In CCA 201442053, the IRS ruled that IRC Section 2701 applied to a recapitalization of a family-owned limited liability company (LLC), causing the taxpayer to have made gifts to her sons. The taxpayer established the LLC with her sons and was the sole member to make a capital contribution. Over time, she made gifts of membership interests to her sons and grandchildren.

Under the LLC’s operating agreement, distributions, profits and losses were to be allocated pro rata to the members according to their membership interests. Later, the operating agreement was amended to provide that, in exchange for the sons’ agreeing to manage the company, all profits and losses would be allocated equally to the two sons. The taxpayer and her grandchildren retained the right to distributions based on their capital account balances.

Because the taxpayer surrendered her right to participate in the future profits and losses but retained the equity interest with a right to distributions, Section 2701 applied. Section 2701 applies to recapitalizations if a taxpayer holds an “applicable retained interest” that’s subordinate to the equity interest transferred and receives property pursuant to the recapitalization (other than her retained interest). The right to distributions based on her existing capital account retained by the taxpayer was senior to the right to future profits and gains transferred to her children. And, the sons’ agreement to manage the company was the property received by the taxpayer in the recapitalization.

The ruling applied Section 2701’s subtraction method to determine the value of the gift. The gift amount was determined by taking the full value of the company and subtracting the fair market value (FMV) of the sons’ and grandchildren’s interests carrying distribution rights. The taxpayer’s distribution right was valued at zero; it didn’t reduce the value of the gift. Then, the taxpayer was deemed to have transferred to her sons a portion of that value based on the taxpayer’s relative ownership percentage as compared to the grandchildren. The ruling noted that the taxpayer could apply a minority discount to the value transferred, if appropriate.

Private Letter Ruling 201442042

IRS allows reformation of trust for gift tax purposes due to attorney’s drafting error

In PLR 201442042 (released Oct. 17, 2014), the taxpayer sought a ruling regarding the gift tax consequences of a trust reformation. The taxpayer retained an attorney to prepare two grantor retained annuity trusts (GRATs). The remainder interests in the GRATs were to be transferred to a trust for the benefit of the taxpayer’s children. The attorney drafted the children’s trust as a revocable trust, over which the taxpayer retained a right to amend, modify or revoke. In addition, the taxpayer was the trustee.

The accountant preparing the gift tax returns noticed that the trust receiving the remainder interests in the GRATs would be includible in the taxpayer’s estate but was assured by the attorney that there was no tax problem. The gift tax returns were filed showing the transfers as completed gifts.

Years later, another attorney reviewed the taxpayer’s estate plan and the GRATs, noted the same problem and advised the taxpayer. The taxpayer then sought to reform the trust under state law to be irrevocable ab initio and requested the IRS to confirm the tax consequences of the rulings: (1) the children’s trust wouldn’t be includible in the taxpayer’s estate, (2) the transfers to the GRATs were completed gifts, and the transfers at the end of the GRAT terms wouldn’t be treated as additional gifts, and (3) the reformation wouldn’t cause any beneficiary to be making a gift to any other beneficiary.

The IRS approved the reformation to fix the gift and estate tax problems. It held that the affidavits made by the taxpayer, attorneys, accountant and financial advisors showed clear and convincing evidence that the reformation conformed to the taxpayer’s original intent, as he and the attorney intended the original gifts to the GRATs to be complete.

CCA 201416007

Foreign trust thwarts both elective share and marital deduction

In CCA 201416007 (released April 18, 2014), the IRS ruled on whether an estate could claim the marital deduction for property in a portion of a foreign trust that the estate included as part of the spouse’s elective share. During his life, the decedent funded a trust in a foreign country for himself and his child. The trust was administered by a foreign corporate fiduciary and owned shares in foreign situs companies. The ruling provided that it wasn’t subject to the jurisdiction of U.S. courts.

After the decedent’s death, his spouse asserted her right to a certain percentage of his estate under the state’s elective share statute. However, her elective share exceeded the amount of property available in his probate estate and revocable trust. The executor filed an estate tax return that claimed a marital deduction for the entire elective share, making up the “shortfall” with property held in the foreign trust.

However, the spouse wasn’t a beneficiary of the foreign trust and had no access to the trust assets. The IRS ruled that because no part of the foreign trust property could pass to the surviving spouse and she had no beneficial interest in the property, under IRC Section 2056, no portion of the trust was eligible for the marital deduction, regardless of the elective share. It based its reasoning on the 2012 case, Estate of Turner v. Comm’r, 138 T.C. 306. In Turner, the Tax Court held that the value of family limited partnership interests included in an estate under IRC Section 2036 weren’t eligible for the marital deduction. The decedent gave the partnership interests to family members during his life. Although the value of the interests was includible in his estate under Section 2036, other family members owned the partnership interests at his death, and his surviving spouse had no beneficial interest in them. Although his revocable trust sought to maximize the marital deduction by using a formula, the Tax Court held that the marital deduction couldn’t apply to assets in which the surviving spouse had no beneficial interest. Similarly, in
CCA 201416007, the IRS held that the trust property that couldn’t be paid to a spouse wasn’t eligible for the marital deduction, even though the spouse was entitled, under state law, to a greater amount of the decedent’s property. Unfortunately for the spouse and the estate, the foreign trust thwarted both the elective share and the marital deduction.

Next Part 4 of 10:  Estate & Trusts Income Tax