IRS has privately ruled that transactions between a marital trust and a decedent's children from his first marriage to resolve discord between his surviving spouse and her stepchildren won't trigger gifts and won't result in a deemed transfer of the remainder interest in the marital trust.
Facts. Decedent and Spouse 1 established Family Trust, a revocable trust. After the death of Spouse 1 and Decedent's remarriage to Spouse 2, Decedent amended and restated Family Trust. Upon Decedent's death, Family Trust became irrevocable. Decedent was survived by Spouse 2, Child 1, Child 2, grandchildren and great-grandchildren. Spouse 1 was the mother of Child 1 and Child 2.
Spouse 2 and Trustee (together, Trustees) serve as co-trustees of Family Trust as well as the trusts created thereunder upon the death of Decedent.
Along with cash and securities, Marital Trust was funded with ownership interests in entities holding commercial real estate. In nineteen of these entities, Marital Trust held only a partial interest, with the balance of ownership held or shared by Child 1, Child 2, and/or a trust for the benefit of Child 1. At the time of Decedent's death, Child 1 served as a manager, managing member, or general partner of at least eight of these entities.
More than 2 years after Decedent's death, Child 1 and Child 2 filed a petition in state court for an accounting by the Family Trust. Trustees filed a petition to establish ownership interests of Marital Trust in certain entities. Eventually, the parties negotiated a settlement agreement (Agreement).
Under the terms of Agreement, Marital Trust will purchase, at fair market value (FMV), the interests of the other parties in certain named entities so that Marital Trust will own an interest of 100% in these entities. Likewise, Child 1 and Child 2 will purchase, at FMV, Marital Trust's interest in certain named entities so that Child 1 and Child 2 and any trust for the benefit of Child 1 will own an interest of 100% in these entities. After these purchases, the entities previously-owned partially by Marital Trust and partially by Child 1, Child 2, and/or a trust for the benefit of Child 1 will be either wholly owned by Marital Trust or wholly owned by Child 1, Child 2, and/or a trust for the benefit of Child 1. To the extent there is any difference in the aggregate FMV of the Marital Trust purchases and the Child 1 and Child 2 purchases, an equalizing payment will be made. FMV will be determined impartially, by two commercial appraisers selected by a retired judge (collectively, “FMV exchange”).
Marital deduction background. Qualified terminable interest property (QTIP) qualifies for the estate tax marital deduction under Code Sec. 2056(b)(7). To qualify as QTIP, the decedent's spouse must get a qualifying income interest for life, an irrevocable election must be made, and other requirements must be met.
The QTIP is included in the donee spouse's estate on her death. (Code Sec. 2044) However, transfer tax is accelerated if the spouse makes a gift of her income interest. Under Code Sec. 2519, if a spouse makes a gift of any portion of her qualifying income interest in the QTIP trust, she is deemed to make a transfer of the entire value of the remainder. In addition, the transfer of the income interest itself is subject to gift tax under general principles. (Reg. §25.2519-1(a))
The conversion of QTIP into other property in which the donee spouse has a qualifying income interest for life is not treated as a disposition of the qualifying income interest. Thus, the sale and reinvestment of assets of a trust holding QTIP is not a disposition of the qualifying income interest, provided that the donee spouse continues to have a qualifying income interest for life in the trust after the sale and reinvestment. Similarly, the sale of real property in which the spouse possesses a legal life estate, followed by the transfer of the proceeds into a QTIP trust, or by the reinvestment of the proceeds in income producing property in which the donee spouse has a qualifying income interest for life, is not considered a disposition of the qualifying income interest. On the other hand, the sale of QTIP followed by the payment to the donee spouse of a portion of the proceeds equal to the value of the donee spouse's income interest, is considered a disposition of the qualifying income interest. (Reg. §25.2519-1(f))
Gift tax background. The gift tax is imposed on the transfer of money or other property by gift. (Code Sec. 2501(a))
The gift tax applies 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. (Code Sec. 2511) The gift tax does not apply to a transfer for full and adequate consideration in money or money's worth. (Reg. §25.2511-1(g)(1))
Where property is transferred for less than an adequate and full consideration in money or money's worth, then the amount by which the value of the property transferred exceeds the value of the consideration received is considered a gift. (Code Sec. 2512) Transfers reached by the gift tax include sales, exchanges, and other dispositions of property for a consideration to the extent that the value of the property transferred by the donor exceeds the value in money or money's worth of the consideration received. However, a sale, exchange, or other transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm's length, and free from any donative intent), is considered as made for an adequate consideration in money or money's worth. (Reg. §25.2512-8)
Favorable rulings. IRS observed that the FMV exchange process was the product of a court-ordered mediation proceeding presided over by a retired judge. The mediation proceeding was ordered to resolve the ongoing and, at times, contentious dispute between Trustees, Child 1, and Child 2 regarding (1) the administration of Family Trust and Marital Trust, (2) Marital Trust's management rights over certain properties, and (3) Marital Trust's ownership interest in entities owned partially by Marital Trust, Child 1, Child 2, and a trust for the benefit of Child 1.
IRS concluded that the FMV exchange procedures were the result of a bona fide adversarial proceeding and arms-length negotiations. Therefore, to the extent the payments made and received in the FMV exchange process are distributed in accordance with each party's respective ownership interest, as properly determined under applicable local law, IRS concluded that the transfers occurring pursuant to the FMV exchange will be made for adequate and full consideration in money or money's worth and will not be subject to the gift tax.
IRS further found that, upon the conclusion of the FMV exchange process, Spouse 2 will continue to possess a qualifying income interest for life in the assets of Marital Trust and Spouse 2's right to income will not be diminished or relinquished. Thus, it concluded that, under Reg. §25.2519-1(f), the sale and purchase of ownership interests in various entities held by Marital Trust and the payment or receipt of an equalizing payment pursuant to the FMV exchange process won't be treated as a disposition of a qualifying income interest life under Code Sec. 2519.
Observation: There is often the potential for disputes when an individual leaves property to a second spouse and children of his prior marriage. The individual's estate plan should be designed to minimize such potential disputes. However, if they should arise and involve facts similar to those in the ruling, the parties should consider employing a process similar to that used in the ruling. It may operate to settle the dispute in a satisfactory manner without adverse gift tax costs.
References: For gifts of income interests in QTIPs, see FTC 2d/FIN ¶Q-6315; United States Tax Reporter Estate & Gift ¶25,194; TaxDesk ¶736,016.