Beneficiary settlement preserves GST grandfathering without gift tax

Plain-English summary

A dispute arose over whether three individuals adopted after reaching adulthood were descendants under a settlor's will and beneficiaries of multiple family trusts. Each trust was irrevocable before September 25, 1985, and had received no later additions, so the trusts were grandfathered from generation-skipping transfer tax. The parties litigated the issue for years and then, with separate counsel, negotiated a court-approved settlement granting the adult adoptees specified cash payments and trust interests. The IRS determined that the agreement was an arm's-length compromise of a genuine construction dispute and was within the range of reasonable results under the will and applicable state law. It ruled that the settlement and related distributions would not remove the trusts' GST-exempt status. It further ruled that the compromise would not result in gifts by the parties because it resolved valid claims in an economically fair manner.

Ruling snapshot

• Question: Would implementing the negotiated settlement over adult adoptees' trust rights destroy GST grandfathering or cause taxable gifts?
• Outcome: No to both
• Key authorities: IRC §§ 2501, 2511, and 2601; Treas. Reg. §§ 25.2511-1(c)(1) and 26.2601-1(b)(4)(i)(B)

Full text (IRS public release)

Internal Revenue Service                                      Department of the Treasury
                                                              Washington, DC 20224

Number: 202343018                                             Third Party Communication: None
Release Date: 10/27/2023                                      Date of Communication: Not Applicable
Index Number: 2501.00-00, 2601.00-00
                                                              Person To Contact:
---------------------------------------------------           ---------------, ID No. -----------------
--------------------------------------------------------      Telephone Number:
------------------------------                                --------------------
-------------------------------------                         Refer Reply To:
-----------------------                                       CC:PSI:04
------------------------------                                PLR-102059-23
                                                              Date:
---------------------------------------------------------     July 27, 2023




LEGEND

Settlor                  =        ------------------------------
Spouse                   =        --------------------------
Child 1                  =        -----------------------------
Child 2                  =        -------------------------------
Child 3                  =        ----------------------
Date 1                   =        --------------------------
Date 2                   =        ------------------
Date 3                   =        ------------------
Date 4                   =        ------------------
Date 5                   =        -------------------------
Date 6                   =        -------------------
Date 7                   =        ----------------------
Date 8                   =        ---------------------------
Date 9                   =        --------------------
Date 10                  =        ---------------------------
Date 11                  =        ----------------------
Date 12                  =        ---------------------------
Date 13                  =        --------------------
Date 14                  =        --------------------
Date 15                  =        -----------------
Date 16                  =        -------------------------
Date 17                  =        ---------------------------
Date 18                  =        --------------------------
Trust A                  =        -----------------------------------------------------------------
Trust B                  =        ------------------------------------------------------------------
Trust C                  =        ---------------------------------------------------------
Trust D                  =        ----------------------------------------------------------------

PLR-102059-23                                     2

Trust E                 =   ------------------------------------------------------------------
Trust F                 =   ---------------------------------------------------------
Trust D1                =   --------------------------------------------------
Trust D2                =   ------------------------------------------------
Trust D3                =   ----------------------------------------------
Trust D4                =   --------------------------------------------------------------------------
Trust D5                =   ----------------------------------------------------------
Trust D6                =   -----------------------------------------------------
Trust A1                =   ---------------------------------------------------
Trust A2                =   -------------------------------------------------
Trust A3                =   -----------------------------------------------
Trust A4                =   ---------------------------------------------------
Trust A5                =   ----------------------------------------------------------
Trust A6                =   ------------------------------------------------------
Trust BE1               =   ------------------------------------------------------
Trust BE2               =   ---------------------------------------------------------
Grandchild 1            =   -----------------------------
Grandchild 2            =   ---------------------------
Grandchild 3            =   -------------------------
Grandchild 4            =   --------------------------------------------------------
Grandchild 5            =   -------------------------------------
Grandchild 6            =   ---------------------------------
Grandchild 7            =   ------------------------
Grandchild 8            =   --------------------------
Adoptee 1               =   -------------------
Adoptee 2               =    ---------------------------------------------------------------------
                                      -----------------
Adoptee 3               =   -----------------------------------------------------
Trust Company           =   --------------------------------------------
State                   =   ------------------
State Court             =   ----------------------------------------------------------
State Law 1             =   ---------------------------------------------------
State Law 2             =   -------------------------------------------------
a                       =   -----------
b                       =   ---------
c                       =   -----------
d                       =   -------------
e                       =   -----------




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

PLR-102059-23                                  3


This letter responds to your authorized representative’s letter dated December 27,
2022, and subsequent correspondence, requesting rulings concerning the federal gift
and generation-skipping transfer tax consequences of a court-approved settlement
agreement.

FACTS

The facts submitted and representations made are as follows. Settlor died testate on
Date 1, a date prior to September 25, 1985. Settlor’s Will consists of the original
instrument dated Date 2, a first codicil dated Date 3, a second codicil dated Date 4, a
third codicil dated Date 5, and a fourth codicil dated Date 6 (collectively, Settlor’s Will).
At his death, Article Fourth of Settlor’s Will created separate trusts for the benefit of his
three children, Child 1, Child 2, and Child 3 (collectively, Children), their spouses, and
their descendants: Trust A for the benefit of Child 1; Trust B for the benefit of Child 2;
and Trust C for the benefit of Child 3.

In addition to the trusts for the primary benefit of Children, Article Third of Settlor’s Will
created a marital trust for Settlor’s wife, Spouse, which granted Spouse a testamentary
general power of appointment over any trust property remaining in the marital trust at
the time of her death. Spouse exercised her power of appointment under Article VII of
Spouse’s Will, dated Date 7, with a first codicil dated Date 8 (collectively, Spouse’s
Will). Pursuant to Spouse’s Will, upon Spouse’s death on Date 9, the remaining
property of the marital trust was divided into three separate trusts for the benefit of
Children, their spouses, and their descendants: Trust D for the benefit of Child 1;
Trust E for the benefit of Child 2; and Trust F for the benefit of Child 3. Section 8 of
Article VI of Spouse’s Will provides that to the extent not specifically stated otherwise,
all trusts created by Spouse’s Will would be governed by the provisions of Settlor’s Will.

Child 3 died on Date 10, leaving no surviving spouse or descendants. Upon Child 3’s
death, the property held in Trust C was divided into two equal shares and each share
distributed to Trust A and Trust B. Similarly, the property of Trust F was divided into two
equal shares and each share distributed to Trust D and Trust E.

On Date 11, pursuant to a State Court order, Trust D for the primary benefit of Child 1
was divided into six separate trusts for the benefit of Child 1’s six children and their
respective descendants, as well as Child 1 and Child 1’s spouse: Trust D1 for the
benefit of Grandchild 1; Trust D2 for the benefit of Grandchild 2; Trust D3 for the benefit
of Grandchild 3; Trust D4 for the benefit of Grandchild 4; Trust D5 for the benefit of
Grandchild 5; and Trust D6 for the benefit of Grandchild 6.

On Date 12, pursuant to a State Court order, Trust A for the primary benefit of Child 1
was divided into six separate trusts for the benefit of Child 1’s six children and their
respective descendants, as well as Child 1 and Child 1’s spouse: Trust A1 for the
benefit of Grandchild 1; Trust A2 for the benefit of Grandchild 2; Trust A3 for the benefit

PLR-102059-23                                   4

of Grandchild 3; Trust A4 for the benefit of Grandchild 4; Trust A5 for the benefit of
Grandchild 5; and Trust A6 for the benefit of Grandchild 6. In a companion State Court
order on the same date, Trust B for the primary benefit of Child 2 and Trust E for the
primary benefit of Child 2, were divided into two separate trusts for the benefit of
Child 2’s two children, Grandchild 7 and Grandchild 8 and their respective descendants,
as well as Child 2 and Child 2’s spouse. The divided trusts were subsequently merged
into two trusts known as Trust BE1 for the benefit of Grandchild 7 and Trust BE2 for the
benefit of Grandchild 8.

Article Fourth of Settlor’s Will governs the distribution provisions of Trust A, Trust B,
Trust D, Trust E, Trusts A1 through A6, Trusts D1 through D6, and Trusts BE1 and BE2
(collectively, the Family Trusts). Until a trust for whom a grandchild is named
terminates, the Trustee has discretion to make distributions of income from such trust to
the grandchild. The portion of income not distributed may be accumulated or may be
distributed to the grandchild’s spouse, the surviving parents of the grandchild, and the
descendants of grandchild, in whole or in part, in the discretion of the Trustee. Trustee
has unfettered discretion to make distributions of principal to a grandchild for whom a
trust is established. A trust for whom a grandchild is named shall terminate upon the
later to occur of the death of the grandchild or the grandchild’s spouse, if any, and at
such time the share for such grandchild shall be distributed to the descendants of such
grandchild, per stirpes.

Section 4 of Article Fifth of Settlor’s Will provides that any trust established pursuant to
Settlor’s Will shall cease and terminate upon the expiration of twenty-one years after the
death of the last surviving of Settlor’s descendants who were in being at the time of
Settlor’s death, and if at the expiration of this period any property is still held in trust,
such property shall immediately be distributed to and among the persons receiving or
entitled to have the benefit of the income therefrom in equal shares.

Pursuant to Article Fourth of Settlor’s Will, if a grandchild of Settlor dies without a living
spouse or descendants, the trust principal of such grandchild’s trust will be distributed to
Settlor’s other descendants.

Section 3 of Article Fifth of Settlor’s Will provides as follows:

       The words “children” and “descendants” shall be deemed to refer to issue
       of the body born in lawful wedlock and to children adopted by legal
       proceedings of public record and to their children and descendants so
       defined.

Of Settlor’s eight grandchildren, Grandchild 5 and Grandchild 7 currently have biological
descendants. Grandchild 2 adopted Adoptee 1 and Grandchild 3 adopted Adoptee 2
and Adoptee 3. Each adopted individual was adopted after reaching the age of majority
(collectively, Adult Adoptees).

PLR-102059-23                                 5

The Trustee of each Family Trust is Trust Company. On Date 13, Trustee filed a
petition with the State Court requesting an order construing the terms “children” and
“descendants” under Section 3 of Article Fifth of Settlor’s Will to determine whether
individuals adopted as adults qualify as “descendants” under Settlor’s Will. A
controversy exists among the descendants of Settlor as to whether the Adult Adoptees
are “descendants” of Settlor under Settlor’s Will. If the Adult Adoptees are considered
descendants of Settlor, the number of potential remainder beneficiaries increases and
affects the per stirpital shares at the time of final distribution of the Family Trusts.

On Date 14, State Court issued a memorandum opinion and order for evidentiary
hearing to determine whether Grandchild 2 and/or Grandchild 3 functioned as parents to
the Adult Adoptees before they reached age 18, based on State Law 1, which was
enacted after Settlor’s date of death. Grandchild 1, joined by other family members,
filed a motion for summary judgment and amendment of the Date 14 order in objection
to the State Court’s application of State Law 1 rather than the law at the time of Settlor’s
date of death.

State Law 1 provides that in construing a dispositive provision of a transferor who is not
the adoptive parent, an adoptee is not considered the child of the adoptive parent
unless the adoptive parent functioned as a parent of the adoptee before the adoptee
reached 18 years of age. State Law 2 provides that the effective date of the title of
State Law 1 is Date 15, a date that is after Settlor’s date of death, and applies to any
proceedings in court then pending or thereafter commenced regardless of the time of
the death of decedent except to the extent that in the opinion of the court the former
procedure should be made applicable in a particular case in the interest of justice or
because of infeasibility of application of the procedure of the title.

Over several years, the interested parties engaged in substantial litigation and other
proceedings in preparation for trial, including filing cross motions for summary judgment,
extensive discovery, and voluntary mediation. Based on the issue before State Court,
the outcome of the litigation would be that the Adult Adoptees are determined to be or
not be descendants of Settlor. After several attempts to resolve the contested issues,
on Date 16 the parties entered into a Settlement Agreement resolving the litigation
regarding the status of the Adult Adoptees as descendants of Settlor. The Settlement
Agreement was revised on Date 17 (Revised Settlement Agreement). Both the
Settlement Agreement and the Revised Settlement Agreement were approved by order
of State Court and contingent upon receipt of a favorable private letter ruling from the
Internal Revenue Service (IRS). All parties to the agreement were represented by legal
counsel.

The Revised Settlement Agreement provides for certain payments to and for the benefit
of Adoptee 1. It provides that the amount of $a will be distributed outright and in cash to
Adoptee 1 from Trusts A1 through A6 and Trusts D1 through D6 (each trust distributing
$b). In addition, the amount of $a will be distributed outright and in cash to Grandchild 2
(adoptive parent of Adoptee 1) from Trust A2 and Trust D2 (each trust for the primary

PLR-102059-23                                  6

benefit of Grandchild 2 and each distributing $c), whereupon Grandchild 2, as settlor
and transferor, will immediately establish (and contribute the $a in cash to) a special
needs trust for the primary benefit of Adoptee 1. Finally, the amount of $d will be
distributed outright and in cash to Adoptee 1 from Trust A2 and Trust D2 (each trust
distributing $e). Upon receipt of cash in the amounts of $a and $d, Adoptee 1, as settlor
and transferor, will immediately establish (and contribute the sum of $a and $d in cash
to) a revocable trust for his primary benefit.

The Revised Settlement Agreement provides for certain payments to and for the benefit
of Adoptee 2 and Adoptee 3. It provides that the amount of $a will be distributed
outright and in cash to each of Adoptee 2 and Adoptee 3 from Trusts A1 through A6 and
Trusts D1 through D6 (each distributing $b). Further, after the cash distributions to
Adoptee 2 and Adoptee 3 are made, the assets then making up Trust A3 and Trust D3
(collectively referred to going forward as the Grandchild 3 Settlement Trusts), each for
the primary benefit of Grandchild 3 (adoptive parent of Adoptee 2 and Adoptee 3), will
be kept separate and segregated from the assets of any other Family Trust. No further
additions shall be made to the Grandchild 3 Settlement Trusts from any other Family
Trust by reason of the death of any beneficiary of those other Family Trusts. Except for
certain excluded property related to agricultural land and business interests in entities
whose primary holding is agricultural land (Excluded Property), Adoptee 2 and
Adoptee 3 are the named beneficiaries of the Grandchild 3 Settlement Trusts. Upon the
death of the survivor of Child 1’s spouse, Grandchild 3, and Grandchild 3’s spouse, the
remaining assets of the Grandchild 3 Settlement Trusts, less the Excluded Property, will
be distributed in equal shares to Adoptee 2 and Adoptee 3, or all to the survivor.
Adoptee 2 and Adoptee 3 have a testamentary power to appoint such individual’s
respective share of the Grandchild 3 Settlement Trusts to or for the benefit of such
individual’s spouse or descendants. If Adoptee 2 or Adoptee 3 does not exercise such
power of appointment but has living descendants, the Trustee shall distribute such
individual’s respective share to such descendants, per stirpes. Any asset appointed
under the terms of the Revised Settlement Agreement (including the assets of the
Grandchild 3 Settlement Trusts) may not extend the time for vesting of that asset
beyond a period of twenty-one years after the death of the last surviving descendant of
Settlor who was in being on Date 18. Any remaining assets of the Grandchild 3
Settlement Trusts not otherwise distributed (including the Excluded Property) shall be
distributed according to Settlor’s Will without regard to any surviving Adult Adoptees or
their descendants.


Under the Revised Settlement Agreement, all claims by the Adult Adoptees with regard
to Settlor and Settlor’s Spouse’s trusts and estates are resolved and, after obtaining a
favorable private letter ruling from the IRS, Trustee will agree to dismiss the petition filed
in State Court with prejudice and all parties will agree that State Court can enter the
dismissal without awarding costs to any party and without further notice.

PLR-102059-23                                7

It is represented that each Family Trust was irrevocable on September 25, 1985, and
that there were no additions, constructive or actual, after that date.

You have requested the following rulings:

    1. The Revised Settlement Agreement, the State Court order approving the
      Revised Settlement Agreement, and the implementation and distributions
      made in accordance with the Revised Settlement Agreement, will not cause
      any of the Family Trusts to lose their status as trusts exempt from GST tax for
      purposes of chapter 13 of the Code.

    2. Entering into the Revised Settlement Agreement will not cause any party to the
      Settlement Agreement to be treated as having made a gift to any other individual
      for purposes of chapter 12 of the Code.

LAW AND ANALYSIS

Ruling 1

Section 2601 imposes a tax on every generation-skipping transfer (GST), which is
defined under § 2611 as a taxable distribution, a taxable termination, and a direct skip.

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 tax does not apply to a transfer under a trust (as defined in
§ 2652(b)) that was irrevocable on September 25, 1985, but only to the extent that such
transfer is not made out of corpus added to the trust after September 25, 1985 (or out of
income attributable to corpus so added).

Section 26.2601-1(b)(4) 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), (b)(2), or (b)(3) will not cause the
trust to lose its exempt status. The rules of § 26.2601-1(b)(4) are applicable only for
purposes of determining whether an exempt trust retains its exempt status for GST tax
purposes. They 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 capital 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 a 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

PLR-102059-23                                 8

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

In the present case, each Family Trust was created and was irrevocable before
September 25, 1985. It is represented that no additions, constructive or actual, have
been made to any of the Family Trusts on or after September 25, 1985. Consequently,
each Family Trust is currently exempt from GST tax.

In this case, each party was represented by separate legal counsel. The prospective
beneficiaries had distinct and adverse economic and administrative interests. The
parties were involved in protracted and substantial litigation to resolve the issue of the
identity of Settlor’s descendants under Settlor’s Will. Settlement negotiations were
carried out over several years until the Revised Settlement Agreement was reached.
The parties have obtained State Court approval of the Revised Settlement Agreement
pending the issuance of this private letter ruling.

We conclude that the Revised Settlement Agreement constitutes a settlement of a bona
fide issue regarding construction of the terms “children” and “descendants” in Settlor’s
Will. We further conclude that the terms of the Revised Settlement Agreement are the
product of arm’s length negotiations. Finally, we conclude that the Revised Settlement
Agreement represents a compromise between the positions of the interested parties
and reflects the assessments of the relative strengths of their positions; therefore, we
additionally conclude that the Revised Settlement Agreement is within the range of
reasonable outcomes under the governing instrument and the applicable State law
addressing the issues resolved by the Revised Settlement Agreement.

Accordingly, based on the facts submitted and the representations made, we rule that
the Revised Settlement Agreement, the State Court order approving the Revised
Settlement Agreement, and the implementation and distributions made in
accordance with the Revised Settlement Agreement, will not cause any of the
Family Trusts to lose their status as trusts exempt from GST tax for purposes of
chapter 13 of the Code.



Ruling 2

Section 2501 imposes a tax for each calendar year on the transfer of property by gift
during such calendar year by any individual. Section 2511 provides that the tax
imposed by § 2501 applies whether the transfer is in trust or otherwise, direct or
indirect, and whether the property transferred is real or personal, tangible or intangible.

PLR-102059-23                                  9

Section 25.2511-1(c)(1) of the Gift Tax Regulations provides that any transaction in
which an interest in property is gratuitously passed or conferred upon another,
regardless of the means or device employed, constitutes a gift subject to tax.

Whether an agreement settling a dispute is effective for gift tax purposes depends on
whether the settlement is based on a valid enforceable claim asserted by the parties
and, to the extent feasible, produces an economically fair result. See Ahmanson
Foundation v. United States, 674 F.2d 761, 774-775 (9th Cir. 1981). Thus, state law
must be examined to ascertain the legitimacy of each party’s claim. A settlement that
fairly reflects the relative merits and economic values of the various claims asserted by
the parties and reaches a settlement that is within a range of reasonable settlements
will not result in a transfer for gift tax purposes.

As discussed above, the Revised Settlement Agreement represents the resolution of a
bona fide controversy among the family members as beneficiaries of Settlor’s Will. All
interested parties have been represented in the proceedings that culminated in the
Court Order approving the Revised Settlement Agreement. Further, based on the facts
as presented, the terms of the Revised Settlement Agreement are the product of arm’s
length negotiations among all the interested parties. We conclude that the Revised
Settlement Agreement reflects the rights of the parties under the applicable law of State
that would be applied by the highest court of State. Accordingly, based on the facts
submitted and representations made, we rule that implementation of the Revised
Settlement Agreement will not result in a gift under § 2501 by the parties to the Revised
Settlement Agreement.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

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

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

PLR-102059-23                                10

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.



                                      Sincerely,

                                      Karlene M. Lesho

                                      Karlene M. Lesho
                                      Chief, Branch 4
                                      Office of Associate Chief Counsel
                                      (Passthroughs and Special Industries)




Enclosures
      Copy for § 6110 purposes



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