trust 2 principal and
Trust 2 income. To avoid costs, fees, and delays associated with litigation, the current
income beneficiaries, the adult remainder beneficiaries, and a court appointed guardian
ad litem (representing the minor and unborn remainder beneficiaries) later entered into
a settlement agreement (Settlement Agreement) that modified the Tax Charging
PLR-138461-14                                 5

Provision and allocated the Year 6 tax payment as being a percent from principal and
b percent from income. Settlement Agreement also provided that all capital gains
incurred in Year 7 and later years would be allocated to principal. State Court approved
Settlement Agreement on Date 8, conditioned on a favorable private letter ruling from
the Internal Revenue Service. The current trustee, the current income beneficiaries,
and all adult remainder beneficiaries have each submitted a private letter ruling request,
requesting the following rulings:

    1. The implementation of Settlement Agreement will not cause any beneficiary of
      Trust 2 to be treated as having made a taxable gift.

    2. The implementation of Settlement Agreement will not cause Trust 2 to lose its
      exempt status for GST tax purposes.

    3. The implementation of Settlement Agreement will not result in gain to Trust 2 or
      any beneficiary of Trust 2 or otherwise be treated as a taxable exchange for
      federal income tax purposes.

LAW AND ANALYSIS

Ruling 1

       Section 2501 imposes a tax on the transfer of property by gift by any individual.

       Section 2511 provides that the gift tax shall apply whether the transfer is in trust
or otherwise, whether the gift is direct or indirect, and whether the property is real or
personal, tangible or intangible.

       Section 2512(a) provides that, if the gift is made in property, the value thereof at
the date of the gift shall be considered the amount of the gift.

       Section 2512(b) provides that where property is transferred for less than an
adequate and full consideration in money or money’s worth, then the amount by which
the value of the property exceeded the value of the consideration shall be deemed a
gift.

        In Commissioner v. Estate of Bosch, 387 U.S. 456 (1967), the Court considered
whether a state trial court’s characterization of property rights conclusively binds a
federal court or agency in a federal estate tax controversy. The Court concluded that
the decision of a state trial court as to an underlying issue of state law should not be
controlling when applied to a federal statute. Rather, the highest court of the state is the
best authority on the underlying substantive rule of state law to be applied in the federal
matter. If there is no decision by that court, then the federal authority must apply what it
finds to be state law after giving “proper regard” to the state trial court’s determination
PLR-138461-14                                 6

and to relevant rulings of other courts of the state. In this respect, the federal agency
may be said, in effect, to be sitting as a state court.

       The relevant inquiry in determining whether transfers made pursuant to a
settlement agreement are exempt from the gift tax focuses on the bona fides and
legitimacy of the claims. See Ahmanson Foundation v. United States, 674 F.2d 761
(9th Cir. 1981). Thus, an intrafamily settlement of litigation will be regarded as a bona
fide compromise agreement when the parties’ claims are bona fide and are satisfied, to
the extent feasible, on an economically fair basis.

       In the present situation, in determining whether the gift tax applies, it is first
necessary to determine if Settlement Agreement properly reflects the economic values
of bona fide claims of the respective parties, with appropriate allowance for litigation
uncertainty. If the settlement does not so reflect those values, then it will be necessary
to consider whether any differences may be justified on the basis of a compromise.
Thus, with respect to each gift tax issue, it is pertinent to examine the law of the
applicable jurisdiction to determine the legitimacy of the parties’ claims in the issues that
are under our consideration for gift tax purposes.

        State Statute 1 provides that the trustee shall allocate money received in total or
partial liquidation of an entity to principal. Furthermore, State Statute 2 provides that a
tax required to be paid by a trustee based on receipts allocated to principal must be
paid from principal, even if the tax is called an income tax by the taxing authority.
However, State Statute 3 provides that in allocating receipts and disbursements to
income or principal or between income and principal, a fiduciary shall first administer a
trust or estate in accordance with the terms of the trust or the will, even if there is a
different provision in the subchapter of State statutes.

       Accordingly, under State law, if a trust instrument is clear and unambiguous in
designating the payment of capital gain taxes out of income, the fiduciary must
administer the trust in accordance with the terms, despite State statutes that are
contrary. However, in the absence of a specified direction from the grantor, capital gain
taxes are payable from principal.

        In this case, the dispositive Tax Charging Provision states that the trustee shall
collect all the income from Trust 1 and out of such income the trustee shall pay or
provide for “all proper taxes.” The Tax Charging Provision did not specifically address
capital gain taxes nor is the term “all proper taxes” defined. A court could construe the
Tax Charging Provision as providing that the capital gain taxes, and specifically, the
significant capital gains taxes incurred here as being extraordinary in nature, and not
within the language, “all proper taxes.” Therefore, the Tax Charging Provision can be
viewed as generally, but not absolutely, requiring the application of income to pay taxes.
Because the Tax Charging Provision is ambiguous and incomplete with respect to
payment of capital gains taxes, and subject to conflicting legal conclusions, we conclude
PLR-138461-14                                 7

that the claims of the current income beneficiaries, the trustee, and the remainder
beneficiaries regarding the allocation of the taxes are bona fide, with the outcome of the
litigation of this issue being uncertain. The allocation in Settlement Agreement
represents the economic viability of the claims of the current income beneficiaries and
the remainder beneficiaries. Accordingly, based on the facts submitted and the
representations made, we conclude that implementation of Settlement Agreement will
not cause any beneficiary of Trust 2 to be treated as having made a taxable gift. This
ruling is applicable to all current income beneficiaries of Trust 2, the adult remainder
beneficiaries of Trust 2, and the minor and unborn remainder beneficiaries of Trust 2.

Ruling 2

      Section 2601 imposes a tax on every generation-skipping transfer made after
October 26, 1986.

       Under § 1433(a) of the Tax Reform Act of 1986 (Act) and § 26.2601-1(a) of the
Generation-Skipping Transfer Tax Regulations, the GST tax is generally applicable to
GSTs made after October 22, 1986. However, under § 1433(b)(2)(A) of the Act and
§ 26.2601-1(b)(1)(i), the GST tax does not apply to a transfer under a trust that was
irrevocable on September 25, 1985, but only to the extent that the transfer is not made
out of corpus added to the trust after September 25, 1985 (or out of income attributable
to corpus so added). Under § 26.2601-1(b)(1)(ii), any trust in existence on September
25, 1985, will be considered irrevocable unless the decedent had a power that would
have caused inclusion of the trust in his or her gross estate under § 2038 or § 2042, if
the decedent had died on September 25, 1985.

        Section 26.2601-1(b)(4)(i) provides rules for determining when a modification,
judicial construction, settlement agreement, or trustee action with respect to a trust that
is exempt from the GST tax under § 26.2601-1(b)(1), (2), or (3) will not cause the trust
to lose its exempt status. Under the regulation, unless specifically provided otherwise,
these rules are applicable only for purposes of determining whether an exempt trust
retains its exempt status for GST tax purposes. Thus (unless specifically noted), the
rules do not apply in determining, for example, whether the transaction results in a gift
subject to gift tax, or may cause the trust to be included in the gross estate of a
beneficiary, or may result in the realization of gain for purposes of § 1001.

        Section 26.2601-1(b)(4)(i)(B) provides that a court-approved settlement of a bona
fide issue regarding the administration of the trust or the construction of terms of the
governing instrument will not cause an exempt trust to be subject to the provisions of
chapter 13, if: (1) the settlement is the product of arm’s length negotiations; and (2) the
settlement is within the range of reasonable outcomes under the governing instrument
and applicable state law addressing the issues resolved by the settlement. A settlement
that results in a compromise between the positions of the litigating parties and reflects
PLR-138461-14                                 8

the parties’ assessments of the relative strengths of their positions is a settlement that is
within the range of reasonable outcomes.

        In this case, as stated above, the Tax Charging Provision is ambiguous,
incomplete, and subject to conflicting legal conclusions. We conclude that the claims of
the current income beneficiaries, the trustee, and the remainder beneficiaries regarding
the allocation of the taxes are bona fide, with the outcome of the litigation of this issue
being uncertain. The allocation contained in Settlement Agreement is the product of
arms-length negotiations and is within the range of reasonable outcomes under the
instrument and applicable state law. Accordingly, based on the facts submitted and the
representations made, we conclude that the implementation of Settlement Agreement
will not cause Trust 2 to lose its exempt status for GST tax purposes.

Ruling 3

       Section 61(a)(3) and (15) provides that gross income includes gains derived from
dealings in property and income from an interest in a trust.

       Section 1001(a) provides that the gain from the sale or other disposition of
property shall be the excess of the amount realized therefrom over the adjusted basis
provided in § 1011 for determining gain, and the loss shall be the excess of the adjusted
basis provided in § 1011 for determining loss over the amount realized.

       Section 1001(b) states that the amount realized from the sale or other disposition
of property shall be the sum of any money received plus the fair market value of the
property (other than money) received. Under § 1001(c), except as otherwise provided
in subtitle A, the entire amount of gain or loss, determined under § 1001, on the sale or
exchange of property shall be recognized.

       Section 1.1001-1(a) of the Income Tax Regulations provides that the gain or loss
realized from the conversion of property into cash, or from the exchange of property for
other property differing materially either in kind or in extent, is treated as income or loss
sustained.

       State Court has approved Settlement Agreement and concluded that it resolves a
bona fide legal issue as to the construction of the Tax Charging Provision. Thus, the
effect of Settlement Agreement carries out the terms of Trust 1 rather than resulting in a
disposition of trust interests. Accordingly, based on the facts submitted and the
representations made, we conclude that the implementation of Settlement Agreement,
as described, will not result in the realization of gain or loss under §§ 61 and 1001 to
Trust 2 or any beneficiary of Trust 2. This ruling is applicable to all current income
beneficiaries of Trust 2, the adult remainder beneficiaries of Trust 2, and the minor and
unborn remainder beneficiaries of Trust 2.
PLR-138461-14                                9

      In accordance with the Power of Attorney on file with this office, we have sent a
copy of this letter to your authorized representatives.

       Except as expressly provided herein, we neither express nor imply any opinion
concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter.

      The rulings contained in this letter are 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 request for rulings, it is subject to verification on
examination.

      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.


                                         Sincerely,



                                         _________________________
                                         Melissa C. Liquerman
                                         Chief, Branch 4
                                         Office of the Associate Chief Counsel
                                         (Passthroughs and Special Industries)



      Enclosures
            Copy for § 6110 purposes
            Copy of this letter




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