PDF: Marital Deduction Planning.wpd
I. Review of Current Wills
The estate tax will resume no later than January 1, 2011. At that time, the exemption amount may be $1 million (if Congress fails to do anything), or it could be between $3 million and $5 million. Under many current wills, if either spouse were to die in 2010 at a time when there is no estate tax, or in a later year when the applicable exclusion amount is high, the credit shelter trust might be funded with more assets than the testator intends. Overfunding of the credit shelter trust might also result in unintended New York state estate tax consequences, since the New York state estate tax exemption amount is only $1 million. One approach which seeks to capitalize on the uncertainty in the estate tax in 2010 involves maximizing dispositions to QTIP trusts.
A QTIP election will enable the decedent’s estate to claim a full marital deduction. The trust must provide that the surviving spouse be entitled to all income, paid at least annually, and that no person may have the power, exercisable during the surviving spouse’s life, to appoint the property to anyone other than the surviving spouse. Since the Executor may request a 6 month extension for filing the estate tax return, the Executor in effect has 15 months in which to make the QTIP election.
QTIP property is included in the estate of the surviving spouse at its then FMV. The estate of the surviving spouse is entitled to be reimbursed for estate tax paid from recipients of trust property. IRC § 2207A. Reimbursement is calculated using the highest marginal estate tax bracket of the surviving spouse. The failure to seek reimbursement is treated as gift made to those persons who would have been required to furnish reimbursement. However, no gift will occur if the will of the surviving spouse expressly waives reimbursement.
Although the IRS at one time litigated the issue, it now appears that the Executor may elect QTIP treatment for only a portion of the trust, with the nonelected portion passing to a credit shelter trust. If a partial QTIP election is anticipated, separating the trusts into one which is totally elected, and second which is totally nonelected, may be desirable. By doing so, future spousal distributions could be made entirely from the elected trust, which would reduce the size of the surviving spouse’s estate.
II. Equalizing The Estates
Inclusion of trust assets in the estate of the first spouse to die may “equalize” the estates. Equalization may have the effect of (i) utilizing the full exemption amount of the first spouse and (ii) avoiding higher rate brackets that apply to large estates. Still, the savings in estate taxes occasioned by avoiding the highest tax brackets may itself be diminished by the time value of the money used to pay the estate tax at the first spouse’s death. On the other hand, if the second spouse dies soon after the first, a credit under IRC §2013 may reduce the estate tax payable at the death of the surviving spouse.
Depending on the combined size of spouses’ estates, QTIP trusts can be used to avoid the imposition of federal estate tax in the estate of either spouse. Assume at a time when the applicable exclusion amount (AEA) is $3.5 million, father has an estate of $6 million, and mother has an estate of $2.5 million. Father (who has made no lifetime gifts other than annual exclusion gifts) wishes to give his children $4.5 million. If $4.5 million were left to the children outright, the $1 million excess over $3.5 million would attract a federal estate tax of $450,000. This would result in children receiving only $4.05 of the $4.5 million father desired to them. If instead of leaving $4.5 million to his children outright, father were to leave only $3.5 million to them outright and place $1 million in a trust qualifying for a QTIP election, the federal estate tax would be entirely avoided in both estates. Although New York would ultimately impose tax on the $1 million whether left in a QTIP trust or outright, the amounts left in a QTIP trust would not become taxable until after the death of the surviving spouse. Of course, the children also would receive nothing from the QTIP trust until the death of the surviving spouse.
III. Dispositions to QTIP Trusts
The rights accorded to a surviving spouse in a QTIP trust are insufficient by themselves to pull the QTIP trust assets back into the estate of the surviving spouse under IRC § 2036. QTIP assets are includable only by reason of the executor of the first spouse to die making a QTIP election and deducting the value of the assets from the gross estate of the first spouse.
QTIP trust assets with respect to which no marital deduction is allowed at the death of the first spouse will not be includible in the estate of the surviving spouse under IRC § 2044. If no estate tax exists at the death of the first spouse in 2010, and a QTIP trust is funded, no QTIP election will be necessary to eliminate estate tax in estate the first spouse. Since no QTIP election was made, no QTIP assets will be included in the estate of the surviving spouse, regardless of the status of the estate tax at the death of the surviving spouse.
If all of the assets are left outright to the surviving spouse, those assets will be included in the estate of the surviving spouse if there is an estate tax at his or her death. Therefore, funding a QTIP trust may effectively shield the estate of the surviving spouse from potential estate tax liability. The QTIP trust may also impart a significant degree of asset protection to the inherited assets, when compared to an outright bequest. Another advantage to funding the QTIP trust is that the $3 million spousal basis adjustment can be utilized, if needed. By the simple expedient of including a disclaimer provision in the will, the surviving spouse may decide whether to disclaim amounts not needed for the $3 million spousal basis adjustment.
IV. Separate NY QTIP Election
A serious New York State estate tax problem encountered in connection with funding a QTIP was recently resolved by the Department of Finance in a manner beneficial to New York residents. Previously, New York had not recognized a “state-only” QTIP election. That is, if no QTIP election were made on the 706 (and no election would be made in 2010 since none is needed to eliminate the federal tax in 2010), no separate New York QTIP election was possible. TSB-M-10(1)M, issued in February, 2010, clarified that a QTIP Election for New York purposes may be made even when no federal return is required.
As the TSB explains: For dates of death on or after February 1, 2000, New York estate tax conforms to the Internal Revenue Code of 1986, including amendments enacted on or before July 22, 1998. Because the Code in effect on July 22, 1998 permitted a QTIP election, that election may be made on a decedent’s New York estate tax return even if a federal return is not required. If no federal return is required, the election is made on a pro-forma federal estate tax return attached to the New York return. The QTIP property for which the election is made must be included in the estate of the surviving spouse.
The QTIP election is made for New York estate tax purposes as the election would have been made for federal estate tax purposes, by entering the amount of the deduction in Part A1 on Schedule M of federal Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, for the applicable date of death and by completing the rest of the schedule. (If there is no federal estate tax for 2010, and an estate is required to file an estate tax return with New York, the Form 706 for 2009 should be used to prepare the pro forma federal estate tax return.)
One peculiar disadvantage to funding the QTIP trust with all of the estate assets, rather than leaving assets directly to the children, is that the surviving spouse will incur taxable gifts if lifetime transfers to children are desired. The surviving spouse may not wish to wait until her will takes effect to transfer wealth to children. Recall that although the estate tax has been repealed, the federal gift tax exemption remains at $1 million in 2010. New York State has no gift tax. The federal rate of tax for taxable gifts has been reduced, however, from 45 percent to 35 percent.
V. Spousal Disclaimers
If, within nine months of his spouse’s death, the surviving spouse decides that he does not need distributions during his life from the credit shelter trust, and disclaims, he will treated as if he predeceased his wife. If the will of the predeceasing wife provides for an outright distribution of the estate to the children if husband does not survive, then the disclaimer will have the effect of enabling the children to receive the property that would have funded the credit shelter trust at the death of the first spouse.
A qualifying disclaimer executed by the surviving spouse may also enable the predeceasing spouse to fully utilize the applicable exclusion amount. For example, assume the will of the predeceasing spouse leaves the entire estate of $10 million to the surviving spouse (and nothing to the children). Although the marital deduction would eliminate any estate tax liability on the estate of the first spouse to die, the eventual estate of the surviving spouse would likely have an estate tax problem. By disclaiming $3.5 million, the surviving spouse would create a taxable estate in the predeceasing spouse, which could then utilize the full applicable exclusion amount of $3.5 million. The taxable estate of the surviving spouse would be reduced to $6.5 million.
Assume wife paid no consideration for certain property held jointly with her predeceasing husband. If she dies within 9 months and her estate disclaims, the property would pass through the predeceasing spouse’s probate estate, and a full basis step up would become available. If the property would then pass to the surviving spouse under the will of the predeceasing spouse. This planning technique creates a stepped up basis for assets which would not otherwise receive such a step up if the disclaimer were not made.
Although a disclaimer creates post-mortem flexibility, a disadvantage to disclaimers is that the surviving spouse must actually disclaim. Some surviving spouses may not disclaim, even if sensible from a tax standpoint. If there is a concern that the surviving spouse will not disclaim, granting the surviving spouse more rights and powers over assets funding a credit shelter trust may alleviate the problem, since the spouse will have less incentive not to disclaim. The suviving spouse might be accorded some or all of the following rights:
¶ the spouse might be named co-trustee of the trust;
¶ the spouse might be given a testamentary limited power of appointment over the credit shelter trust;
¶ the trustee might be directed to make greater distributions to the surviving spouse; or
¶ the trustee or “trust protector” might be given authority to make discretionary distributions to the spouse of as much of the income or principal of the trust as the trustee or trust protector believes is in the best interest of the spouse.
Giving the spouse more rights in a credit shelter trust may eliminate the need to rely on a disclaimer. However, this solution might result in less flexibility, and would likely result in New York estate tax on the death of the first spouse. (As noted, the only way to avoid New York estate tax on the death of the first spouse is to make a transfer qualifying for the New York state estate tax deduction. This type of transfer could be (i) an outright transfer to the surviving spouse; (ii) a QTIP transfer for which a QTIP election is made on the 706; or (iii) a general power of appointment trust.)
A final disadvantage to foregoing the funding a QTIP in favor of a credit shelter trust with greater spousal rights, is that only outright transfers or transfers for a QTIP trust are eligible for the $3 million basis allocation at the death of the first spouse. A transfer to a credit shelter trust would not qualify for any basis allocation.
VI. Residence Changes and QTIPs
Assume a valid QTIP election is made on a New York estate tax return, but the surviving spouse is no longer a resident of New York at her death and the trust has no nexus to New York. Will New York seek to “recoup” the estate tax deduction claimed on the first spouse to die in a manner similar to the way in which California’s “clawback” tax recoups deferred tax in a like-kind exchange if out-of-state replacement property is later sold? Apparently not, provided the surviving spouse is a bona fide nonresident of New York at her death. Would the state in which the surviving spouse dies have a right to tax the assets in the QTIP trust? Also, probably not. Generally, a QTIP trust is not includible under IRC §2036 in the estate of the surviving spouse if no QTIP election is made. Although in this situation a QTIP election would have been made in New York, no QTIP election would have been made in the state in which the surviving spouse had died. Therefore, that state would appear to have no basis to impose estate tax on the assets in the QTIP trust.
Note, however, that if the state in which the surviving spouse dies imposes an inheritance tax (such as that imposed by Pennsylvania) then this tax would not be avoided, since an inheritance tax is imposed on the transferee, rather than on the estate.
VII. Defective QTIP Elections
The IRS takes the position that if the election taken on the initial federal and state estate tax returns was defective — but the IRS did not notice the defect and allowed the marital deduction — the assets will nevertheless be includible in the estate of the surviving spouse under IRC §2044. Thus, the assets are includible even if the estate of the first spouse would have incurred no estate tax had the QTIP election not been made. See PLR 9446001.
On the other hand, a properly made but unnecessary QTIP election will occasion of fewer harsh results. Under Rev. Proc. 2001-38, an unnecessary QTIP election for a credit shelter trust will be disregarded to the extent that it is not needed to eliminate estate tax at the death of the first spouse. Similarly, a mistaken overfunding of the QTIP trust will not cause inclusion of the overfunded amount in the estate of the surviving spouse. TAM 200223020.
VIII. Gifting of QTIP Distributions
Although there must be no prearranged agreement that spouse will make the contemplated transfer of his or her lifetime income interest, use of a QTIP trust can leverage the $3.5 million AEA by leaving assets to the surviving spouse in a QTIP trust. The surviving spouse would then be expected — but not required — to make a gift of the qualifying income interest.
A surviving spouse’s right to withdraw principal may be used for gift planning, but the trust may not require the surviving spouse to apply the principal in that manner, as this would constitute an impermissible limitation on the spouse’s unqualified right to income during his or her lifetime. Treas. Reg. §20.2056(b)-7(d)(6) provides: “The fact that property distributed to a surviving spouse may be transferred by the spouse to another person does not result in a failure to satisfy the requirement of IRC § 2956(b)(7)(B)(ii)(II).”
If the spouse is given an unlimited right to withdraw principal, the trust might constitute a general power of appointment trust. While this would preserve the unlimited marital deduction, the right of the decedent to choose who would ultimately receive the property could be lost. The IRS has ruled, however, that granting the surviving spouse a power to withdraw the greater of 5 percent of trust principal or $5,000 per year (a “five and five” power) will not result in disqualification of QTIP treatment.
Caution: If greater rights are given to surviving spouse under an intended QTIP, but those rights do not rise to the level of a general power of appointment, the trust no longer qualifies for QTIP treatment, and the marital deduction could be lost. The result would be inclusion of trust assets in the estate of the first spouse to die.
If the surviving spouse has no right in the trust instrument to withdraw principal, may the trustee make discretionary distributions of principal to further gift planning by the surviving spouse? Estate of Halpern v. Com’r, T.C. Memo. 1995-352, held that discretionary distributions made to the surviving spouse and used to make gifts were not included in her estate.
If the surviving spouse has no right to withdraw principal and the trustee cannot make discretionary distributions of principal, gift planning is more difficult, but still possible by a release or a disclaimer. However, IRC §2519 may pose a problem with a release or disclaimer.
IX. Release of QTIP Interest
The surviving spouse can make a gift of or release her qualifying income interest in the trust property to which she would otherwise be entitled. This would constitute a garden variety gift under IRC §2511. However, the disposition would also trigger IRC §2519. IRC §2519(a) provides that the disposition of “all or part of a qualifying income interest for life in any property” for which a QTIP election was made is treated as a “transfer of all interests in such property other than the qualifying income interest.”
Therefore, were spouse to gift one-half of a qualifying income interest, she would be deemed to have made a gift of the entire remainder interest in trust, in addition to the gift of the income interest. This means that a gift tax would be imposed on all trust property, even though the income interest released by the surviving spouse pertained only to part of the trust property. Under IRC §2207A, she would have a right to recover gift tax attributable to the deemed transfer of the remainder interest under IRC §2519.
The harshness of the rule is unjustified from a transfer tax standpoint. If the statute required reporting as a gift only that portion of the trust property which related to the qualifying income interest disposed of, then the estate of the surviving spouse would include the trust assets not previously reported as a gift. Nevertheless, this is not the case, and a gift of a partial qualifying income interest will in fact trigger the harsh result mandated by IRC §2519. Fortunately, the IRS allows taxpayer to sever QTIP trusts prior to the surviving spouse disposing of a partial income interest in the QTIP. This avoids the harshness of the “transfer of all interests” rule. See PLRs 200438028, 200328015.
To illustrate IRC §2519, assume the surviving spouse is 85 years old and releases his qualifying income interest in a trust worth $1 million. Under the prevailing applicable federal rate (AFR) and using actuarial tables, the surviving spouse is deemed to have made a gift of $180,000. For purposes of IRC §2511, the surviving spouse has made a taxable gift of $180,000. For purposes of IRC §2519, the surviving spouse is deemed to have made a gift of $820,000, i.e., all interests in the property other than the qualifying income interest. If instead of releasing the qualifying income interest, the surviving spouse had made a qualified disclaimer with respect to that interest, no gift would have resulted.
Net Gift Treatment of Deemed Gift
Under IRC §2207A, if the surviving spouse is deemed to have made a gift under IRC §2519, she has a right of reimbursement for gift taxes paid. Proposed regulations provide for “net gift” treatment of the deemed gift of a remainder interest under IRC §2519. A net gift occurs where the donee is required, as a condition to receiving the gift, to pay gift taxes associated with the gift. Since the value of what the donee receives is reduced by the gift tax reimbursed to the surviving spouse, the amount of the gift reportable is also reduced by the reimbursement. The gift tax so paid by the donee is deducted from the value of the transferred property to determine the donor’s gift tax.
To illustrate, assume the value of the income and remainder interest in a QTIP trust is $500,000. Husband makes a gift of one-half of his income interest, or $250,000. Under IRC § 2519, he will be deemed to have made a gift of the entire $500,000. An interrelated calculation gives the result that at a 50 percent gift tax rate, a gift of $333,333 would result in a gift tax of $166,667. Backing into the hypothetical, a gift of $500,000 would result in a net gift of $333,333, since the value of the gift is reduced by the gift tax, which in this case is $166,667. In this case, $500,000 is reduced by $166,667, to leave $333,333.
X. Disclaiming QTIP Interest
Although releasing a qualifying income interest may be effective if the surviving spouse cannot withdraw principal, and the trustee cannot make discretionary distributions, typical spendthrift limitations which appear in most testamentary trusts may pose problems. An income beneficiary of a spendthrift trust generally cannot assign or alienate an income interest once accepted. See, e.g., Hartsfield v. Lescher, 721 F.Supp. 1052 (E.D. Ark. 1989). However, if a spendthrift limitation bars the spouse from alienating the income interest, it may still be possible to disclaim the interest under EPTL 2-1.11. New York law requires that the disclaimer be made within nine months, but the time period may be extended for “reasonable cause”.
To be a qualified disclaimer under federal law, the disclaimer must be made within nine months. If a New York Surrogate extended the time for reasonable cause, the renunciation would not constitute a qualified disclaimer under IRC §2519. Rather, the disclaimer would be a “nonqualified disclaimer”. A nonqualified disclaimer would likely also trigger IRC §2519.
XI. Fractionalizing QTIP Assets
IRC §2044 requires remaining QTIP assets to be included in the gross estate of the surviving spouse. However, those assets are not aggregated with other assets in the estate of the surviving spouse. Thus, in Estate of Bonner v. U.S., 84 F.3d 196 (5th Cir. 1996), the surviving spouse at her death owned certain interests outright, and others were included in her estate pursuant to IRC §2044. The estate claimed a fractional interest discount, which the IRS challenged. The Fifth Circuit held that assets included in the decedent spouse’s gross estate which were held outright were not aggregated with those included under IRC §2044 by virtue of the QTIP trust. The estate was entitled to take a fractional interest discount. Apparently, even if the surviving spouse were a co-trustee of the QTIP trust, no aggregation would be required. See FSA 200119013.
Under Bonner, could the trustee of the QTIP trust distribute a fractional share of real estate owned by the QTIP trust in order to generate a fractional interest discount at the death of the surviving spouse? Possibly, but in Bonner, the surviving spouse owned an interest in certain property, and then became the income beneficiary of a QTIP trust which was funded with interests in the same property. The surviving spouse already owned a separate interest in the same property.
This situation is distinguishable from one where the QTIP trust owns all of a certain piece of property, and then distributes some of that property to the surviving spouse. In that case it is less clear that the IRS would fail in attempting to aggregate the interests in the same property for the purpose of defeating a valuation discount.