In Private Letter Ruling 201419001 (released May 9, 2014), the Internal Revenue Service issued five rulings regarding the federal income and gift tax consequences of a proposed division of an irrevocable trust.
The Will Provisions
A decedent left a will in which he established a trust for the benefit of his spouse during her lifetime. The decedent named his spouse as trustee and executor of his estate. On Schedule M of Form 706, the spouse elected to treat the trust as a qualified terminable interest property (QTIP) trust.
Under the terms of the will, the trustee was to pay the net income of the trust in quarterly (or more frequent) installments to the spouse during her lifetime. The trust didn’t provide for distributions of principal during the spouse’s lifetime and terminated on the spouse’s death. At the spouse’s death, the trust assets were to be divided equally between two trusts.
The trustee had uncontrolled discretion to exercise all rights under state law and, if state law conferred expanded powers to the trustee, she would maintain those expanded powers. The will also provided that the trustee would have no authority to restrict the spouse’s enjoyment of the trust income inconsistent with QTIP property.
On a certain date, shares of a Subchapter S corporation from another state were transferred to the trust. Subsequently, the spouse, as the trust’s beneficiary, filed an election to treat the trust as a qualified subchapter S trust (QSST), effective within two years from the date the shares were initially transferred to the trust.
Trust 1 and Trust 2
State law provided that a trustee, unless prohibited by the trust itself, could divide a trust into separate trusts without a judicial proceeding, so long as the result didn’t impair the rights of any beneficiary or adversely affect the trust’s purpose. The spouse, as trustee of the trust in the instant case, wanted to exercise her trustee powers to divide the trust, pro rata, into Trust 1 and Trust 2. She intended to be the trustee of both subtrusts and receive all of the income distributions during her lifetime. After her death, Trust 1’s assets would be distributed to a new trust (Trust P), and Trust 2’s assets would be distributed to a new trust (Trust R). Other than different trust beneficiaries, Trust 1 and Trust 2 would have identical terms.
The spouse requested that the IRS address five issues. First, the spouse asked whether the division of the trust into Trust 1 and Trust 2 would cause the original trust to realize gain or loss under Internal Revenue Code Sections 61 or 1001. The IRS applied Cottage Savings Association v. Commissioner, 499 U.S. 555 (1991), in which the U.S. Supreme Court ruled that that an exchange of property gives rise to realized gain or loss if the property is “materially different.” Properties are materially different, stated the Supreme Court, if their respective possessors enjoy legal entitlements different in kind or extent. In the instant case, the legal entitlements and interests of the beneficiaries of Trust 1 and Trust 2 wouldn’t materially differ in kind or extent from the interests in the original trust. Thus, ruled the IRS, the division of the trust into two trusts wouldn’t result in the recognition of gain or loss under Section 61 or Section 1001.
The IRS’ second ruling addressed whether the adjusted bases of the assets received by Trust 1 and Trust 2 from the original trust would be the same as the adjusted bases of the assets held by the original trust immediately prior to the division, pursuant to IRC Section 1015. Under Section 1015(b), if property is acquired by a transfer in trust (other by gift or bequest), the basis is the same as it would be in the hands of the grantor, increased or decreased by the amount recognized to the grantor. In this case, the original trust’s assets were to be divided pro rata among the two successor trusts, and Sections 61 and 1001 were inapplicable to the transaction. Therefore, the bases of the assets for each of the two trusts are the same as the original trust’s basis at the time of the transfer.
In its third ruling, the IRS determined that Trust 1 and Trust 2 qualified as QSSTs as defined in IRC Section 1361(d)(3)(B). Under that section, a QSST is a trust in which all of the income is distributed to one individual who’s a U.S. citizen or resident. The section also requires that: during the lifetime of the current income beneficiary, there be only one income beneficiary; any corpus distributed during the life of the current beneficiary be distributed only to such beneficiary; the income interest shall terminate on the beneficiary’s death or the termination of the trust (whichever is earlier); and on the trust’s termination, all of its assets be distributed to such income beneficiary. In the instant case, Trust 1 and Trust 2 were modifications of the original trust, and for federal income tax purposes, the two trusts were treated as a continuation of the original trust. Thus, a division of the trust into Trust 1 and Trust 2 wasn’t a distribution of principal for the purposes of Section 1361(s)(3), and, provided that Trust 1 and Trust 2 distribute their income currently to the spouse during her lifetime, both trusts will be treated as QSSTs after the division.
In the remaining two rulings, the IRS determined that the division of the trust into two subtrusts wouldn’t constitute a disposition of all or any part of QTIP and wouldn’t cause any beneficiary of the original trust or the two subtrusts to have made a gift. Under IRC Section 2519(a), any disposition of a qualifying income interest for life in any property is treated as a transfer of all interests in the property other than the qualifying interest. Treasury Regulations Section 25.2519-1(a) provides that if a donee spouse disposes of a qualifying income interest for which a deduction was allowed under IRC Section 2056(b)(7), the donee spouse is treated as transferring all interest in property other than the qualifying income interest. The donee spouse is treated as making a gift under Section 2519 of the entire trust, less the qualifying income interest. In the instant case, after the division of the trust into Trust 1 and Trust 2, the spouse was still entitled to all of the income, payable at least annually from Trust 1 and Trust 2. She thus had a qualifying income interest in both trusts; therefore, the division of the original trust wouldn’t constitute a disposition of the QTIP as defined in Section 2519.
Moreover, the division into two trusts didn’t change the beneficial interest of the trust beneficiaries, because the spouse will continue to have a qualifying interest in Trust 1 and Trust 2. Furthermore, Trust P and Trust R will remain principal beneficiaries of one-half of the original trust after the spouse’s death. That is, after the spouse’s death, Trust P would be the beneficiary of Trust 1, and Trust R would be the beneficiary of Trust 2. As such, the division of the trust into two subtrusts wouldn’t cause any beneficiary of the original trust, Trust 1 or Trust 2 to have made a taxable gift for federal gift tax purposes under IRC Section 2501.