By Joseph L. Wyatt Jr.

Resolution of estate and trust litigation usually has tax consequences. Keeping these consequences in mind when negotiating settlements before, during and after litigation is important. Positive or negative answers to tax liability questions can substantially affect the net result and can even make or break the settlement. Fortunately, the IRS can help guide these settlements out of the woods. A private letter ruling may be just what is needed to give parties and their lawyers the lay of the land in completing a settlement.

Assume, for example, that a trustee pays money to the trust to settle a claim against the trustee for breach of trust. If the trustee paid the money to remedy damage to trust principal, the payment will result in a reduction of the trust's basis in its assets. If the trustee paid the same amount for damage to trust income, the trust will recognize income from the payment. If a deceased trustee's estate makes the payment, the estate may deduct the payment as a claim under Code 2053(a)(3). If an individual trustee serving without fee pays the claim, he or she probably cannot deduct the payment. The point of these examples is that the structure of a settlement can affect its tax consequences, and knowing the tax consequences of a settlement first is a lot cheaper and less risky than finding out afterward. Fortunately, parties can determine the answers to federal tax questions raised by a proposed settlement before they finalize their agreement or at least can make the settlement contingent on a satisfactory resolution of the tax questions. Because the tax consequences of settlements are so important, the willingness of the IRS to issue rulings on tax matters is just as important. This article discusses the IRS' willingness to cooperate in settlement efforts, focusing particularly on the use of private letter rulings.

Private Letter Ruling Requests
The lawyer's tool of choice to obtain IRS assistance in settling disputes is the private letter ruling. A private letter ruling is a written statement, issued by the National Office of the IRS to a taxpayer, that interprets and applies the tax laws to a specific set of facts. The IRS issues explicit instructions for requesting a letter ruling at the start of each year in a Revenue Procedure, which in large part takes the mystery out of drafting ruling requests. See Rev. Proc. 98-1, 1998-1 I.R. B. 7.

Trusts and estates litigators requesting private letter rulings should pay particular attention to the following requirements:

  • Include the names, addresses and taxpayer account numbers of all interested parties, such as trust or estate beneficiaries, concerned heirs and guardians ad litem for the unborn or minors appearing in the litigation.
  • State fully and precisely the "business" (i.e., "non-tax," including "family" and "personal") reasons for the transaction.
  • Analyze each document bearing on the issues and highlight the pertinent provisions. Do not unload a pile of unintelligible documents on the IRS without detailing the relevance of each.
  • Do not propose alternative plans or hypothetical situations, although you may submit an alternative plan after the IRS has ruled in an unwelcome manner or modify a proposed transaction in the face of informal expressions by the IRS.
  • Provide a statement of proposed deletions of information that is to be kept confidential.
  • If seeking a desired conclusion on a prospective transaction, sum-marize the facts that control in reaching the requested conclusion, and include a complete statement of facts, documents and other data. This type of ruling is known as a "two-part" ruling.
  • State your view of the tax results, whether you are for a particular result or not. Discuss the authorities con as well as pro.
  • Include a declaration by every taxpayer under penalty of perjury. (The person signing the required declaration under penalty of perjury for a trust (who must be the requesting person, not a representative) must have personal knowledge of the facts.)
When all parties interested in a settlement desire the ruling or will be affected by the ruling, they should all join in the request_even though it may be onerous to obtain declarations under penalty of perjury from all parties in the case of private trust or estate matters. Why all? For at least three reasons:
  • to ensure that all interested parties are before the IRS;
  • to protect the separate interests of each party in any of the negotiations that may occur as the IRS considers the matter; and
  • to be sure that whatever beneficial effect is derived from the ruling will be enjoyed by all interested parties and that all may rely on it.
Otherwise, the proceedings in connection with the IRS' consideration of the matter will exclude those who do not join in the request, and the ruling will not apply to the non-signers when issued because the IRS routinely directs all rulings to the requesting taxpayer only; outsiders may not cite private letter rulings as precedent.

When the IRS Will Not Rule
Although the IRS has discretion in issuing letter rulings, it will not ordinarily refuse to rule on the facts of a bona fide situation. The IRS, however, refuses to issue advance letter rulings in certain general areas:

  • situations involving primarily fact issues, such as fair market value;
  • transactions to be consummated in the indefinite future, although the fact that the settlement depends on specific future events that may occur at an indeterminate date or may not occur at all (such as a settlement conditioned on issuance of a favorable letter ruling) is no obstacle to obtaining a private letter ruling;
  • transactions having tax reduction as a major purpose;
  • part (only) of an integrated transaction;
  • alternate plans of proposed transactions or hypothetical situations.
Even if the IRS is unwilling to issue a ruling, it may sometimes issue "information letters" to provide a general discussion of the issue for the taxpayer's guidance.

The IRS also maintains a list of areas in which it refuses or "ordinarily" (i.e., absent "unique and compelling reasons") refuses to issue advance letter rulings; it updates this list at the beginning of each calendar year. For instance, Rev. Proc. 98-3, 1998-1 I.R.B. 100, lists topics on which the IRS will not "ordinarily" rule or will not rule because the subject is "under extensive study." The Revenue Procedures now identify changes from the prior year's lists, and the IRS may modify the lists during the year. The lists are not all-inclusive; the IRS may decline to issue a ruling whenever warranted in a particular case.

The IRS similarly identifies specific areas on which it has consistently refused to issue rulings, including the following matters related to trusts and estates:

  • Whether the period of administration or settlement of an estate is reasonable or unduly prolonged (Code 641).
  • Whether an estate or trust may obtain an unlimited deduction for amounts set aside by the estate or trust for charitable purposes when there is a possibility that the principal of the trust or estate may be invaded (Code 642(c)).
  • Actuarial factors valuing interests in the prospective gross estate of a living person (Code 2031).
  • Actuarial factors for valuing a taxpayer's prospective or hypothetical gifts (Code 2031). The IRS also announces a list of "areas under extensive study" about which it will not issue private rulings until it resolves the issue by publishing a revenue ruling, revenue procedure, regulation or other authority. The list currently includes these items affecting trusts and estates:
  • Whether a grantor will be considered the owner of any portion of a trust when:
  • v the trust principal consists or will consist substantially of insurance policies on the life of the grantor or the grantor's spouse;
  • the trustee or any other person has a power to apply the trust's income or principal to the payment of premiums on policies of insurance on the life of the grantor or the grantor's spouse;
  • the trustee or any other person has a power to use the trust's assets to make loans to the grantor's estate or to pur-chase assets from the grantor's estate; and
  • there is a right or power in any person that would cause the grantor to be treated as the owner of all or a portion of the trust under Code 673 - 677.
  • Whether the transfer of property to a trust will be a gift of a present interest in property when:
  • the trust principal consists or will consist substantially of insurance policies on the life of the grantor or the grantor's spouse;
  • the trustee or any other person has a power to apply the trust's income or principal to the payment of premiums on policies of insurance on the life of the grantor or the grantor's spouse;
  • the trustee or any other person has a power to use the trust's assets to make loans to the grantor's estate;
  • the trust beneficiaries have the power to withdraw, on demand, any additional transfers made to the trust; and
  • there is a right or power in any person that would cause the grantor to be treated as the owner of all or a portion of the trust under Code 673-677. If the beneficiaries of a trust permit a power of withdrawal to lapse, whether Code 2514(e) will be applicable to each beneficiary in regard to the power when:
    • the trust principal consists or will consist substantially of insurance policies on the life of the grantor or the grantor's spouse;
    • the trustee or any other person has a power to appoint the trust's income or principal to the payment of premiums on policies of insurance on the life of the grantor or the grantor's spouse;
    • the trustee or any other person has a power to use the trust's assets to make loans to the grantor's estate or to purchase assets from the grantor's estate;
    • the trust beneficiaries have the power to withdraw, on demand, any additional transfers made to the trust; and
    • there is right or power in any person that would cause the grantor to be treated as the owner of all or a portion of the trust under Code 673-677.
    • Whether a "grandfathered" trust, irrevocable on September 25, 1985, will lose its status if its situs is moved outside the United States.
When the IRS Will Help Settle Disputes
Critical for litigation settlements is the IRS' longstanding position against ruling on "the tax effect of a transaction if any part of the trans-action is involved in litigation among the parties affected by the transaction [except bankruptcy reorganization transactions]." Rev. Proc. 98-3, 4.02(6), 1998-1 I.R.B. 100. Although this restrictive provision has been on the books since July 1983, the IRS has cited it only once, in a 1986 private letter ruling involving pending Tax Court litigation. PLR 8635033.

Despite this rather specific restriction when the "transaction is involved in litigation among the parties affected by the transaction," in many areas the IRS has issued rulings that materially assisted litigants in determining the tax consequences of proposed settlements in pending disputes. Although, under Code 6110(j)(3), almost every letter ruling dutifully recites that it "may not be used or cited as precedent," in fact these past rulings are valuable to litigators as well as tax professionals because they reveal not only the attitude of the IRS towards the tax law that the ruling interprets but also the IRS' view on questions of local law that frequently arise in trust and estate disputes and the factual situations that give rise to the proposed settlements.

The IRS may issue a ruling even if the settlement and court approval is contingent on a favorable ruling, and even though the litigation may recommence if the ruling is not favorable or does not meet the approval of the settling parties. The IRS will also issue rulings that are essential to the settlement of disputes, whether the parties are embroiled in litigation or have not yet made it to the courthouse. E.g., PLR 8321162 (involving disputes between a charity and the charity founder's family); PLR 7851034 (involving a settlement of "pending or threatened lawsuits").

Although the existence of controversy between the parties as a predicate to a good faith settlement is no guarantee that the IRS will recognize the settlement for tax purposes, the most important common denominator in settlement rulings is the frequent emphasis on the extensive and disputatious character of litigation, a feature that obviously impresses the IRS when the parties seek its help in settling. PLRs 8726027, 8709058, 8244124.

Conversely, the absence of controversy may lead the IRS to reach a negative conclusion. For instance, in PLR 9610004, the parties agreed not to probate a deceased husband's will so that the wife would take everything under intestacy laws. The IRS ruled that the property did not pass from the decedent to the surviving spouse for purposes of the marital deduction but rather from the heirs to the surviving spouse. Accordingly, the marital deduction was not available for the payment to the spouse. The IRS noted that "there was no indication of a conflict among the parties to the agreement that would result in adversarial proceedings and, therefore, "the agreement does not represent a compromise, bona fide or otherwise, between the parties that would constitute an arm's length negotiation."

  • The rulings noted below (listed by Code section) illustrate the extent to which the IRS has ruled in matters affected by, and affecting, the settlement of trust or estate disputes for purposes of resolving tax questions raised by the settlement.
  • Section 61: Whether a settlement will create income to any of the parties. PLRs 8902045, 8743019, 8726016.
  • Section 102: Whether a payment received in a settlement is excluded from income as a gift under Code 102. PLR 9423015.
  • Section 302: Whether a stock redemption is within the provisions of Code 302, thereby making any gain recognized on the redemption capital gain. PLR 8709058.
  • Section 501(c)(3): Whether the settlement of a controversy involving a tax-exempt charitable organization will endanger the organization's tax-exempt status. PLR 9525056, PLR 8818012.
  • Section 507: Whether the spin-off of assets to a separate foundation by a tax-exempt nonprofit corpora-tion under a settlement results in a foundation termination tax under Code 507(c). PLR 9513006.
  • Section 643(f): Whether trusts partitioned into separate trusts as part of a settlement will be taxed separately or together under Treas. Reg. 1.641(a)-(c), which requires that trusts be aggregated for federal income tax purposes if they were formed to avoid tax. PLRs 8902045, 8726027. It is in cases like these that the IRS will investigate__and be impressed by__the contentious (even hostile) character of the disputes between, for instance, a grantor's estate, a trust and the trust beneficiaries.
  • Section 661: Whether the distribution and transfer of assets under a settlement agreement will result in income tax to an estate or trust or whether such a distribution or transfer constitutes distribution of property and satisfaction of the right to receive specific property under Treas. Reg. 1.661(a)-(2)(f)(1).
  • Section 664(d)(2): Whether a trust established under a settlement between a family and a charitable foundation as a device to allocate the income and remainder interests of assets of an estate qualifies as a charitable remainder unitrust. PLR 8929049.
  • Section 1001(a): Whether any party to a settlement agreement realizes gain or loss as a result of complying with a settlement agreement. PLRs 9649015, 8902045, 8743019.
  • Section 1031: Whether the exchange of commonly owned properties, designed to eliminate common ownership and terminate litigation, qualifies as income tax free like- kind exchanges. PLRs 9543011 and 9535028-9535033 (apparently illustrating a situation in which separate taxpayers, though involved in a common settlement transaction, were either unable or unwilling to join together to request one ruling for all).
  • Section 2053: A divorcing couple in a community property state sought to avoid selling stock in a closely held company that was the principal asset of the marriage and entered into a complex settlement including an annuity agreement in favor of the wife. The IRS ruled that if the husband predeceased the wife, the total of the outstanding payments that the husband's estate would need to pay to the wife under the annuity agreement constituted a claim against the husband's estate that would qualify for a deduction under Code 2053. The IRS ruled that the claim would be valued based on its actuarially determined present value at the husband's date of death, which would include consideration of post-death events as evidence of that pres-ent value. PLR 9644053.
  • Whether payments under a settlement agreement qualify for the federal estate tax marital deduction. For instance, the IRS has ruled whether payments in settlement of a widow's claim contesting the validity of her husband's irrevocable trust in favor of a charity qualified for a marital deduction and whether the claim was invalid under state law because it was barred by the statute of limitations. TAM 7840008. This ruling shows the effect of persistent advocacy and illustrates the fact that more than one conference at the National Office level may be permitted when new facts or new law is uncovered to overcome initial IRS resistance. IRS recognition of the settlement payment as entitled to the marital deduction substantially reduced the federal estate tax in the situation presented in the ruling. In effect, the government helped subsidize the settlement and thus made it palatable.
Similarly, when a decedent's surviving spouse became embroiled in litigation with his first wife and children of the first marriage who sought to enforce a property settlement incident to the end of the first marriage, the parties negotiated a settlement that gave certain funds to some of the decedent's first family and distributed the residue outright to the surviving spouse_in effect rewriting the decedent's will and deleting the marital trusts created under the will. The IRS allowed a marital deduction for the sum distributed outright to the surviving spouse, thereby facilitating the settlement. PLR 9610018.

Finally, in PLR 9546004, the decedent was survived by a spouse, son and daughter and left a will giving his estate solely to his children, with no provision for his widow. The widow petitioned the probate court for an order to enforce her claims against the estate and to grant her certain rights provided to a surviving spouse by local law. The executor objected. The parties settled the matter with an agreement by the executor to set up a marital deduction trust for the wife_again in effect rewriting the decedent's will. The IRS ruled that the date-of-death fair market value of the trust would qualify for the marital deduction, contingent on the executor making a valid QTIP election under Code 2056(b)(7).

If, however, the surviving spouse had no enforceable right to a payment received in settlement of litigation, the IRS will not recognize the settlement for tax purposes under the "passing" test. Carpenter v. Comm'r, 52 F.3d 1266, 1274 (4th Cir. 1995). For example, PLR 9530003 involved a widow accused of murdering her husband. Local law precluded the widow, if convicted, from receiving any interest in her husband's estate. The widow entered into an agreement with her children purporting to settle their respective claims to the husband's estate under his will before the widow's murder trial. The widow was thereafter convicted of second degree murder but still received property under the settlement agreement. The IRS did not recognize the settlement for the purposes of determining what property passed to the widow from her husband and what qualified for the estate tax marital deduction under Code 2056. The IRS noted that, in view of her conviction and the effect of local law, whatever she received under the agreement did not pass from the decedent to the spouse but rather from her children.

  • Section 2501: Whether a divi-sion of trusts is a taxable gift. PLRs 9528012, 9523029.
  • Section 2511: Whether a party to a settlement agreement and court order implementing the settlement agreement will make a taxable gift as a result of complying with the agreement and order. PLR 8902045.
  • Section 2601: Whether an agreement partitioning trusts grand-fathered from the generation-skipping tax causes any of the trusts to lose their grandfathered status. E.g., PLR 9423015 (ruling on gift, income and GST tax issues arising from a court-affirmed settlement of litigation that followed the breakdown of a 22 year old settlement adjusting a lawyer's will drafting mistake).
  • Section 4941: Whether a settlement agreement between a charity and a disqualified person constitutes an act of self-dealing, including situations in which the charity makes a payment to a disqualified person. PLRs 8324085, 8321162.
  • Section 7872: Whether interest is imputed to any beneficiary or to a trust in consequence of the apportionment of capital gains taxes in settlement of the question of whether income or principal must pay the taxes under an ambiguous tax payment clause in a trust. PLR 8902045.
Since 1988 (and currently until October 1, 2003) a fee program to obtain rulings is in force, the amounts varying according to categories established by the Secretary of the Treasury. A schedule of fees appears at Appendix A of the current Revenue Procedure, ranging from $25 to $3,650. One of the advantages of pre-submission conferences, discussed below, is that the IRS does not charge a fee for the conference, even though the lawyer submits a written draft of the ruling request.

Keeping It Confidential
Many famous family names and family disputes are hidden in published private letter rulings. The Code and the IRS honor the privacy of participants. The family need not sacrifice privacy when it seeks a letter ruling, even though the IRS must make letter rulings available for public inspection under Code 6110(a). The IRS will not disclose, in any event, a taxpayer's identity, address or TIN. Code 6110(c)(1). The IRS will also delete identifying details, matters constituting an "unwarranted invasion of privacy" and other confidential information at the taxpayer's request. Code 6110(c)(5).

To assist the IRS in making the required deletions of confidential information from documents that will be open to public inspection, each ruling request must be accom-panied by a separate statement of proposed deletions and the statutory basis for each proposed deletion or a separate statement that no infor-mation other than names, addresses and taxpayer identifying numbers need be deleted. The annual Rev- enue Procedure describes this requirement in detail, including additions, afterthoughts and rights to petition the Tax Court in cases of disagreement. Rev. Proc. 97-1, 8.01(9), and Appendix C, Item 24, at 1997-1 I.R.B. 11, 27 and 62.

Conferences - Informal and Formal
Although the IRS does not issue oral letter rulings or issue letter rulings in response to oral requests, IRS representatives often answer oral inquiries about whether the IRS will rule on particular issues, procedural matters about submitting requests for letter rulings for a particular case and even about substantive issues_but nothing is binding.

Better yet, a lawyer can, on a "time-available" basis, schedule a pre-submission conference before submitting a letter ruling request to discuss substantive or procedural issues of a proposed transaction. Generally, the lawyer will provide a draft of the letter ruling request and a detailed description of the transaction ahead of time. At these conferences, lawyers seeking settlement tax solutions can get real help. The latest Revenue Procedure specifically says that if, a tax issue is not under examination, in appeals or in litigation, that tax issue "may be discussed even though the issue is affected by a nontax issue pending in litigation."

The IRS has found pre-submission conferences to be very useful and time saving, especially when the ruling request involves a fairly complicated transaction. The taxpayers' and the IRS' representatives often have a free-flowing discussion, in effect engaging in a form of tentative tax planning aimed at producing a ruling request that can be handled more expeditiously by the IRS and resolved to the taxpayer's satisfaction more quickly. If the discussions disclose problems, it is not uncommon to have a sort of "what if this" and "what if that" type of exchange, to the extent that the participants from the IRS have prior experience with the "what ifs."

There is no fee for a pre-submission conference. The objective of those who request pre-submission conferences is often to sense what the IRS' position is and then prepare the final ruling request accordingly, so as to avoid multiple fees that could otherwise be generated by repetitious requests.

Taxpayers may request a formal conference on a letter ruling request, usually scheduled only when the National Office considers it helpful in deciding the case or when an adverse decision is indicated. The best procedure is to ask for that conference in the written request_one as a matter of right, more in unusual cases.

General Comments
The IRS is not a supine participant in these matters. An analysis of the longer rulings indicates it is imperative that lawyers plan for the possi- bility of IRS "participation" in a settlement long before they request a ruling. Otherwise the record may be inconsistent, resulting in negative consequences. For instance, in TAM 9534001, the IRS observed certain inconsistencies between the federal estate tax return and the settlement agreement in the course of reviewing the executor's allocation of decedent's $1 million GSTT exemption. The result was an unfavorable ruling.

If a settlement agreement has not been court-approved, any ruling based on that agreement does not necessarily remain applicable if the parties modify or amend the agreement. Short of that cautionary statement, if subsequent changes in documents appear likely, the IRS will in its ruling direct the parties to report to the Key District Director for assessment of the effect of those changes on the ruling. E.g., PLR 8324085 (involving a proposed gift of an office building, subject to a variety of leases after trust litigation had been settled, with potential future changes in the leases as well as the settlement terms).

The tax consequences of settling estate and trust disputes is often critical to finalizing the settlement. Fortunately, the IRS has prepared clear, up-to-date charts of the procedures to guide lawyers and their clients in determining these tax consequences, thereby putting a final settlement one step closer to reality.

Joseph L. Wyatt Jr. is Senior Counsel to Morrison & Foerster in Los Angeles, California and is chair of the Probate Division's (H-1) Committee on Estate and Trust Litigation and Controversy.

Probate & Property Magazine is published six times annually and is included in section members' annual dues.