Recoverable tax payment does not add property to grandfathered trust

Plain-English summary

A beneficiary and her spouse mistakenly paid income taxes attributable to capital gain earned by an irrevocable trust created before September 25, 1985. State law required the trust to bear those taxes, and the beneficiary never waived her recovery right. After she objected to the trustee's accounting, a court ordered the trust to reimburse the remaining taxes, interest, and attorney's fees. The IRS ruled that the temporary payment did not constructively add property to the trust because the liability remained enforceable and was being reimbursed. As a result, the trust kept its grandfathered exemption from generation-skipping transfer tax, the beneficiary made no taxable gift, and no part of the trust became includible in her estate under section 2036.

Ruling snapshot

• Question: Did a beneficiary's recoverable, mistaken payment of trust taxes create a constructive addition, gift, GST exposure, or estate inclusion?
• Outcome: approved
• Key authorities: IRC §§ 2036, 2501, 2511, 2601; Treas. Reg. §§ 25.2511-2(b), 26.2601-1(b)(1)

Full text (IRS public release)

Internal Revenue Service                                     Department of the Treasury
                                                             Washington, DC 20224

Number: 201735005
Release Date: 9/1/2017
Index Number: 2501.00-00, 2601.00-00,
              2036.01-00
                                                             Person To Contact:
-------------------------                                    ----------------------------, ID No. --------------
---------------------------------------                      ----------------------------------------------------
-----------------------------------------                    Telephone Number:
---------------------------------------                      ---------------------
----------------------------------                           Refer Reply To:
                                                             CC:PSI:B04 – PLR-136395-16
                                                             Date:
                                                             May 08, 2017




Re: ---------------------------------

Legend:

Date 1                             = -------------------
Date 2                             = ------------------
Date 3                             = ---------------------
Date 4                             = ------------------
Date 5                             = ------------------
Date 6                             = -------------------
Date 7                             = ----------------
Date 8                             = ----------------
Year 1                             = -------
Year 2                             = -------
Grantor                            = -----------------------
Trust                              = -------------------------------------------------
                                ----------------------------------
Daughter                           = ---------------------------------------------------
Spouse                             = ---------------------------------------------------
State 1                            = ------------------
State 2                            = ----------------
Trustee                            = ----------------------------------------------------------
Corporation                        = ------------------
Court                              = --------------------------------------------------------
                                       ---------------------------------------------------
State Statute 1                    = ---------------------------------------------------------------
State Statute 2                    = ---------------------------------------------------------------
PLR-136395-16                                    2

State Statute 3             = -------------------------------------------------------------
State Statute 4             = ------------------------------------------------------------------
X                           = ---
Y                           =----
Z                           =----
A                           = -------------
B                           = -----------

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

       This letter responds to your authorized representative’s letter of November 4,
2016, requesting rulings under §§ 2036, 2501, and 2601 of the Internal Revenue Code.

         The facts submitted and representations made are as follows. On Date 1, a date
prior to September 25, 1985, Grantor created an irrevocable trust (Trust) for the benefit
of Daughter and her issue. Trust was funded with shares of stock in Corporation. It is
represented that Corporation was an S corporation within the meaning of § 1361(d) and
that Trust is a qualified subchapter S Trust (QSST) within the meaning of § 1361(d)(3).
It is also represented that there have been no additions to trust since September 25,
1985.

       Article 1, Paragraph A, of Trust provides that Trustee shall accumulate income
until Daughter reaches the age of X. Upon Daughter attaining the age of X, Trustees
are to pay all net income to Daughter semi-annually.

      Article 1, Paragraph B, provides that Trustee may apply so much of accumulated
income and principal of the trust estate during the minority of daughter as it deems
necessary for her comfortable maintenance, medical care and education.

      Article, Paragraph C provides that upon Daughter attaining the age of Y, she may
request in writing one-fourth of the principal of Trust, and upon attaining the age of Z
she may request one-third of the remaining principal of Trust. Upon the death of
Daughter the Trustee is directed to distribute the corpus of Trust to the issue of
Daughter, as she appoints in her last will. In default of Daughter’s appointment the
corpus of Trust is to be distributed to her issue per stirpes.

        Trust is administered under the laws of State 1.

       State Statute 1, as in effect during the year at issue, provides that proceeds from
the sale of an asset held by a trust will be allocated to trust principal.
PLR-136395-16                                 3

       State Statute 2 provides that any income taxes due on capital gains is to be paid
from the trust principal, notwithstanding that the tax may be denominated a tax upon
income by the taxing authority.

        State Statute 3 provides a trustee shall take reasonable steps to enforce claims
of the trust and to defend claims against the trust.

      State Statute 4 provides that a beneficiary is barred from challenging a
transaction or asserting a claim against a trustee for breach of trust if:

       (i) the trustee provided the beneficiary at least annually with periodic written
financial reports concerning the trust;

      (ii) the transaction was disclosed in a report to which subparagraph (i) refers or
such report provided sufficient information so that the beneficiary knew or should have
known of the potential claim or should have inquired into its existence;

       (iii) in the 30 months after a report to which subparagraph (ii) refers was sent by
the trustee to the beneficiary, the beneficiary did not notify the trustee in writing that the
beneficiary challenges the transaction or asserts a claim and provides in writing the
basis for that challenge or assertion; and

       (iv) all reports were accompanied by a conspicuous written statement describing
the effect of this paragraph.

        On or about Date 2, Trustee sold Trust’s share of stock in Corporation in a
transaction that resulted in capital gain to Trust for federal and state tax purposes.
Pursuant to State law, the capital gains should have been allocated to Trust principal
and all income taxes due on the capital gains were required to be paid from Trust
principal. However, Trustee in connection with Trust’s Form 1041, U.S. Fiduciary
Income Tax Return, erroneously issued Daughter a K-1, Beneficiary's Share of In-come,
Deductions, Credits, Etc., which treated the capital gain as a taxable distribution to
Daughter for both federal and state tax purposes. As a result of receiving the K-1
Daughter reported the entire amount of the capital gain on her individual Federal and
state income tax returns which she jointly filed with Spouse. The errors on the
Schedules K-1 were in Year 1. Trustee distributed $A to Daughter in Year 2 as a partial
reimbursement for the income taxes erroneously paid by Daughter and Spouse.
Daughter did not waive the right of recovery with respect to the erroneous payment of
income taxes in Year 1.

       Trustee prepared a draft of its first accounting as Trustee on Date 3. Upon
receipt of the draft accounting, Daughter became aware that she was due an additional
PLR-136395-16                               4

reimbursement from Trustee for the income taxes paid by Daughter and Spouse in
connection with the sale of S Corporation stock.

        On or about Date 4, Trustee filed a Petition for Adjudication with Court seeking
judicial approval of its first intermediate accounting (Accounting) from Date 5 to Date 6.
On Date 7, Daughter, through her counsel, filed an objection (Objection) to the
Accounting alleging that it failed to provide for the additional reimbursement to Daughter
from Trust for state income taxes in the amount of $B, together with interest on the
unreimbursed taxes at a specified rate, and reimbursement of Daughter’s attorney’s
fees incurred in connection with the Accounting and Objection.

       On Date 8, Court entered an order (Order) ruling that the statute of limitations
remains open for Daughter to object to any and all matters disclosed in the Accounting;
and that the Accounting fails to provide for an additional reimbursement from Trust to
Daughter for the unreimbursed taxes, interest and attorney’s fees associated with the
Accounting and Objection. Trustee intends, in accordance with the Order, to reimburse
Daughter for the amount of the unreimbursed taxes, interest, and attorney’s fees due for
the erroneous payment of income taxes by Daughter and Spouse in Year 1.

      You have requested the following rulings:

       1. The inadvertent payment by Daughter and Spouse of federal, State 1 and
State 2 income taxes in connection with taxable income of Trust does not constitute a
constructive addition by Daughter and Spouse to Trust under § 26.2601-1(b)(1)(v)(C).

       2. The inadvertent payment by Daughter and Spouse of federal, State 1 and
State 2 income taxes in connection with taxable income of Trust, and the subsequent
reimbursement to them of the income taxes paid, together with interest and attorney’s
fees, does not cause any portion of Trust to become subject to chapter 13.

        3. The inadvertent payment by Daughter and Spouse of federal, State 1 and
State 2 income taxes in connection with the taxable income of Trust, does not constitute
a gift to Trust for federal gift tax purposes.

       4. The inadvertent payment by Daughter and Spouse of federal, State 1 and
State 2 income taxes in connection with taxable income of Trust does not cause any
portion of Trust to be includible in Daughter’s gross estate for federal estate tax
purposes.

      Law and Analysis
PLR-136395-16                                 5

        Section 2601 imposes a tax on every generation-skipping transfer (GST) made
after October 22, 1986. Section 2611(a) defines a GST to mean (1) a taxable
distribution, (2) a taxable termination, and (3) a direct skip.

        Under section 1433(b)(2)(A) of the Tax Reform Act of 1986 and
§ 26.2601-1(b)(1)(i) of the Generation-Skipping Transfer Tax Regulations, the tax
generally does not apply to any GST transfer made under a trust that was irrevocable
on September 25, 1985. However, the tax does apply to a pro rata portion of any GST
under an irrevocable trust if additions (actual or constructive) are made to the trust after
that date. Under § 26.2601-1(b)(1)(ii)(A), any trust in existence on September 25, 1985,
will be considered an irrevocable trust except as provided in §§ 26.2601-1(b)(1)(ii)(B) or
(C) (relating to property includible in a grantor's gross estate under §§ 2038 and 2042).

       Section 26.2601-1(b)(1)(v)(A) provides, in relevant part, that, except as provided
under § 26.2601-1(b)(1)(v)(B), where any portion of a trust remains in the trust after the
post September 25, 1985, release, exercise, or lapse of a power of appointment over
that portion of the trust, and the release, exercise, or lapse is treated to any extent as a
taxable transfer under chapter 11 or chapter 12, the value of the entire portion of the
trust subject to the power that was released, exercised, or lapsed is treated as if that
portion had been withdrawn and immediately retransferred to the trust at the time of the
release, exercise, or lapse.

         Under § 26.2601-1(b)(1)(v)(C), where a trust that is not subject to the GST tax by
reason of being irrevocable on September 25, 1985, is relieved of any liability properly
payable out of the assets of such trust, the person or entity who actually satisfies the
liability is considered to have made a constructive addition to the trust in an amount
equal to the liability. The constructive addition occurs when the trust is relieved of
liability (e.g., when the right of recovery is no longer enforceable).

        Section 2501 imposes a tax for each calendar year on the transfer of property by
gift during the calendar year by any individual.

       Section 2511 provides that the tax imposed by § 2501 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 25.2511-2(b) provides, in part, that as to any property, or part thereof or
interest therein, of which the donor has so parted with dominion and control as to leave
in him no power to change its disposition, whether for his own benefit or for the benefit
of another, the gift is complete.

       Section 2036(a) provides that the value of the gross estate shall include the
value of all property to the extent of any interest therein of which the decedent has at
PLR-136395-16                                6

any time made a transfer (except in case of a bona fide sale for adequate and full
consideration in money or money’s worth), by trust or otherwise, under which he has
retained for his life or for any period not ascertainable without reference to his death or
for any period which does not in fact end before his death - (1) the possession or
enjoyment of, or the right to the income from, the property, or (2) the right, either alone
or in conjunction with any person, to designate the persons who shall possess or enjoy
the property or the income therefrom.

        Based on the facts submitted and representations made, we conclude that there
is no constructive addition to Trust under § 26.2601-1(b)(1)(v)(C). Daughter did not
waive her right to recovery. Daughter petitioned Court to reimburse her for
unreimbursed income taxes together with interest and attorney’s fees. Trustee has
agreed to reimburse Daughter. Thus, no addition to Trust has occurred as a result of
Daughter's inadvertent payment of income tax and her prior reimbursement of income
taxes and subsequent reimbursement under Court Order for income taxes, together
with interest and attorney’s fees. In addition, Daughter's inadvertent payment of income
tax and her prior reimbursement of income taxes and subsequent reimbursement under
Court Order for income taxes, together with interest and attorney’s fees, will not cause
Trust to be subject to chapter 13. Thus, Trust retains its exempt status.

       Daughter did not make a constructive addition to Trust under § 26.2601-
1(b)(1)(v)(C), thus, is not a transferor for gift tax purposes. There has been no change
in beneficial interests of the beneficiaries and no transfer of property has occurred as a
result of Daughter's inadvertent payment of income tax and her prior reimbursement of
income taxes and subsequent reimbursement for income taxes, together with interest
and attorney’s fees. Consequently, Daughter has not made a gift to Trust for federal gift
tax purpose.

       Sections 2036 includes in a decedent's gross estate property only to the extent
that the decedent has made a transfer of the property during his life. In this case,
Daughter did not transfer property to Trust. In addition, because the beneficial interests
of beneficiaries are the same, before and after of the reimbursement of Daughter for
income taxes, interest and attorney’s fees, no transfer of property will be deemed to
occur as a result of the of reimbursement of Daughter for income taxes, interest and
attorney’s fees. Accordingly, based on the facts presented and the representations
made, we conclude that the Daughter's inadvertent payment of income tax and her prior
reimbursement of income taxes and subsequent reimbursement for income taxes,
together with interest and attorney’s fees, will not cause inclusion, under § 2036 of any
portion of Trust in the gross estate of Daughter.

       Accordingly, we rule as follows:
PLR-136395-16                               7

       1. The inadvertent payment by Daughter and Spouse of federal, State 1 and
State 2 income taxes in connection with taxable income of Trust does not constitute a
constructive addition by Daughter and Spouse to Trust under § 26.2601-1(b)(1)(v)(C).

       2. The inadvertent payment by Daughter and Spouse of federal, State 1 and
State 2 income taxes in connection with taxable income of Trust and the subsequent
reimbursement to them of the income taxes paid, together with interest and attorney’s
fees, does not cause any portion of Trust to become subject to chapter 13.

        3. The inadvertent payment by Daughter and Spouse of federal, State 1 and
State 2 income taxes in connection with the taxable income of Trust does not constitute
a gift to Trust for federal gift tax purposes where Daughter and Spouse have a right of
recovery from Trust, they have exercised their rights, and Trustee, in fact, has
previously reimbursed Daughter and Spouse a portion of the income taxes, and will
further reimburse Daughter and Spouse the balance of income taxes together with,
interest and attorney’s fees.

       4. The inadvertent payment by Daughter and Spouse of federal, State 1 and
State 2 income taxes in connection with taxable income of Trust does not cause any
portion of Trust to be includible in Daughter’s gross estate.

      Except as specifically ruled herein, we express no opinion on the federal tax
consequences of the transaction under the cited provisions or under any other
provisions of the Code.

      This ruling is directed only to the taxpayer who requested it. Section
6110(k)(3) provides that it may not be used or cited as precedent.

                                         Sincerely,

                                         Lorraine E. Gardner

                                         Lorraine E. Gardner
                                         Senior Counsel, Branch 4
                                         Office of Associate Chief Counsel
                                         (Passthroughs and Special Industries)

Enclosure
      Copy for section 6110 purposes


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