Settlement Agreement Distributions Retain GST Tax-Exempt Status

In Private Letter Ruling 201519012 (May 8, 2015), a taxpayer requested four rulings related to a settlement agreement.  Specifically, it asked the Internal Revenue Service to address whether:

1. A trust will continue to be a generation-skipping transfer (GST) tax-exempt trust, such that distributions from the trust won’t be subject to GST tax, after a settlement agreement is implemented;
2. Trust distributions to two of the great-grandchildren won’t result in gifts by the other beneficiaries for federal gift tax purposes;
3. A distribution from a limited liability company (LLC) made pursuant to the settlement agreement isn’t income under Internal Revenue Code Section 643(b); and
4. Distributions from the trust to two of the great-grandchildren aren’t includible in their income under IRC Section 662.

The Terms of the Trust and the Will

Prior to Sept. 25, 1985, the decedent passed away, leaving a will that established a testamentary trust.  The trust, which was funded with company stock, was for the benefit of decedent’s spouse, issue and relatives.  At a later date, the trust exchanged the company stock for an interest in an LLC.  A bank and one of the grandchildren (Grandchild 1) served as trustees of the trust. 

Under the will, the trust was to terminate 21 years after the last to survive the spouse, the two children or the three grandchildren.  Distributions of specified trust income were to be made at least annually to certain beneficiaries for their lifetimes, but not to exceed the trust’s duration.  The total amount of the distributions was limited to one-third of the trust income.  After the death of the spouse and the two children, trust income was to be distributed equally to one of the children’s widows (if there was one), the living grandchildren and the issue of any deceased grandchild, per stirpes.  On the death of the last surviving grandchild, the trust income was to be distributed equally to the living great-grandchildren and the issue of any deceased great-grandchildren, per stirpes. When the trust terminated, its assets were to be distributed to the income beneficiaries. 

The will also provided that a bequest to a beneficiary will be annulled if that beneficiary objected to the probate of the will or contested the will.  A no-contest provision also provided that the objecting beneficiary will be absolutely barred from any share of the decedent’s estate.

Beneficiaries

At the time of the PLR request, there were eight income beneficiaries of the trust.  The decedent’s only surviving grandchild (Grandchild 3) would receive one-third of the income.  The three children of Grandchild 1 (Great-grandchildren 1, 2, and 3) would each receive one-ninth of the income.  The four children of Grandchild 2 (Great-grandchildren 4, 5, 6, and 7) would each receive one-twelfth of the income.

Great-grandchild 4 and Great-grandchild 5 filed objections to the trust’s annual accountings, petitions and joinders (the objectors’ claims).  They alleged that the trustees breached their duty of impartiality and their fiduciary duties. Great-grandchild 1 and Great-grandchild 8 (a daughter of Grandchild 3) responded that some of the objectors’ claims violated the will’s no-contest provision.  A Probate Commissioner ruled that the objectors’ claims violated the no-contest provision.

Settlement Agreement

Because the litigation in was intensive, divisive and expensive, the parties entered into an agreement to resolve the issues (Settlement Agreement).  A court issued an order approving the Settlement Agreement.  Under the terms of the Settlement Agreement and the court order, if the IRS issues a favorable PLR on all four of the rulings stated above, then:

(1) the interest of Great-grandchild 4 and 5 in the trust will be completely terminated in exchange for a distribution of a specified amount to each great-grandchild from the trust;

(2) the LLC will distribute a specified amount to its members, of which an amount will then go to the trust to fund the distributions to Great-grandchild 4 and 5;

(3) Great-grandchild 4 and 5 will dismiss with prejudice their objectors’ claims, and Great-grandchild 1 and 8 will dismiss their no-contest claims;

(4) until Grandchild 3’s death, the trust income will be distributed in a certain percentage to Grandchild 3, a certain percentage each to Great-grandchild 1 or his

issue in the event of his death, Great-grandchild 2 or his issue in the event of his death, Great-grandchild 3 or her issue in the event of her death, and a certain  percentage each to Great-grandchild 6 or his issue in the event of his death and Great-grandchild 7 or her issue in the event of her death; and

(5) following Grandchild 3’s death, all distributions to a beneficiary will be  determined under the trust terms assuming for this purpose that Great-grandchildren 4 and 5 are deceased, without issue surviving them.

GST Tax Exemption Remains

IRC Sections 2601 and 2611 provide the rules for GSTs.  Although a GST tax typically applies to GSTs made after Oct. 22, 1986, it doesn’t apply to a transfer under a trust that was irrevocable on Sept. 25, 1985, except to the extent the transfer is made out of corpus added to the trust by an actual or constructive addition after Sept. 25, 1985.

Treasury Regulations Section 26.2601-1(b)(4)(i) determines when a modification, judicial construction, settlement agreement or trustee action with respect to a GST tax-exempt trust won’t cause the trust to lose its exempt status.  Treas. Regs. Section 26.2601-1(b)(4)(i)(B) provides that a court-approved settlement relating to the trust administration or construction of its terms won’t cause an exempt trust to lose its status if the settlement was made by an arm’s length negotiation and it’s within “the range of reasonable outcomes under the governing instrument and applicable state law addressing the issues resolved by the settlement.” 

In this instance, the trust was GST tax-exempt because it was irrevocable prior to Sept. 25, 1985, and no additions were made.  Moreover, the Settlement Agreement resulted in a compromise between the litigating parties and reflected the parties’ assessments of their relative positions; therefore, it was a settlement within the range of reasonable outcomes.  Great-grandchild 4 and 5’s interests would terminate when the Settlement Agreement was implemented.  The partial termination would accelerate the distribution of a portion of the corpus of the trust to them; it wouldn’t shift a beneficial interest to a beneficiary who occupies a lower generation.  And, the Settlement Agreement doesn’t extend the time for vesting of any beneficial interest in the trust beyond the original time period.  Accordingly, the trust and its distributions continue to be GST tax-exempt after implementation of the Settlement Agreement.

Distributions Aren’t Gifts

The IRS stated that whether the Settlement Agreement was effective for gift tax purposes depends on whether it’s based on a valid enforceable claim asserted by the parties and, to the extent feasible, produces an economically fair result. (Ahmanson Foundation v. U.S., 674 F.2d 761, 774-75 (9th Cir. 1981), citing Commissioner v. Bosch, 387 U.S. 456 (1967)).  To determine whether each party had a valid enforceable claim, the IRS must turn to state law.  If each party did have a valid claim, the IRS must make a determination whether the distribution under the Settlement Agreement reflects the results that would apply under state law.

In this instance, the Settlement Agreement resolved the bona fide controversies among the parties.  All of the interested parties were represented in the proceedings that produced the order approving it.  The Settlement Agreement was the product of an arm’s length negotiation among all of the interested parties and reflected the rights of the parties under applicable state and federal law.  Thus, the distributions from the trust to Great-grandchild 4 and 5 made according to the Settlement Agreement don’t result in gifts for federal gift tax purposes by the other trust beneficiaries.

Distribution is Extraordinary Dividend and Not Income

IRC Section 643(a), which defines the term “distributable net income” (DNI), excludes items of gross income constituting extraordinary dividends that a fiduciary, acting in good faith, doesn’t pay to any beneficiary by reason of a determination that such dividends are allocable to corpus under the terms of the governing instrument and applicable local law.

In this case, a court determined that state law and the governing instrument would characterize the distribution from the LLC to the trust as a return of corpus.  Thus, the distribution meets the definition of an extraordinary dividend under IRC Section 643(b) and isn’t income under that section.  Therefore, the distribution from the LLC to the trust is an extraordinary dividend excluded from income.

Distributions to Two Great-grandchildren Not Includible in Income

Under IRC Section 662, 1) the amount of income for the taxable year required to be distributed currently to a beneficiary, and 2) all other amounts properly paid or required to be distributed to a beneficiary for the taxable year, shall be included in a beneficiary’s gross income. 

The distributions to Great-grandchild 4 and 5 were extraordinary distributions excluded from the definition of “income” under Section 643(b).  The distributions weren’t part of the trust’s DNI and thus not includible in Great-grandchild 4 and 5’s income under Section 662.