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Trust Assets Pursuant to Divorce Settlement Agreement

Beneficiary spouse recognizes no gain, loss or estate inclusion

In Private Letter Ruling 201707008 (released Feb. 17, 2017), the Internal Revenue Service ruled that a wife wouldn’t recognize gain or loss from her husband’s transfer of property to a trust for her benefit under a proposed divorce settlement agreement. Moreover, except for any unexercised withdrawal right that the wife may hold at her death, the trust assets wouldn’t be included in her gross estate.

Divorce Settlement Agreement
A husband and wife separated and filed for divorce. Their proposed divorce settlement agreement provided for a trust to be established for the wife’s benefit. The husband would initially fund it with half of his shares in his company. The wife was to receive the net income of the trust annually, and when the trust held assets other than the company shares, she had a right to withdraw the greater of a certain dollar amount or a percent of the principal for the trust each year. The wife had no powers to appoint trust property during her life or on her death.

The wife was to relinquish all marital rights and property claims acquired during her marriage. On her death, the remaining trust principal would revert to the husband or his estate. The proposed divorce settlement wouldn’t become final or binding until the parties received a favorable PLR from the IRS. Thus, the parties requested three rulings related to their proposed settlement agreement.

No Taxable Gain or Loss
The parties first asked the IRS whether the wife would recognize income tax gain or loss on the creation of the trust. The IRS ruled that she wouldn’t recognize gain or loss on the trust creation. Under Internal Revenue Code Section 1041(a), no gain or loss shall be recognized on a transfer of property from an individual to, or in trust for the benefit of: (1) a spouse, or (2) a former spouse, but only if the transfer is incident to a divorce. IRC Section 1041(b) provides that such property will be treated as acquired by the transferee by gift; the basis of the transferee in the property will be the adjusted basis of the transferor. Section 1041(c) provides that a transfer of property is incident to divorce if the transfer occurs within one year after the date on which the marriage ceases or is related to the cessation of the marriage.

Under Treasury Regulations Section 1.1041-1T(b), Q&A-7, a transfer of property is related to the cessation of a marriage if it’s pursuant to a separation agreement, and the transfer occurs no more than six years after the date on which the marriage ends. In this instance, there was a proposed, formal separation agreement. Under the separation agreement, the husband was to transfer shares of his company to the trust within six years after the entry of the final divorce judgment. In return, the wife was to relinquish all marital rights and property claims that she acquired during the marriage. Thus, under Section 1041, the wife wouldn’t recognize any income tax gain or loss on the creation of the trust.

No Taxable Gift
The parties next asked the IRS whether the wife made a gift of an interest in the trust to any person and was thus liable for federal gift tax.

IRC Sections 2501 and 2511 impose a gift tax on an individual for the transfer of property by gift, whether the transfer is in trust or not. IRC Sections 2702(a)(1) and 2702(a)(2)(A) provide that to determine whether a transfer in trust to or for the benefit of a member of the transferor's family is a gift, the value of any retained interest by the transferor—other than a qualified interest—shall be zero. Under Treas. Regs. Section 25.2702-1(c)(7), Section 2702 doesn’t apply to a transfer in trust if the transfer to a spouse is deemed to be for full and adequate consideration by reason of IRC Section 2516 (relating to property settlements), and the remaining interests in the trust are retained by the other spouse.

In this instance, under the settlement agreement, the husband was to transfer property to the trust in exchange for the wife relinquishing her marital support and property rights. This transfer is one for full and adequate consideration under Section 2516. The husband will retain the entire remainder interest in the trust by reason of the reversion. Therefore, Sections 2501 and 2702 won’t apply to cause the wife to be treated as having made a gift of an interest in the trust to any other person, and she isn’t a transferor for purposes of the federal gift tax.

No Assets Included in Wife’s Estate
Lastly, the parties asked whether the trust assets, to the extent of any unexercised withdrawal rights held by the wife at her death, would be included in her gross estate for federal estate tax purposes. To determine which assets would be included in the wife’s gross estate on her death, the IRS analyzed IRC Sections 2031, 2033, 2036(a) and 2038(a)(1). Because the husband was the transferor, and the wife didn’t retain any power to amend, alter, revoke or terminate any interest in the transfer, those IRC sections didn’t apply to cause inclusion. Moreover, because the wife didn’t pay any part of a purchase price for her interest in the trust, IRC Section 2039(b) didn’t apply to cause inclusion. Similarly, there’s no estate inclusion under IRC Section 2041 because the wife didn’t have any powers to appoint trust property either during her life or on her death. Rather, on her death, her interest in the trust would terminate, and the trust property would revert to her husband or his estate.

However, if the wife predeceased her husband, and if the trust held assets other than the company shares at that time—in addition to trust income payable to the wife on her death—the greater of a certain dollar amount or percent of the non-company principal share minus any non-company principal actually withdrawn would be includible in the wife’s gross estate. 

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