In recent months several clients and others have asked me about having their partial interests in limited liability companies bequeathed to trusts for estate planning and asset protection purposes. I advised them there are significant tax and legal headaches that may be triggered.
To that end I recently submitted a revenue ruling request to the IRS regarding an issue of first impression regarding a qualified terminable interest property marital deduction issue in the event that the QTIP trust owns a partial interest in an LLC.
I requested that guidance be given when a QTIP trust document provides that the surviving spouse is entitled to all the accounting income from the trust property for life, payable annually or in more frequent intervals and the election under Section 2056(b)(7) of the Internal Revenue Code is made. However, the jurisdiction's statutory trust law regarding accounting income does not permit all or part of the accounting income to be paid to the surviving spouse, the mandatory income beneficiary of the trust. It is instead used under the statutory trust laws in most jurisdictions (over 35) to help the trustee pay the fiduciary income taxes of the trust. Accounting income means trust accounting income determined under the jurisdiction's trust laws (including the District of Columbia) that is recognized by the IRS for trust tax-related purposes.
This issue is prevalent to the extent that the QTIP trust owns a partial interest in a pass-through entity such as an LLC pursuant to, say, a provision in the decedent's will that is permitted under the terms of the operating agreement of the LLC. It happens when an LLC issues a K-1 to the trust and provides an allocation of the entity's taxable income to the trust (with respect to the interest the trust owns in the LLC) in an amount that exceeds the cash distributions of accounting income that is made from the LLC to the trust.
Assume there are no receipts of principal (or insufficient receipts of principal) by the trust from the LLC in the year to pay in whole or in part the fiduciary income tax liabilities of the trust. If the trustee does not pay the fiduciary income taxes, then collection actions against the trust are triggered by the IRS and the state, if applicable.
The following is an example of how the rules are applied in over 35 jurisdictions:
Example 1
Assume that Phil resides in Connecticut and has a 40% interest in a Connecticut LLC. This is his major asset and has a value of $7 million. In his will dated April 15, 2008, Phil provides that a 20% interest in the LLC shall be payable to a QTIP trust under Article 12 of his will for the benefit of his second wife, Mary. Phil also provides in his will for a bequest of the other 20% interest in the LLC to be payable to his son, Marty.
These bequests are consented to in writing by the remaining members of the LLC (or by the necessary percentage of the remaining members of the LLC, as the case may be) and are permitted under the terms of the operating agreement of the LLC if such written consent is granted.
Assume that Phil passes away on Feb. 1, 2022 and that the QTIP trust's allocated share of the entity's taxable income as reflected on the K-1 for the calendar year 2022 is $700,000. This taxable income allocation of $700,000 is for the period Feb. 1, 2022, through Dec. 31, 2022. In addition the LLC issues a distribution check on Dec. 1, 2022, to the QTIP trust in the amount of $200,000, which is allocated to accounting income under Connecticut trust law. Walter the trustee does not remit the $200,000 check to Mary, the mandatory income beneficiary of the trust at that time. He was waiting until he received the K-1 from the LLC for 2022.
Assume that both the trust and Mary, the surviving spouse, are in the 35% tax bracket for illustrative purposes only. Connecticut taxes are not considered in this example.
The trustee, Walter, realizes that if he pays the surviving spouse (the mandatory income beneficiary of the trust) the accounting income of $200,000, he will not have any funds to pay the fiduciary income tax liability if the K-1 allocates more than $200,000 of taxable income to the trust for 2022. Walter finds out that the attorney who drafted the will on April 15, 2008, passed away in 2020, and that the will was never updated. Walter retains an attorney in Connecticut for advice on how to handle the $200,000 check representing accounting income that he received from the LLC on Dec. 1, 2022.
The attorney reviews Connecticut trust law and finds out that effective as of Oct. 1, 2010 the Connecticut trust law in essence provides that the trustee by statute uses the $200,000 amount of accounting income limited to the extent of the fiduciary income tax liability of the trust. This is so if there are no receipts of principal in the year.
The following is a brief computation of the IRS tax results under the Connecticut trust law which was effective as of October 1, 2010:
| 1. Taxable income per K-1 for 2022 | $700,000 |
| 2. Payment to beneficiary Mary, the mandatory income beneficiary of the trust | -$0- |
| 3. Trust taxable income for 2022 | $700,000 |
| 4. 35% fiduciary income tax liability for 2022 | $245,000 |
| 5. Accounting income used to pay the fiduciary income tax liability for 2022 | $200,000 |
| 6. Shortfall to IRS in the payment of the 2022 fiduciary income tax liability | $45,000 |
Mary, the mandatory income beneficiary of the trust, receives nothing, despite the language in the QTIP trust document that provides that the surviving spouse is entitled to all the accounting income from the trust property for life.
Obviously, Mary can commence a lawsuit against Walter, the trustee, on the grounds that the trust document mandates that she receive the accounting income pursuant to the terms of the trust document. Walter would then defend against the lawsuit on the grounds that the state trust law in Connecticut was changed effective as of Oct. 1, 2010, to provide that the trustee must use the accounting income of $200,000 to pay the fiduciary income tax liabilities of the trust if there are no receipts of principal in the year.
Example 2
Assume the same facts in Example 1, but Phil is a New York domiciliary; the will is prepared in New York and the LLC is a New York LLC. On Dec. 5, 2022, Walter retains Harold, a New York attorney, for advice on how to handle the $200,000 check. The New York attorney advises Walter on Dec. 10, 2022, to issue the $200,000 check to Mary based on his interpretation of New York trust law. Walter then issues the $200,000 check representing accounting income to Mary on Dec. 15, 2022, based on the advice of the New York attorney.
New York and eight other jurisdictions never enacted the legislation that Connecticut and most other jurisdictions did to benefit the trustee instead of the mandatory income beneficiary of the trust.
The interpretation of the statute such as found in New York can lead to the following IRS results:
| 1. Taxable income per K-1 for 2022 | $700,000 |
| 2. Payment to beneficiary Mary, the mandatory income beneficiary of the trust | $200,000 |
| 3. Trust taxable income | $500,000 |
| 4. 35% fiduciary income tax liability for 2022 | $175,000 |
| 5. Accounting income used to pay the fiduciary income tax liability for 2022 | -$0- |
| 6. Shortfall to IRS in the payment of the 2022 fiduciary income tax liability | $175,000 |
| 7. Accounting income paid to Mary | $200,000 |
| 8. 35% income tax liability to Mary, re: Form 1040 for 2022 | $70,000 |
| 9. Amount paid to the IRS by Mary for 2022 | $70,000 |
| 10. Shortfall to IRS by Mary for 2022 | -$0- |
In Example 2, Mary comes out with a result that is consistent with the terms of the QTIP trust document. In addition the result is consistent with the IRS QTIP marital deduction rules.
This result, however, is a disaster for Walter, the trustee of the QTIP trust, since the trust has a fiduciary income tax liability of $175,000 for 2022 with no funds to pay the IRS. In Example 1, the unpaid fiduciary income tax liability of the trust for 2022 is $45,000.
In my opinion it is extremely doubtful that a potential trustee would be willing to serve as a trustee or successor trustee of, say, a QTIP trust that has interests in a pass-through entity without having resources to pay the fiduciary income tax liabilities of the QTIP trust.
In the revenue ruling request, I asked the Internal Revenue Service to provide a course of conduct that can be followed in order for the IRS to permit the QTIP marital deduction after considering the statutory trust laws that were enacted by most jurisdictions that were well-intended and for the purpose of providing the necessary funds to the trustee so the fiduciary income liabilities of the trust can be paid to the extent possible.
Revenue Ruling 2006-26 had a national trust accounting issue that involved a QTIP trust marital deduction. The IRS did provide relief and a course of conduct going forward to remedy the issue. The IRS did not apply this revenue ruling on a retroactive basis.
