• Company’s operating units constituted active trade or business under IRC Section 6166(a)(1)—In Private Letter Ruling 201928007 (released July 12, 2019), a revocable trust owned shares of a company (which was comprised of six operating units) at the time of the decedent’s death. The taxpayer requested several rulings concerning whether the activities of Operating Units 2, 3, 5 and 6 (collectively, the Operating Units) of the company were sufficient to constitute “carrying on of a trade or business” for purposes of Internal Revenue Code Section 6166(a)(1).
IRC Section 6166(a)(1) provides that if the value of an interest in a closely held business that’s included in determining the gross estate of a decedent exceeds 35% of the adjusted gross estate, the estate may elect to pay all or part of the estate tax attributable to the business in up to 10 installments. Revenue Ruling 2006-34 contains a non-exclusive list of factors that are relevant in determining whether real property interests are interests in a closely held business for purposes of Section 6166. Although Rev. Rul. 2006-34 addresses interests in real estate, the factors in the revenue ruling are helpful in evaluating whether other interests are those of an active trade or business.
For an interest in a business to qualify as an “interest in a closely held business,” a decedent must conduct an active trade or business or must hold an interest in a partnership, limited liability company or corporation that itself carries on an active trade or business.
The Internal Revenue Service held that the activities of the Operating Units each separately constituted an active trade or business for purposes of Section 6166(a)(1). Operating Unit 2 provided remarketing, management and support services regarding equipment owned by the company, had full-time employees and secured most lessees and customers through its direct activities. Operating Unit 3 employed full-time employees who were involved in the day-to-day operations, management and maintenance of real estate. Operating Unit 5 employed full-time employees who were responsible for overseeing all facets of construction and supervising operations of an independent property management firm. Operating Unit 6 hired employees who were involved on a daily basis in all aspects of the management and food services of a hotel (which was owned and operated by a separate hotel management company).
The IRS noted that the use of independent contractors to perform work doesn’t prevent the business activities from rising to the level of the conduct of an active trade or business provided that the third-party activities don’t reduce the activities of the corporation to merely holding investment property.
Notably, the IRS held that only specific Operating Units of the company (not the company itself) were “carrying on of a trade or business” for purposes of Section 6166(a)(1). Footnotes in the ruling expressly state that the IRS didn’t address whether the decedent’s interests in the Operating Units qualified as an interest in a closely held business for purposes of Section 6166(a)(1).
Operating Unit 2 was a division of Operating Unit 1. Operating Unit 3 was a division of the company. Operating Unit 5 was owned by a holding company, which was owned by the company. The ruling provides that the company is the “sole member” of Operating Unit 6. Section 6166 requires the entity owned by the decedent to carry on the trade or business, not a subsidiary. However, an estate that owns stock in a “holding company” (which is defined as “any corporation holding stock in another corporation”1) may also qualify for Section 6166 deferral (with some modifications) if the executor makes an election pursuant to Section 6166(b)(8). If the executor makes this election, then the portion of the stock of any holding company that represents direct ownership (or indirect ownership through one or more other holding companies) by such company in a “business company” (defined as any corporation carrying on a trade or business2) will be deemed to be stock in such business company.3
However, there’s no guidance as to whether or when an interest in a holding company (regardless of form) that owns interests in one or more active businesses that are in forms other than corporations may qualify under Section 6166. In this ruling, the legal form of the Operating Units is unclear.
• CLAT recognizes no gain or loss from distribution of assets on early termination—In PLR 201928005 (released July 12, 2019), a taxpayer requested a ruling on the federal income tax consequences of the termination of a charitable lead annuity trust (CLAT). The CLAT provided for annual annuity payments to an IRC Section 501(c)(3) tax-exempt charitable foundation (Foundation). At the end of the CLAT, the remaining property would revert to the trust creator or its assigns. The trust creator assigned its interest to A, who died before the end of the CLAT term. Under A’s will, A’s estate transferred the remainder interest in the CLAT to the Foundation.
The CLAT proposes to seek a state court order to terminate the trust and to transfer all of the CLAT’s property to the Foundation. Under applicable state law, a court may terminate a trust if, because of circumstances not anticipated by the settlor, termination will further the purposes of the trust.
Treasury Regulations Section 1.661(a)-2(f)(1) provides that if property is paid, credited or required to be distributed in kind by a trust or estate, no gain or loss is realized by the trust or estate (or the other beneficiaries) by reason of the distribution, unless the distribution is in satisfaction of a right to receive a distribution in a specific dollar amount or in specific property other than that distributed. Rev. Rul. 83-75 holds that the distribution by a trust of appreciated securities in satisfaction of its obligation to pay a fixed annuity to a charitable organization results in a taxable gain to the trust.
The IRS held that the distribution of the CLAT’s assets to the Foundation as a result of the state court order isn’t a distribution in satisfaction of a right to receive a distribution of a specific dollar amount or in specific property other than that distributed, nor is it a distribution in satisfaction of a general claim for an ascertainable value, and, therefore, the CLAT will recognize no gain or loss as a result of such distribution.
• GST tax exemptions automatically allocated to transfers made to trusts—In PLR 201924001 (released June 14, 2019), a taxpayer requested a ruling on whether a settlor and settlor’s spouse’s respective generation-skipping transfer (GST) tax exemptions were automatically allocated to transfers made to trusts created for the settlor’s issue under the automatic allocation rules of IRC Section 2632(c).
The settlor created separate irrevocable trusts for each of the settlor’s children. The settlor funded each child’s trust with an interest in a limited partnership. Each child’s trust provided that the trustee may make distributions of income and principal to the beneficiary for health, maintenance, education and support in the trustee’s discretion, and after attaining age 30, the beneficiary would be entitled to receive all of the net income of the trust. On the beneficiary’s death, if the beneficiary attained age 34, the beneficiary could appoint the principal in favor of anyone other than the beneficiary, the beneficiary’s estate, the beneficiary’s creditors and the creditors of the beneficiary’s estate. The beneficiary also had a contingent general power of appointment (GPA), so that if the beneficiary was survived by the issue of the settlor’s parents and the distribution of principal to such issue would trigger GST taxes, the beneficiary would have the power to appoint that share to the beneficiary’s creditors. On the beneficiary’s death, any portion of the remaining balance for which the beneficiary hasn’t exercised such GPA would be divided among the beneficiary’s issue who survive the beneficiary or, if none, among the living issue (who are also the living issue of the settlor) of the nearest ancestor of such beneficiary.
On a timely filed Form 709, the settlor and the settlor’s spouse reported the transfers to each child’s trust and elected to split the gifts, but failed to report the transfers as indirect skips (instead reporting the transfers as only being subject to gift tax). No automatic allocation of the GST tax exemption was indicated on the Form 709.
The IRS held that each child’s trust satisfied the definition of a GST trust under Section 2632(c)(3)(B), the transfers were indirect skips and the settlor and the settlor’s spouse’s respective GST tax exemptions were automatically allocated to the transfers. Section 2632(c)(3)(B)(iv) excludes from the definition of a GST trust one in which any portion would be included in the gross estate of a non-skip person if such person died immediately after the transfer.
Assuming the settlors had living grandchildren, it wasn’t certain that if a beneficiary died, the trust property would pass to a skip person, which was a prerequisite to the GPA. The beneficiary, if age 34, would also have a special power of appointment (SPA) in favor of others, including non-skip persons. Thus, it couldn’t be definitely said that the trust property would be included in the beneficiary’s estate, rendering it a GST trust. We can only presume that the beneficiaries were at least 34 years of age at the time of the gift and could exercise the SPA, or none of them had any children at the time of the gift. If a child was under 34 (that is, couldn’t exercise the SPA) and there were any living grandchildren of the settlors at the time of the gift, then the GPA would have applied if a beneficiary died immediately after the gift, making it a non-GST trust.
• U.S. citizen due to residence in U.S. possession treated as nonresident alien for purposes of federal estate, gift and GST taxes—In PLR 201924009 (released June 14, 2019), the taxpayer requested a ruling regarding the taxpayer’s status as a nonresident, not a citizen of the United States for purposes of federal estate, gift and GST tax under IRC Sections 2209, 2501(c), 2652 and 2663 and Treas. Regs. Section 26.2652-1(a)(2).
The taxpayer was born outside the United States, and at the time of his birth, neither of the taxpayer’s parents were born in or were citizens, nationals or residents of the United States nor any of its possessions or territories. The taxpayer later relocated to a U.S. possession under IRC Section 7701(d) (presumably Puerto Rico, based on the ruling) with a student visa. Section 7701(d) provides: “… references in this title to possessions of the United States shall be treated as also referring to the Commonwealth of Puerto Rico.” After graduating from college, the taxpayer began working in Puerto Rico with a work visa. Since his relocation, the taxpayer continuously resided in Puerto Rico. The taxpayer became a permanent resident of Puerto Rico, and later, the taxpayer became a citizen of the United States through naturalization proceedings.
The IRS held that because the taxpayer acquired his U.S. citizenship solely by reason of his residence within a U.S. possession, the taxpayer is presently considered a “nonresident not a citizen of the United States” for federal estate, gift and GST tax purposes. So, despite being a U.S. citizen, the gift and estate tax rules applicable to a nonresident alien (NRA) apply to this taxpayer: If a U.S. spouse bequeaths assets to the taxpayer, it must be in a qualified domestic trust; there’s a limited gift tax annual exclusion for gifts by the U.S. spouse to the taxpayer; the taxpayer has only a $60,000 estate tax exemption; only those assets of the taxpayer that would be subject to estate tax for an NRA would be subject to estate tax (for example, stocks in U.S. companies); and only transfers by the taxpayer of real estate and tangible property situated in the United States would be subject to gift tax.
• Ohio court refuses to provide equitable reimbursement to grantor for trusts’ income tax liability—In Millstein v. Millstein, 110 N.E.3d 674 (8th Dis. App. 2018), Norman Millstein sought to compel the trustee of two irrevocable grantor trusts to reimburse him for income taxes he paid on behalf of the trusts. Norman created the irrevocable trusts for the benefit of his children, and each of the trusts were grantor trusts as to Norman for income tax purposes. Norman argued it was inequitable for the trustee not to reimburse him for those taxes and that he was entitled to a “fiduciary accounting” because he “has been saddled with millions of dollars of income tax liability” over a 20-year period due to the administration and activities of the trusts. He didn’t attach copies of the trust agreements to his complaint.
The Court of Appeals of Ohio affirmed the trial court’s dismissal of Norman’s claims for reimbursement and for a full accounting of the trusts’ assets. The court agreed with the trial court’s assessment that there’s no cognizable claim in Ohio for equitable reimbursement to a grantor for tax liability incurred under the terms of a trust that the grantor created. Also, as per the clear terms of the trusts, Norman was entitled to an annual financial report of the trusts’ assets (not a full fiduciary accounting). The court noted that Norman “voluntarily created the situation that he now claims is inequitable.” This decision may serve as a reminder for practitioners to build in an “escape hatch” for clients to turn off grantor trust status if the payment of income taxes becomes too onerous.
1. Internal Revenue Code Section 6166(b)(8)(D)(i).
2. IRC Section 6166(b)(8)(D)(ii).
3. Section 6166(b)(8)(A). Under Section 6166(b)(8)(C), for purposes of determining whether stock in a business company that the estate is deemed to hold is an “interest in a closely held business” within the meaning of Section 6166(b)(1)(C) (that is, for purposes of passing the 20% test), such stock will be treated as voting stock to the extent that the voting stock that the holding company owns directly (or through its voting stock of one or more other holding companies) is voting stock in the business company.