Tax Law Update: June 2023Tax Law Update: June 2023
David A. Handler and Alison E. Lothes highlight the most important tax developments of the past month.
• Kentucky court reviews husband’s claim to halt mid-divorce decanting—In an unpublished opinion (McKim and Smith v. McKim, 2023 WL 2437475), the Court of Appeals of Kentucky reviewed whether a husband and successor trustee had standing to contest a wife’s actions to decant the trust while divorce proceedings were pending.
Kevin and Mary were married when Kevin established an irrevocable trust for the benefit of Mary and their two daughters and future descendants and named Mary as trustee. On divorce, the trust would divide into two trusts managed by another trustee, Theresa, solely for the benefit of the daughters. In 2018, Kevin filed for divorce, and the case was still pending in 2020 when Mary, as trustee, executed a document to decant the trust to a new trust of which she remained trustee and beneficiary.
Kevin sued in 2021, claiming that the decanting was invalid and that Mary breached her fiduciary duties. The Circuit Court dismissed the action for lack of standing. The Court of Appeals agreed, finding that as the divorce was still pending, there was no imminent harm and that it was possible the divorce wouldn’t in fact occur.
The named successor trustee of the trust for the daughters, Theresa, claimed that she had standing to contest the decanting. Again, the court held that the harm wasn’t actual or imminent because none of the prerequisites for her succession as trustee had in fact transpired.
• Private letter ruling confirms settlement agreement approved by state court to clarify ambiguities—In PLR 202317001 (Feb. 1, 2023), a family sought to reform a testamentary trust that was grandfathered for generation-skipping transfer (GST) tax purposes because the decedent had died before Sept. 25, 1985.
The language of the trust wasn’t clear about the division of property at a certain time. When the survivor of a certain group died, the trust was to divide “among the descendants in equal shares per stirpes and not per capita.” There’s some inherent contradiction in dividing property in equal shares and per stirpes, because per stirpes requires it to be divided into equal shares at a certain generation, and then subdivided at lower generations, so each individual may not receive an equal share, depending on their generation. It wasn’t clear from the trust at which generation the division into equal shares should be made.
The family reached a compromise and entered into a settlement agreement pursuant to state law, which allows interested persons to enter into settlement agreements to the extent they don’t violate a material purpose of the trust. The state court approved the agreement on the condition that the Internal Revenue Service issue a ruling that the agreement wouldn’t cause adverse tax consequences. Under the settlement agreement, each remainder beneficiary received somewhat more than their worst-case litigation outcome and somewhat less than their best-case litigation outcome.
The family then sought a PLR to confirm that the settlement agreement wouldn’t cause any adverse tax consequences.
For GST tax purposes, modifications to grandfathered trusts may risk the trust losing its exempt status, unless the modification falls into one of a few safe harbors under the Treasury regulations. Settlement agreements that resolve a bona fide issue won’t interfere with GST status of a grandfathered trust if the settlement is the result of arm’s-length negotiations, within the range of reasonable outcomes under the instrument and state law. The PLR confirmed that there was a bona fide issue and this compromise was within the range of reasonable outcomes.
The PLR further explained that there were no gift tax consequences to any of the beneficiaries under the settlement agreement because all of the beneficiaries had legitimate claims under state law due to the ambiguity of the trust.
Modifications or conversion of trust interests can trigger gain and loss if the property received is materially different in kind or extent than the interest exchanged. However, here, because the settlement agreement only resolved ambiguity, it wouldn’t be treated as a sale, exchange or disposition of property that would result in gain or loss. Further, the interest received wouldn’t be treated as income by any beneficiary.
