Jay and Gloria are a wealthy, married couple. Jay has an adult daughter from a previous marriage. Her name is Claire. Gloria also has a child from a previous marriage, a 12-year-old boy named Manny. Jay and Gloria have a daughter together. Her name is Chloe.
Jay is old enough to be Gloria’s father. The rigors of marriage are too much for Jay to handle and he dies, a happy man. He is survived by Gloria and the three children. Before he died, Jay had created, on his own, a will, stating that half of his “adjusted gross estate” would pass to a marital trust for Gloria, and the other half of his adjusted gross estate would pass in equal shares to all his children, including Manny, outright and free of trust.
All net income of the marital trust will be distributed to Gloria annually. The marital trust does not allow for invasion of principal. Upon Gloria’s death, the marital trust passes in equal shares to all children, including Manny, outright and free of trust.
Years before Jay’s death, he and Gloria separated, but did not divorce. During that time, they entered into a marital settlement agreement. They later reconciled.
After Jay’s death, his daughter, Claire, claimed Jay’s will should be set aside and no part of Jay’s estate should pass to Gloria due to the marital settlement agreement.
Jay’s estate, and Chloe and Manny, settle Claire’s claims by buying out Claire’s interest in the marital trust and paying out her share of the residue of the trust early. So, what are the tax consequences?
General Tax Considerations
The settlement of a will contest does not generate income tax if the settlement payment is made pursuant to an enforceable right, there is a bona fide dispute, and the nature of the transfer is that of a gift or inheritance. For tax purposes, it is important to substantiate these elements in the Settlement Agreement. Moreover, even though court approval of a settlement agreement is not absolutely necessary, it helps to bolster the legitimacy of the settlement agreement in front of the IRS.
Income Tax Considerations
Generally, most trusts will contain a spendthrift clause that prohibits the assignment of an interest in the trust. In this case, Jay prepared his own will and failed to include a spendthrift clause, thereby making it possible to effectuate a sale of the remainder interest in the trust.
The sale of remainder interest by Claire to Chloe and Manny is a taxable event and a capital transaction. For purposes of determining the amount of gain or loss, the basis divided between the life tenant (Gloria) and the remainder beneficiary (Claire) is based on IRS factors.
In this case, the value paid for interest must account for the time value of money (i.e., the purchased reminder interest will not vest until Gloria’s death) and the likelihood that estate taxes will be paid by the marital trust upon Gloria’s death. Because the purchase price of the remainder interest will be much less than its pro rata share of the marital trust’s underlying assets in order to account for those factors, the transaction may result in a capital loss rather than a capital gain. The basis that Chloe and Manny will have in the trust interest purchased from Claire is not important because the assets in the marital trust will be included in Gloria’s estate, and, therefore, will receive an adjustment in basis at the time of her death.
Lastly, it should be noted that Claire and her descendants would likely be contingent remainder beneficiaries of the marital trust in the event either or both Chloe and her descendants and Manny and his descendants did not survive Gloria. Therefore, those interests must be accounted for in the sale or it may be necessary to judicially reform the provisions of the marital trust to remove those contingent remainder interests and ensure that the trust passes correctly in the event of an out of order death.
Gift, Estate and Generation-Skipping Transfer Tax Considerations
Because the purchase of the remainder interest in the marital trust is for full and adequate consideration after arm’s length negotiations in settlement of a will contest, the transfer should not be characterized as a gift.
Chloe and Manny used their own assets to purchase the remainder interest in the marital trust from Claire. Gloria’s interest in the marital trust was unaffected by the transaction. Consequently, there would be no loss of the marital deduction due to the transaction.
Lastly, the purchase of the remainder interest in the marital trust did not involve any transfer of value to a grandchild or more remote descendant. Thus, the transaction should not have any generation-skipping transfer tax implications.
The settlement of a will contest can be effectuated in any number of different ways. Not only is it important to be creative in the design of the settlement, it is critical to plan for the tax implications of a settlement.
The scenario described above is taken from the recent seminar that was presented by Dean Mead’s Estate & Succession Planning department on August 5, 2014 in Orlando. Please check back soon and we’ll provide another case study that was included in that presentation.