• District court holds that ex-spouse beneficiary is obligated to pay share of tax related to insurance under Internal Revenue Code Section 2206—In Smoot v. Smoot, a case in the U.S. District Court for the Southern District of Georgia (March 31, 2015), Thomas Smoot III sued his father’s ex-wife, Dianne Smoot, seeking contribution for a proportionate share of the estate taxes due. The gross estate of his father, Thomas Smoot II, was valued at approximately $7.7 million. Dianne was named as the beneficiary of retirement plans, including deferred compensation benefits, an individual retirement account, a 401(k) and an annuity, as well as several life insurance plans, all totaling about $5.4 million.
Thomas III, as executor of his father’s estate, initially filed an estate tax return that took the position that the estate was insolvent and owed no taxes. However, the Internal Revenue Service disputed the position, and the estate ultimately settled on an estate tax liability of about $1.27 million. After the settlement, Thomas III contacted Dianne to seek reimbursement, but she refused.
Thomas II’s will required that all estate taxes (other than generation-skipping transfer (GST) taxes) be paid by the recipient of such property or be charged against the property to be received. Similarly, under IRC Section 2206, the executor is entitled to recover from beneficiaries of life insurance policies the portion of estate tax related to policy benefits that are includible in the estate but not paid to the estate, as long as there’s no other direction in the decedent’s will. The court found that the decedent’s will didn’t direct otherwise, that (after an analysis of the admissibility of the documents related to the insurance as evidence) Thomas II did have incidents of ownership over the various policies payable to Dianne and, as a result, that they were includible in his estate. The court held that Dianne was responsible for the share of estate taxes (and interest) related to the insurance under IRC Section 2206.
However, the court also held that Dianne wasn’t obligated to pay the proportional share of estate tax related to the other assets (IRA, 401(k), annuity and deferred compensation) because the divorce nullified the provision of the will requiring apportionment as applied to Dianne. Georgia law provides that on divorce, all provisions of a will made without contemplation of a divorce or annulment take effect after such divorce or annulment as if the former spouse has predeceased the testator. The court held that the plain language of the Georgia statute meant that the tax apportionment clause must be applied as if Dianne had predeceased Thomas II; therefore, she wasn’t responsible for any portion of the estate tax. Interestingly, the court didn’t address the effect of Georgia law when analyzing whether Thomas II’s will “directed otherwise” in apportioning taxes under Section 2206.
The court noted that the Georgia legislature may not have intended this result, but there was nothing the court could do. Smoot is a good reminder to update client documents frequently and, when appropriate, acknowledge an impending divorce. Thomas II had reviewed his beneficiary designations two months before his death to make sure they were in order and confirmed that Dianne should be the beneficiary of his retirement benefits and insurance policies, but it isn’t clear whether he intended her to receive the retirement benefits without sharing the tax burden.
• Merger of two trusts doesn’t affect GST tax grandfathered status—In Private Letter Ruling 201516036 (April 17, 2015), the IRS held that a merger of two trusts wouldn’t affect the grandfathered status of one of the trusts for GST tax purposes. The interesting aspect of the ruling was that different grantors established the two trusts to be merged.
An individual established a trust for his son and descendants prior to Sept. 25, 1985, so it was grandfathered for GST tax purposes (Trust A). The son’s spouse also established an irrevocable trust for the son (Trust B). She allocated GST tax exemption to the trust so that it was fully exempt. The terms of the trusts during the son’s life were identical.
After the son’s death, Trust A provided that any trust property would be paid to the son’s descendants, subject to being held in trust for any person under age 21. Trust B provided that on the son’s death, the trust property would also be divided among the son’s descendants but held in separate trusts for each individual’s benefit and over which each individual beneficiary had a general power of appointment (POA).
The family proposed merging the two trusts; the resulting trust would be subject to the terms of Trust B. The IRS held that the merger wouldn’t affect the grandfathered status of Trust A’s property because there were no material changes in the beneficial interests of the trust beneficiaries, and the time for the vesting of beneficial interests wasn’t postponed or suspended. This result was due to the general POA granted to each of the son’s descendants in Trust B, which caused his share of the trust property to be includible in his estate and each descendant to be treated as the transferor of his share of the trust property for GST tax purposes. So, even though property could continue to be held in trust for a descendant over age 21, it didn’t present a problem for GST tax purposes.
The IRS also confirmed that after the merger, the portions attributable to the different trusts would be treated as separate trusts for GST tax purposes because each had a different grantor.
Presumably, the merger was proposed to prevent outright distribution of the son’s trust to his descendants at his death. This merger had the effect of a decanting, as the taxpayers were able to alter the dispositive terms governing the property of Trust A for the son’s descendants.