Mrs. Theodosia Frost, who claims a distant and somewhat spurious relation to Aaron Burr, comes to you in rather a dither, as only a rich widow might muster. Her husband’s ungrateful spawn, Theodosia’s stepdaughter Janice, had the unfailing gall to contest her late husband’s trust, and she now needs your help to mop up the pieces.

You stop Theodosia and explain that you are many things, but a family law attorney, you are not, and although you have dabbled in trust and estate litigation in your younger and more vulnerable years, your practice is 100% dedicated to tax controversy work now. Through muffled tears, she explains that her issue is tax related, but in order to understand the tax issue you must first understand the background to her lamentable situation. After wiping away her tears on a silk Hermes kerchief, she explains the facts to you as calmly as possible.

Theodosia’s late husband, Hamilton,[1] established a revocable trust in 1984, the year after “that little witch” (Janice) was born. In 1991, Theodosia married Hamilton in a lovely ceremony, but only after entering into a marital agreement that was effective as of the date of their marriage. In 1994, Hamilton amended and restated the trust. Hamilton died under mysterious circumstances in November 2017, survived by Theodosia and Janice.

Sadly, the trust and the marital agreement had terms that were inconsistent, such that the trust and the marital agreement could not be administered as executed. The trust provided for certain outright distributions to Theodosia as well as the creation of a qualified terminal interest property (QTIP) trust for her. The balance of the trust’s assets was to be distributed outright to Janice.

Contrary to the terms of the marital agreement, the trust specifically provided that certain real property was to be transferred to the QTIP trust, rather than distributed outright to Theodosia as provided in the marital agreement. Further, while Hamilton provided some benefits to Theodosia in the marital agreement, he provided substantially greater financial benefits to her under the trust.

Most importantly to Theodosia, however, the beneficiary of an IRA owned by Hamilton at his death is uncertain. Hamilton initially designated the trust as the beneficiary of the IRA. However, after he married Theodosia and transferred his IRA to a different bank, he failed to execute a new beneficiary designation the IRA agreement with the new bank provides that, if no beneficiary designation is executed and filed with the bank, distribution of the IRA is made to the account owner’s surviving spouse.

The Settlement Agreement

After much ado and tremendous verbal sparring, which verged on uncouth (though Theodosia would never deign to lower herself to Janice’s level), the women reached a basis of settlement and executed a settlement agreement on December 31, 2019. The settlement agreement generally provides for the termination of the trust. Theodosia was to receive certain property including real property required to be distributed to her under the terms of the marital agreement, as well as the IRA outright and free of trust. Janice was to receive the remaining assets, outright and free of trust. The amounts to be distributed to both would be reduced equally by the expenses of administration of the trust incurred from the date of Hamilton’s death until the date of distribution, and the estate taxes would be charged against and paid from the amount distributed to Janice.

The Form 706

The executor of Hamilton’s estate filed a Form 706 (U.S. Estate and GST Tax Return). On Schedule M, the estate made an election to qualify the entire date of death value of the assets passing to Theodosia under the terms of the settlement agreement for the estate tax marital deduction under IRC § 2056.

You are being hired, Theodosia explains, to obtain a favorable Private Letter Ruling from the IRS supporting the position taken on the Form 706.

The Legal Posture of the PLR

The value of a taxable estate is determined by deducting from the value of the gross estate an amount equal to the value of any interest in property which passes or has passed from the decedent to the surviving spouse.[2] In the case of qualified terminable interest property for purposes of the marital deduction, such property shall be treated as passing to the surviving spouse and not to any person other than the surviving spouse.[3] QTIP property, in turn, is property that passes from the decedent, in which the surviving spouse has a qualifying income interest for life, and to which an election applies.[4]

If as a result of a controversy involving the decedent’s will, or involving any bequest or devise thereunder, a property interest is assigned or surrendered to the surviving spouse, the interest so acquired will be regarded as having “passed from the decedent to the surviving spouse” only if the assignment or surrender was a “bona fide recognition of enforceable rights of the surviving spouse in the decedent’s estate.”[5] Such a bona fide recognition will be presumed where the assignment or surrender was pursuant to a decision of a local court upon the merits in an adversary proceeding following a genuine and active contest.

Importantly, such a decree will be accepted only to the extent that the court passed upon the facts upon which the deductibility of the property interest depends.[6] If the assignment or surrender was pursuant to a decree rendered by consent, or pursuant to an agreement not to contest the will or not to probate the will, it will not necessarily be accepted as a bona fide evaluation of the rights of the spouse.

In Rev. Rul. 66-139, the IRS determined that a valid claim by the surviving spouse to a share in the decedent’s estate, made in good faith and settled as a result of arm’s length negotiations without any court contest, will qualify as a bona fide claim within the meaning of the regulations. Where such claim is paid by the decedent’s estate, the payment qualifies for the marital deduction to the extent that the interest that would have passed to the surviving spouse as a result of the completed exercise of the spouse’s right (i.e., in a court contest) would have been a deductible interest.

In Ahmanson Foundation v. United States,[7] the court held that property distributed to a spouse pursuant to a compromise settlement will be treated as passing from the decedent for marital deduction purposes, only if the distribution represents a good faith settlement of an enforceable claim. Relying on Commissioner v. Estate of Bosch,[8] the court stated that “either a good faith settlement or a judgment of a lower state court must be based on an enforceable right under state law properly interpreted, in order to qualify as ‘passing’ pursuant to the estate tax marital deduction.”[9]

In the present case, Florida statutes provide that a court may terminate a trust due to changed circumstances not foreseen by the settlor of the trust, which is to say the court may terminate the trust if due to circumstances not known and not anticipated, continuation of the trust under its terms would defeat or substantially impair the accomplishment of the purposes of the trust.[10]

Conclusion

In view of Ahmanson, property passing to a spouse pursuant to the settlement of a claim will be treated as passing from the decedent—to the extent the compromise is a bona fide settlement of a legally enforceable claim, meaning that the claim must be settled pursuant to arm’s length negotiations.

You explain to Theodosia that you believe the settlement agreement was bona fide, that both she and Janice had legally enforceable claims, and that the IRS should respect the terms of the settlement agreement. Examining the Code (§ 2056), Treasury Regulations (§ 20.2056-2(d)(2)), administrative decisions (Rev. Rul. 66-139), and case law (Ahmanson and Bosch), it’s your opinion that the IRS will conclude that the property passing to Theodosia under the settlement agreement should be treated as passing directly from Hamilton; therefore, the distributions under the settlement agreement to Theodosia qualify for the federal estate tax marital deduction under IRC § 2056.[11]

Footnotes:

[1] No, the irony wasn’t lost on you either.

[2] IRC § 2056(a).

[3] IRC § 2056(b)(7)(A).

[4] IRC § 2056(b)(7)(B) (stating that the surviving spouse has a qualifying income interest for life if the surviving spouse is entitled to all of the income payable annually or at more frequent intervals and no person has the power to appoint any part of the property to anyone other than the surviving spouse).

[5] Treas. Reg. § 20.2056-2(d)(2).

[6] PLR 201046004 (Nov. 19, 2010).

[7] 674 F.2d 761 (9th Cir. 1981).

[8] 387 U.S. 456 (1967).

[9] Ahmanson Foundation, 674 F.2d at 775.

[10] Fla. Stat. § 736.04113(2)(b) (2020).

[11] As the IRS, in fact, concluded in PLR 201046004, from which the basic facts of this article were taken (and edited for humor).

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