Here We Go Again

It is a common theme of these posts that a transaction has to make sense from a business perspective, that it should not be undertaken primarily for tax purposes, and that the goal of tax planning should be to maximize the economic benefit of the transaction by reducing the resulting tax burden.

Another theme of our posts is that transactions between related persons will be subject to special scrutiny by the IRS to ensure that they comport with arm’s length dealing. If a transaction is not conducted on an arm’s length basis, the government will be free to recharacterize the nature of the transaction so as to realize the appropriate tax result.

The IRS recently ruled on a situation involving the sale of a property by two trusts to a purchaser that was controlled by one of the trust beneficiaries.  The IRS considered  a number of transfer tax issues, some of which may not have been evident to an inexperienced adviser, but the implications of which would have been serious without proper planning. imagesEYV8Z3EW

The Trusts

Grantor 1 had established an irrevocable trust (Trust 1) for the benefit of himself, Spouse, and his lineal descendants. Grantor and Spouse were both dead at the time of the sale.

Grantor 2 had established two equal trusts, one for the benefit of his daughter (Spouse) and her descendants (Trust 2).

Both Trust 1 and Trust 2 were irrevocable prior to September 25, 1985, and no additions were made to either trust after September 25, 1985.  Thus, distributions from the trusts were not subject to the generation-skipping transfer tax (“GSTT”).

The beneficiaries and terms of the two trusts were essentially the same. Trust 1 provided that the trustees were to pay the net income for the benefit of Grantor 1’s issue, per stirpes. Trust 1 was to terminate twenty-one years after the death of the survivor of Grantor 1’s three children (the so-called “perpetuities period”). Trust 2 provided that the trustees were to pay the net income to Spouse’s issue, per stirpes. Trust 2 was to terminate twenty-one years after the death of the last surviving lineal descendant of Grantor 2 living at the time of Grantor 2’s death.

The Sale

Trust 1 and Trust 2 together owned Business Property. The trustees of both trusts decided it was in the best interest of the trusts to sell Business Property in a coordinated sale.

Business Property had been on the market for several years when the trusts found a purchaser: Limited Partnership, which was owned by A, a lineal descendant of both Grantor 1 and Grantor 2, who was the trustee of a trust that was a current beneficiary of Trust 1, and a contingent beneficiary of Trust 2. A was experienced in dealing with assets like Business Property.

An agreement of sale (the “Agreement”) was negotiated by the trusts, with some input from the beneficiaries. The trusts and the purchaser were represented by separate counsel. The agreed-upon sale price was consistent with two independent appraisals. Upon completion of the closing, Trust 1 and Trust 2 each received their proportionate share of the sale price.

The GSTT

The IRS considered whether the execution and/or the carrying out of the terms of the Agreement would constitute an addition to either trust that would cause the trust to lose its exemption from the GSTT.

The IRS also considered whether the entering into the Agreement, and the carrying out of the terms thereof, would cause any beneficiary of either trust to make or be deemed to have made a taxable gift to any other trust beneficiary or to A.

According to IRS Regulations, a modification of the governing instrument of a GSTT exempt trust, including a reformation that is valid under state law, will not cause an exempt trust to become subject to the GSTT if the modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation than the person(s) who held the beneficial interest prior to the modification, and the modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust. A modification that is “administrative” in nature will not be considered to shift a beneficial interest in the trust.

The trusts sought Court approval of the sale of Business Property. The trustees joined with all living beneficiaries of Trust 1 and Trust 2 in the proposed Court proceeding. The Agreement would only be binding on the trusts if the trusts received approval from Court. As part of the proceedings, the trustees petitioned the Court to appoint a guardian and trustee ad litem to represent the interests of minor, unborn, and unascertained descendants of Grantor 1 and Grantor 2. In addition, the Agreement would be binding only if Trust 1 and Trust 2 received from all their beneficiaries ratification and approval of the Agreement. As part of the court approval process, Court had to determine that the Agreement was fair and reasonable, which determination included the determination that the price reflected a fair market value and that the other terms of the sale were reasonable.

The IRS found that the execution and/or the carrying out of the terms of the Agreement and the sale of Business Property were administrative in nature and, so, would not shift a beneficial interest in Trust 1 or Trust 2 to any beneficiary who occupied a lower generation than the person or persons who held the beneficial interest prior to entering into the Agreement or the sale of Business Property. Further, the execution of the Agreement and the sale of Business Property would not extend the time for vesting of any beneficial interest in Trust 1 or Trust 2 beyond the period provided for in the original trusts.

Based on the foregoing, the IRS concluded that the execution and/or the carrying out of the terms of the Agreement would not constitute an addition to either trust or cause either trust to lose its GSTT exempt status.

 The Gift Tax

The IRS next considered whether or not there was a gift tax issues.  Transfers reached by the gift tax include sales, exchanges, and other dispositions of property in exchange for 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 given therefor. However, the IRS Regulations also provide that 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), will be considered as made for an adequate consideration in money or money’s worth and, so, not subject to the tax.

After considering the fact that the trustees obtained two independent appraisals on the value of Business Property, that the Agreement had been negotiated at arm’s length by the corporate trustees of Trust 1 and Trust 2, that the beneficiaries of both trusts consented to the sale, that each of the trusts and the purchaser were represented by separate counsel, that the approval of Court was secured by the trustees demonstrating that the Agreement was fair, reasonable, and that the terms were arm’s length, and that the trustees have a fiduciary duty to act in the best interests of all of the beneficiaries, the IRS concluded that the entering into the Agreement and the carrying out of the terms thereof would not cause any beneficiary of either trust to make or be deemed to have made a taxable gift to any other beneficiary or to A.

It Pays to Plan

The ruling above had a happy ending for the taxpayers, as well it should have. After all, they anticipated, considered and planned for a number of tax issues.

However, what if the facts had been a little different? For example, what if the trustees had been related to the beneficiaries, including the principal of the buyer? What if the trusts did not have separate counsel? What if the purchase price for the property had not been supported by independent appraisals? What if the trustees had decided against seeking a court’s approval? Under those circumstances, the IRS could more easily have argued that the parties did not act at arm’s length and that the sale price did not reflect fair market value.

In that case, the IRS could have concluded that either too much or too little had been paid for the property.

On that basis, the IRS could have concluded that one trust benefited more than the other. One or both trusts may have been treated as having received an additional contribution, either from the related buyer, or from one another, thereby causing them to lose their GSST exemption and subjecting future distributions from the trusts to the 40% GSTT. The IRS could also have concluded that the beneficiaries had made a gift to the principal of the buyer. The surprises abound.

The point is that these “surprises” can and should be avoided. Taxpayers just need to plan ahead, and that means they need to speak to their advisers at the inception of the trust arrangement and at every subsequent event that is out of the ordinary course of business.