IT'S DEJA VU ALL OVER AGAIN:
RECENT DEVELOPMENTS IN
MARITAL DEDUCTION PLANNING
by Alvin J. Golden
Ikard & Golden, P.C.
Copyright © 1997 by Alvin J. Golden
TABLE OF CONTENTS
III. THE EXECUTOR AS A DECISION MAKER
A. First Things First
B. Tax-Related Decisions
1. Fiscal Year
2. Valuation Date
4. Redemption or Deferred Pay Out
5. Valuation of Assets
6. QTIP Elections
8. Administration Expenses
9. GSTT Exemption Allocation
IV. THE MARITAL DEDUCTION - PAST AND PRESENT
D. 1981 Changes
E. The Present
1. Traditional Marital Deduction Provisions
2. Qualified Terminable Interest Provision - §2056(b)(7)
3. Non-Citizen Spouses
V. QTIP ELECTIONS
A. Requirements for Election
1. Qualifying Income Interest for Life
2. No Power to Appoint to Third Party
3. Election by Executor
4. Can Disposition Be Contingent?
B. Making the QTIP Election
1. Who May Make the Election
2. How the Election is Made
3. Other Property to Which Election Applies
4. Includability in Surviving Spouse's Estate (§2044)
C. Partial Elections
1. Formula Clause
2. Division into Separate Shares or Trusts
3. Invasion of Marital Share
4. Definition of Specific Portion
D. Reverse QTIP Elections
VI. FUNDING THE MARITAL BEQUEST
A. Types of Marital Bequests
1. Pecuniary Marital
2. Pecuniary Exemption Equivalent
3. Fractional Share
B. Funding Standards
1. "True Worth"
2. Federal Estate Tax Value
3. Minimum Worth Funding
4. Fractional Share Funding
C. Miscellaneous Funding Problems
1. Vanishing Residue
2. Closely-Held Stock
3. Allocation of Income to Pecuniary Bequests
D Failure to Fund
1. Total Failure
2. Partial Failure
VII. THE PANDORA'S BOX OF VALUATION PROBLEMS
A. A Little Historical Perspective
B. Valuation for Gift Tax Purpose
1. Minority Discount - Rev. Rul 93-12.
2. Control Premium
3. "Swing Vote" Premium
C. Estate Tax Issues
1. Valuation in the Gross Estate
2. Valuation When Funding Specific Bequests
3. Where Does All This Premium and Discount Leave Us
VIII. ANNUITIES AND QUALIFIED PLANS
A. Statutory Scheme for Annuities
1. Qualification as QTIP
2. Joint and Survivor Annuities
3. Charitable Remainder Trusts
B. Qualified Plans and IRAs
IX. PURCHASE OF REMAINDER INTEREST IN QTIP TRUST
A. Spendthrift Clause
1. If There is a Spendthrift Clause
2. If There Is No Spendthrift Clause
B. The Contingent Interest Problem
C. The Adequate Consideration Analysis
D. §2702 Problem
E. Income Tax Effect
F. Is Anybody Really Doing These Things?
X. ALLOCATION OF ADMINISTRATION EXPENSES TO INCOME.
A. If the Deductions Are Taken on the Federal Estate Tax Return
B. If the Deductions Are Taken on the Income Tax Return
1. Deductions Charged to Principal
2. Deductions Charged to Income
C. The Confusion in the Courts
XI. FORMATION OF LIMITED PARTNERSHIP
IT'S DEJA VU ALL OVER AGAIN:
RECENT DEVELOPMENTS IN
MARITAL DEDUCTION PLANNING
by Alvin J. Golden
Ikard & Golden, P.C.
Austin, Texas 78701
The Economic Recovery Tax Act of 1981 (ERTA) established not only the concept of the
unlimited marital deduction, but also the concept of qualified terminable interest property, both of
which constituted major philosophical as well as legal changes in the taxation of estates of married
decedents. The immediate reaction to the passage of ERTA was that the estate planner had
become a dinosaur in the tax field, since it was now possible simply to leave "everything to my
spouse" and avoid all tax. Obviously, since Congress never adopts the simple approach to
anything, the rumors of the death of the estate planning practice were greatly exaggerated. If
anything, the last fifteen years have been a tribute to the ability of taxpayers, counsel, the
government, and the courts to invest the simplest of concepts with the most complex and
In an area which should, after almost a decade and a half, be developing some certainty, there is
now more uncertainty than ever. Part of this is brought about by the increased emphasis on
valuation techniques [particularly in light of Chapter 14, about which the only really good thing
that can be said is that it is better than § 2036(c)], part is brought about by the interaction of
discounts and premiums in funding, and part is brought about by counsel who seek to stretch the
law in every direction for the benefit of one client without regard to the impact on the overall
administration of the tax laws.
This paper deals with some of what the author believes to be the "hottest" issues in the marital
deduction area, both in pre-mortem and post-mortem planning. Although a body of case law is
slowly beginning to develop, it is through published rulings and private letter rulings that much of
the "law" in this area has developed and is developing. Further, some passing comments are made
with respect to drafting, but no attempt is made to provide forms or deal in detail with drafting
language and techniques.
III. THE EXECUTOR AS A DECISION MAKER
The entire administrative process is dependent upon the skill and effort of the executor (and/or his
counsel). The litany of decisions to be made by an executor during the course of administration
becomes more overwhelming every day. While this paper emphasizes the elections and decisions
to be made with respect to tax matters, the executor is also faced with the day-to-day decisions of
managing the assets, and dealing with the beneficiaries and creditors. These decisions must be
made within the framework of the instrument itself and the legal duties imposed upon the personal
representative or all with an eye toward potential fiduciary liability.
- . First Things First. Although the proposition may seem so obvious that it need not be stated,
the first act of the executor should be to read carefully the testamentary document and all other
ancillary documents (e.g., non-testamentary trusts, life insurance policies and beneficiary
designations, deferred compensation plans and their beneficiary designations, prenuptial or
other marital agreements, employment contracts, and stock restriction agreements). Although
problems may arise later in the administration (particularly in the tax area) which are not
apparent from the reading of the document, a careful reading initially will eliminate many of the
problems which might otherwise be encountered.
- . Tax-Related Decisions. While dealing with the problems that arise from the management of
property and interaction with people, the executor also must deal with the complexities of the
federal tax laws as they affect the particular estate which the executor is administering.
- Fiscal Year. The executor must select a fiscal year for the estate, taking into account that the
initial fiscal year may be a short year. Depending upon the character and the nature of the
assets in the estate, this choice alone could make a substantial economic difference. If the
estate that contains a partnership interest, for example, substantial income may be deferred by
electing a fiscal year for the estate which terminates before the partnership year.
Estates are still allowed a fiscal year, although trusts were required to convert to a calendar year
after 1986. §645, Internal Revenue Code of 1986 (the "Code").(1) Both trusts and estates must
file estimated taxes, although neither an estate nor a grantor trust which receives the residue of
the probate estate under the grantor's will need do so until it has been in existence for two years.
- Valuation Date. The Code gives the executor the authority to value the assets at date of death
or at a date six months following the date of death if the election decreases the value of the
gross estate and decreases the sum of the amount of tax imposed upon the estate and the tax
imposed under Chapter 13. §2032(c). Thus, in an estate which increases in value, the alternate
valuation date can no longer be elected to increase basis. This was an especially useful tool in
the optimal marital deduction situation whereby income tax basis could be increased at no
estate tax cost. In all fairness, it must be noted that the statute, as amended, now carries out
its original intent.
- §2032A. This section of the Code allows an election to tax property which reflects its value
based upon actual use rather than its fair market value, if the property is used primarily in
agricultural or business pursuits, subject to certain dollar limitations. If the election is made by
all heirs, then the property must be held for an extended period of time or additional estate
taxes are imposed. A detailed discussion of §2032A is well beyond the scope or purpose of
this paper, but the decision to use or not to use a tool with results as dramatic as the election
under §2032A must be carefully made. It is the §2032A value that is used to compute the
marital deduction if the election is made.
- Redemption or Deferred Pay Out. §6166 permits a deferral of estate taxes in certain cases,
and §303 permits the redemption of corporate stock to pay estate taxes and administration
expenses if the assets in the estate qualify under those sections. There are also many hidden
traps in those sections, and the benefits and costs must be carefully weighed in determining
whether to utilize them.
- Valuation of Assets. Perhaps the most difficult of all decisions to be made by the executor,
because this decision affects all of the assets of the estate, is how to value each asset. The
valuation question impacts all of the considerations above (except perhaps the choice of a fiscal
year) as well as those listed below. Valuation, for instance, can affect the ability of the estate
to qualify for a §303 redemption or a §6166 payout. More critically, valuation can affect the
amount of property passing to each heir or beneficiary because the funding of all bequests is
based upon the valuation of the assets at some point in time. Further, with the addition of
penalty provisions to the Code, the failure to value assets properly can result in severe
penalties. The funding problems and the penalties are discussed more fully below. Chapter 14
also complicates this area.
Perhaps the most interesting valuation problems now occur in the questions involved in funding
the marital and non-marital bequests. This is an area fertile with opportunity and rife with danger.
- QTIP Elections. A most dramatic change in the estate planning law occurred in 1981 with the
addition of the qualified terminable interest property rules. Any practitioner who purports to
work in the estate planning and probate area must be familiar with these rules. It is extremely
easy to become mired in the many technical problems of the drafting of QTIP provisions and
the election after death.
- Disclaimer. There are two prongs to the decisions to be made with respect to disclaiming
property. Often, a disclaimer by the surviving spouse goes hand in hand with the decision as to
whether or not to make a QTIP election. The executor must be prepared to advise the
surviving spouse as to the effects of that disclaimer. Further, there may be occasions in which
the executor has the power to disclaim property coming into the estate. If so, in many cases,
the executor's time frame for making such disclaimers will be extremely short, and thus prompt
and accurate decision making is a requisite.
- Administration Expenses. The Code permits the executor to elect whether to take certain
administration expenses on the estate's federal estate tax return or on the estate's federal
income tax return. These so called "swing" expenses can create some dramatic differences
depending upon the dispositive scheme and the allocation of taxes and expenses. Recent court
decisions concerning the effect on marital deduction of allocating administrative expenses to
income have added further complexity.
- GSTT Exemption Allocation. The executor will be allowed to allocate the unallocated portion
of the $1,000,000 exemption from the Generation Skipping Transfer Tax among the various
bequests created under decedent's will or to inter-vivos gifts.
AUTHOR'S NOTE: Throughout the course of this paper I will discuss several tax and planning
strategies which impact who bears the tax or how trusts are funded. While it is well and good to
try to develop tax strategies which benefit the beneficiaries, DO NOT FORGET that almost every
decision has an economic impact, and that the beneficiary who is adversely affected may not think
as highly of the idea. In other words, many of these tax planning ideas carry the potential of
IV. THE MARITAL DEDUCTION - PAST AND PRESENT
To understand the present state of the marital deduction it is helpful to understand the provisions
of law which have preceded it, even though many of the philosophical underpinnings of prior law
were negated by ERTA. One principle, which has run through the law since 1948, is that some
sort of interest essentially equivalent to full ownership of the beneficial interest must be available
to the surviving spouse in order to claim the marital deduction. The impetus for legislative action
arose from the fact that residents in community property states owned marital property equally,
and thus only one half of the property accumulated during marriage was taxable in the estate of
the first spouse to die. In a common law state, however, if one spouse owned all of the property,
then all of the property was taxable at the death of that spouse. Beginning in 1942, Congress
decided to act; and the law has never been simple since.
- . 1942-1948. By the Revenue Act of 1942, Congress added §811(e)(2) to the Internal
Revenue Code of 1939. Their approach in this Act was to penalize community property states
by including the entire community plus all of the deceased spouse's separate property in the
estate of the first spouse to die, unless a portion of the community could be traced to
compensation for the surviving spouse's personal services. In other words, rather than
allowing state law to determine ownership, a federal ownership standard was established for
federal estate tax purposes.
- . 1948-1976. In 1948, Congress amended §811(e)(2) to create the marital deduction which
existed until 1981. That amendment restored community property taxation to its status prior
to the Revenue Act of 1942 and created a deduction for separate property based on 50% of the
adjusted gross estate, provided that the surviving spouse had what was essentially full
ownership of the property and that the property was includible in the surviving spouse's estate
at that spouse's death. It was thus clear that Congress did not intend to create any sort of tax
windfall, but rather simply to equalize separate property and community property states.
Revenue Act of 1948. See also S. Rep. 1013, 80th Congress, 2nd Session, 26-29 (1948). The
law in the marital deduction area stayed fairly constant for the next 28 years.
- . 1976-1981. In the Tax Reform Act of 1976, Congress once again felt compelled to meddle
with an area of law after enough time had passed to create some degree of certainty. In
conjunction with unifying the estate and gift tax tables, the Congress created what Professor
Stanley Johanson referred to as the "mini-max" marital deduction which was a minimum
marital deduction of $250,000 and a maximum marital deduction of one-half of the adjusted
gross estate. Ostensibly, the purpose for this was to remove small estates from the tax rolls
completely, and for the first time community property could qualify for the marital deduction
within certain rules under the $250,000 minimum deduction.
- . 1981 Changes. In 1981, Congress created the unlimited marital deduction under the
Economic Recovery Tax Act. For the first time, Congress recognized that property
accumulated by spouses during their marriage should be allowed to pass to the surviving
spouse free of tax at the death of the first spouse. The unlimited marital deduction also applies
to all property owned by the decedent spouse, irrespective of whether accumulated during
marriage or not and without regard to the community property or separate property nature of
the property. Further, the 1981 Act added the qualified terminable interest property
provisions, which for the first time permitted less than essentially full ownership rights to pass
to the surviving spouse and still qualify for the marital deduction by leaving control of the
ultimate devolution of the property in the decedent spouse rather than the surviving spouse.
- . The Present. In order to understand and analyze the qualified terminable interest property
provisions, an examination of the overall statutory scheme must be undertaken.
- Traditional Marital Deduction Provisions. It is easy to view the qualified terminable interest
property provisions as creating an entirely new and different form of marital deduction, and to
forget that those provisions simply create a relatively narrow exception to the terminable
interest rule. The general rules which have long surrounded the marital deduction apply to the
qualified terminable interest property provisions as well.
- Property "Passing" to Spouse. In order to qualify for the marital deduction, property must
"pass" to the surviving spouse in a qualifying manner. §2056(a). Detailed regulations deal
with what property has passed from the decedent to his surviving spouse or to persons other
than the surviving spouse of the decedent. See Treas. Regs. §20.2056(e)-1 through Regs.
§20.2056(e)-3. See also Estate of Allen, T.C. Memo 1990-514 (1990). Property interests
claimed as curtesy, dower, or an elective share are treated as having passed from the decedent;
but not property acquired by agreements among the heirs and beneficiaries which change the
character and quality of such amounts. PLR 9101025. The character and quality may change if
there has been a bona fide dispute. PLR 9101034. See also, PLR 9040032 (dealing with trusts
required to be established by prenuptial agreement).
- Terminable Interest Rule. The interest passing to the spouse is considered a terminable
interest, and thus not qualified for the marital deduction, if the lapse of time, the occurrence of
an event or contingency, or the failure of an event or contingency to occur will cause the
interest to terminate. §2056(b). There are two primary types of disposition which satisfy this
rule and which existed prior to ERTA's creation of a qualified terminable interest concept.
(1) General Testamentary Power of Appointment Trust. A trust in which all of the income is
payable to the surviving spouse no less often than annually, and which is subject to a general
power of appointment by the spouse either during the spouse's life or by will, and which power is
exercisable alone and in all events by such surviving spouse qualifies for the marital deduction.
§2056(b)(5). Treas. Regs. §20.2056(b)(5) elaborate upon the definitions and application of the
various provisions required for the general testamentary power of appointment trust. Capital
gains during the term of this trust are taxed to the trust itself, the entire trust is includible in the
surviving spouse's estate and the surviving spouse has the absolute authority to control the
devolution of the property. It is this absolute control, more than any other feature, which caused
concern among estate planners as to the use of this trust, especially in a second family situation.
(2) Estate Trust. Although the statute requires that the income from a trust be payable to the
surviving spouse not less often than annually during the life of that spouse, the regulations provide
that a trust will satisfy the requirements of the statute if the trust income may be accumulated or
paid out for the life of the surviving spouse, and then must be paid to that surviving spouse's
estate. Regs. §20.2056(e)-2(b)(1)(iii). The ability to use a trust which accumulates income now
has distinct income tax disadvantages, since the trust will reach the 39.6% bracket after only
$7,500 of income. The fact that the trust must be paid to the estate of the surviving spouse
causes the assets to have to pass through probate again, and clearly subjects them to the claims of
creditors of the spouse's estate. There is an additional problem in that the estate trust is subject to
the throwback rule.
- Power in Spouse to Compel Conversion. In order to attain the goal of essential ownership of
the property, the marital deduction rules require that any interest passing in trust to the
surviving spouse (whether under the general testamentary power of appointment trust, the
estate trust or a QTIP trust) must be subject to a power in the surviving spouse to cause any
non-income producing property to be converted to income producing property or require the
distribution of principal to compensate for the income lost as a result of the property being
non-productive. Treas. Regs. §2056(b)-5(f)(4) and (5).
- Qualified Terminable Interest Provision - §2056(b)(7). ERTA added §2056(b)(7) to the
Internal Revenue Code. This provision, as noted above, creates an additional exception to the
terminable interest rule which essentially allows life estates, unaccompanied by a general power
of appointment, to qualify for the marital deduction. The new flexibility added by the QTIP
provisions and the additional control left in the hands of the testator created and continues to
create several new opportunities for more responsive planning.
- Testator's Control of Ultimate Disposition. Under the QTIP rules, the testator can devise the
property to the surviving spouse for life or in a trust with a qualifying income interest, and
provide that the property will pass to persons named under the deceased testator's will. The
surviving spouse can also be given a special testamentary power of appointment exercisable at
death only. CAVEAT: The surviving spouse cannot be given a general testamentary power of
appointment, nor can the property be left to the spouse's estate, since this would automatically
qualify the trust for the marital deduction as either a general testamentary power of
appointment trust or an estate trust, thereby taking away the ability of the executor to elect
partial or total exclusion of the property from the marital deduction.
- Especially Useful in Second Marriage. In the second marriage situation, the testator was
sometimes unwilling to take advantage of the marital deduction because it meant giving the
surviving spouse a power to appoint the property to anyone the survivor chose, thereby leaving
open the possibility that the property would be diverted from the decedent's children. With the
advent of the qualified terminable interest property rules, however, the testator is able to take
advantage of the marital deduction, provide for the surviving spouse, and still control the
ultimate disposition of the property and keep it in the deceased spouse's bloodline.
- Allows Determination of Amount. The use of the old general testamentary power of
appointment provisions or the estate trust provisions forced the testator to determine the
amount which would qualify for the marital deduction at the time of drafting of the will, which
could be several years prior to and in extremely different circumstances from those existing at
the date of death. One major benefit of the QTIP rules is the fact that they allow the
determination to be made as to how much property to qualify for the marital deduction based
upon the facts as they exist at the time of the death of the first spouse to die. Thus, the estate
plan can effectively be crafted when many more facts are known than were known at the time
the will was executed.
- Non-Citizen Spouses. A donor or a decedent's estate cannot utilize the marital deduction if
such donor's spouse or decedent's spouse is not a citizen of the United States except through
the creation of a Qualified Domestic Trust (QDT). §2056A, 2106 and 2523. A detailed
discussion of QDT's is one of the many things beyond the scope of this paper.
V. QTIP ELECTIONS
- . Requirements for Election. Obviously, no tax election would be complete unless there were a
plethora of technical requirements surrounding qualification for the special treatment provided
by the election. This is also true of the QTIP election.
- Qualifying Income Interest for Life. The surviving spouse must be entitled to all the income
during the term of the trust, payable not less often than annually. §2056(b)(7)(B)(ii)(I). Note
that the requirement is not that the income must be paid out annually, but rather that the
spouse must be entitled to all the income. Treas. Regs. §20.2056(b)-(5)(f)(8). See also, PLR
9030001, in which the Service permitted QTIP treatment where the spouse was entitled to
require that the trustee pay out all the income, and any not paid out was to be accumulated. If
a court has the power to change beneficial interests, then the trust will not qualify. PLR
9325002. While facility of payment clauses do not in themselves violate this requirement (PLR
8706008, citing Rev. Rul. 85-35, 1985-1 C.B. 328, to the same effect with respect to general
testamentary power of appointment trusts), they can cause problems if the ability of the spouse
to withdraw terminates on disability. PLR 8901008. Although the "all-income" requirement
has been around since 1948, there still appears to be a substantial number of taxpayers and
draftsmen who stumble over this requirement, and then try (most unsuccessfully) to remedy
- State Law. The proposed regulations permit the all income test to be satisfied by the
provisions of state law even if the instrument does not make it clear. Treas. Regs.
§20.2056(b)-7(g). See also, PLR 8450018 and PLR 8528009 and PLR 9119047. However,
the taxpayers often do not succeed in asserting this position. Estate of Nicholson v.
Commissioner, 94 T.C. 666 (1990); and Wisely v. United States, 893 F.2d 660 (4th Cir. 1989).
In Estate of Peacock v. Commissioner, 914 F.2d 230 (11th Cir. 1990), the court found that
Alabama law allowing the surviving spouse to occupy the residence was sufficient to satisfy the
QTIP requirements. See PLR 9119047 (to the same effect under Pennsylvania law); and PLR
9046031 (Hawaiian law). But see, Estate of Kyle v. Commissioner, 94 T.C. 289 (1990), holding
that a Texas homestead did not qualify; and PLR 9033004 (holding that a mere right to occupy is
- Spouse as Trustee. Taxpayers have also tried, again most unsuccessfully, to create a marital
deduction when the surviving spouse is trustee with discretion as to income distributions. The
courts point to the fact that the spouse may not always be trustee, and therefore disallow the
marital deduction. Estate of Doherty v. Commissioner, 95 T.C. 446 (1990); followed in Estate
of Ellingson v. Commissioner, 96 T.C. 760 (1991). See also, Wells v. U.S., 746 F.Supp. 1024
(D. Hawaii 1990); Estate of Bowling v. Commissioner, 93 T.C. 286 (1989). See also, PLR
- Accrued but Undistributed Income. Treas. Regs. §20.2056(b)-7(d)(4), as did the proposed
regulations, provides that income accrued from the date of the last required distribution to date
of death is not required to be distributed to a surviving spouse or subject to a power in such
spouse, even though it must be included in that spouse's estate under §2044. Regs.
§20.2044-1(d)(2). The Tax Court, however, upheld the taxpayer's contention that the
proposed regulation was nothing more than the opinion of the Service, and that the QTIP
election was not available where the accumulated income did not pass to the surviving spouse's
estate. Estate of Howard v. Commissioner, 91 T.C. 329 (1988). In that case, a QTIP election
was made in the estate of the first spouse to die. The second spouse died very unexpectedly a
short time thereafter, within the statute of limitations on the first estate. The executors sought
to, in effect, revoke the election by contending that it should not have been allowed. They
hoped to gain two things: (i) the assets of the first spouse would not be stacked in the estate of
the second; and (ii) the TPT credit under §2013 would be available for the income interest in
the estate of the second spouse. Howard led to the initiation of a remedial procedure by the
Service so that taxpayers who had relied on the proposed regulation would not lose the ability
to claim the marital deduction. Fortunately, the Ninth Circuit reversed the Tax Court's
hyper-technical and logically mystifying holding. Estate of Howard v. Commissioner, 910 F.2d
633 (9th Cir. 1990).
However, the Tax Court still clung to the old interpretation of the rules involving the proposed
regulations, even though the result was that the Internal Revenue Service got whipsawed (which
did not happen in Howard) because the deduction was allowed in the first estate (as to which
limitations had run) but the property was not included in the survivor's estate. Estate of Shelfer v.
Commissioner, 103 T.C. No. 2 (1994).(2)
Shelfer was reversed by the 11th Circuit, with the Court finding that the Commissioner's
interpretation comported with the meaning and intent of the statute. Shelfer v. Commissioner, __
F.3d ___ (11th Cir. 1996). See also PLR 9537004, in which the taxpayer raised the Howard and
Shelfer arguments among others.
NOTE: The really important message in both Shelfer and Howard is that the Tax Court is
perfectly willing to let the taxpayer profit in both estates based upon a technical interpretation of
the statute. This attitude, while apparently pro-taxpayer, may only encourage the Service to take
technical positions in order to deny the marital deduction in the first estate in order to protect
itself. The Service's rule appears to be simple and justifiable -- if the deduction was allowed in the
first estate, then inclusion is required in the second estate. This would appear to be a proper
construction of §2044 as discussed below. (At least one practitioner has suggested, on the
Internet, that he might start putting "very subtle (but fatal) flaws" into his QTIP trusts to take
advantage of the failure of the courts to adopt the obvious construction. Another commentator
suggested that the first practitioner engage in asset protection planning before doing so.)
- No Power to Appoint to Third Party. No one, including the surviving spouse, may have a
power to appoint the property at any time during the life of the surviving spouse to any one
other than the surviving spouse. §2056(b)(7)(B)(ii)(II). See alsoTreas. Regs.
§20.2056(b)-7(d)(6) and Treas. Regs. §20.2056(b)-7(h), Example 4. The avowed purpose of
this rule is to prevent the spouse from transferring the property during the spouse's life without
incurring a gift tax, although this seems unnecessarily inflexible. There should be no reason
why the surviving spouse should not have the power to appoint to third parties during his or
her life so long as such transfer would be subject to the gift tax. Such a result could be easily
achieved by a provision in the gift tax rules (perhaps in §2519) comparable to §2044.
In a combined gift tax - marital deduction private ruling, the Service created much consternation
and fear, to the point that the ABA and the American College of Trust and Estate Counsel were
considering seeking legislative remedies. PLR 9113009 (12/21/93).
In that PLR, rulings as to the estate tax and gift tax effects of certain loan guarantees are
discussed. The father ("T") personally guaranteed certain loans for corporations in which he has
an equity interest (the "personal guarantees"), and in addition guaranteed loans for corporations in
which his adult children have an interest (the"gift guarantees"). It is stipulated that the children
could not have obtained those loans, or would have had to pay a higher interest rate for them, if T
had not guaranteed them. All guarantees are traditional commercial guarantees in that they are, in
reality, primary obligations of T. Additionally, T has borrowed money directly from financial
institutions and used the proceeds to make direct loans to the children. T has a right of
subrogation to the extent that he is required to satisfy the guarantees.
T proposes to create two trusts for the benefit of his wife upon his death. One is an estate trust
which is to be funded with an amount equal to twice the "net value cost" of the guarantees. "Net
value cost" is defined as the amount of the guarantees which T's estate is likely to be called upon
to repay. The residue of the estate is to pass into a QTIP trust.
As to the gift tax questions, the Service ruled that there is a possibility of two taxable gifts:
(i) At the time of making the guarantee, to the extent that there is no consideration received,
there has been a transfer of a valuable property right (i.e., T's credit), and that transfer creates a
taxable gift. Dickman v. Commissioner, 465 U.S. 330 (1984). This would be true not only of the
gift guarantees, but also of the personal guarantees, which would be treated as gifts to the other
shareholders to the extent that they did not execute prorata guarantees.(3) Assuming that there is a
gift, it would seem that a proper valuation would be the fee required to obtain a guarantee from a
third party, or the reduction in the interest rate as a result of the guarantee, since that is the
economic value of the transfer.
(ii) If T is called upon to pay the notes so guaranteed, then there is a gift at that time, based upon
the amount paid, less any reimbursement from the debtor. QUERY: If the debtor is solvent, is
the value of the gift zero? Or is actual repayment by the debtor in the year the guarantee is
satisfied required? If the latter, then the gift would almost always be the amount of the guarantee,
for if the debtor could have paid the note, the guarantor would not have been called upon.
Coupled with the "gift" at the making of the guarantee, the value of the "gifts" exceeds the value
of what was "transferred," assuming anything was.
AUTHOR'S COMMENT: Interestingly enough, the PLR implies that if T had borrowed the
money personally and loaned it to the children's corporations (or those in which he had an
interest), there would have been no gift at the inception of the transaction.
The estate tax implications are even more horrific than the gift tax results:
(i) Reasoning that the estate trust may be called upon to pay the full amount of the guarantee, the
Service ruled that the estate trust qualifies for the marital deduction only to the extent that it
exceeds the full face amount of the guarantees. Any concept of net value cost was rejected. (It is
fairly obvious that the estate's valuation of net value cost would have produced a fairly low
(ii) If the estate trust was not funded to the full extent of the guaranteed liability, then it is possible
that the QTIP trust would have to satisfy some of the debt, in which case it would not be
exclusively for the benefit of the surviving spouse, and THE ENTIRE QTIP GIFT WOULD FAIL
(iii) No deduction is allowed as a claim against the estate under §2053(a)(3) for the amount of
the guarantee unless it is actually paid by the estate, and then the deduction is limited to the
guarantee net of the expectation of reimbursement.
(iv) The loans made directly by T from the bank are deductible as a claim against the estate, and
the value of the notes receivable from the various business entities are to be included in the gross
Fortunately, the Service withdrew this private ruling. PLR 9409018 (12/01/93). However, the
Service specifically reserved any opinion as to the tax effects of the transactions set forth in the
1991 PLR except as to the marital deduction. With regard to the marital deduction, the Service
analogized the transfer of property which might be called upon to answer a guarantee to the
transfer of a promissory note which is subject to the risk of default by the maker. In both
instances, there is a risk of loss, but neither the lender whose loan is guaranteed nor the maker of
the note "possesses an 'interest in' or a 'power to appoint' property as those terms are used in
In PLR 9418013 (2/2/94), an unrelated third party trustee made loans from a QTIP trust
(aggregating less than 8% of its value), to the surviving spouse's three sons. Such loans were
repayable at the death of the surviving spouse, and all interest accrued until such time. The
spouse has a special power of appointment which she intends to exercise in favor of each maker
of the note. Each year, the spouse is to be paid the amount of the accrued interest from principal.
The Service ruled that the transaction was a valid loan and not a disposition of any part of the
spouse's interest in the QTIP under §2519.
- Election by Executor. Property passing to the spouse which meets all of the requirements of
the qualified terminable interest property rules is nonetheless not subject to the marital
deduction unless the executor elects to make it so. §2056(b)(7)(B)(v), except as to joint and
- Can Disposition Be Contingent? The Service has long maintained, and continues to maintain
that the distribution of income from or other disposition of the trust cannot be contingent upon
whether the executor makes the election. According to the Service's position, a will cannot
provide that if the executor fails to elect QTIP treatment as to part or all of the trust, the
income distribution standard will be converted from a mandatory income to spouse to a spray
power in the trustee among spouse and children, or that the property will pass to a different
trust. Such a provision, according to the Service, would disqualify the trust. This was the
position taken in Prop. Regs. §20.2056(b)-7(c), and it is reiterated in Regs.
§20.2056(b)-7(d)(3) and Regs. §20.2056(b)-7(h), Example 6. See also PLR 8611006 (QTIP
election not available where trust not to be funded unless executor made election) and TAM
9104003 (QTIP election not available if executors can appoint to someone other than surviving
spouse). But see PLR 8631005 (QTIP election available where executrix/spouse had sole
power to determine amount of assets to be allocated between QTIP trust and non-qualifying
trust), which is discussed below. See also, PLR 9018022, allowing a marital deduction to a
trust giving a spouse a general testamentary power of appointment if a QTIP election is made,
but only a special power if the election is not made.
The Tax Court consistently agreed with the Service on this position. However, the three
appellate courts that have dealt with this issue have disagreed and have reversed the Tax Court on
each occasion. Estate of Clayton v. Commissioner, 976 F.2d 1486 (5th Cir. 1992); Estate of
Robertson v. Commissioner, 15 F.3d 779 (8th Cir. 1994); and Estate of Spencer v.
Commissioner. 43 F.3d 226 (6th Cir. 1995). In those cases the court relied upon the legislative
history and what it perceived to be the clear statutory language in holding that the Service has no
legitimate concern about property as to which no election was made. So long as the elective
portion meets the all income test, then the fact that the non-elective portion does not is
immaterial. While the 5th Circuit and the 6th Circuit disagreed as to the reasoning, the results
were identical. The Service's argument, reiterated in T.D. 8522, accompanying the final QTIP
regulations, is that qualification must be determined as of date of death. The appellate courts
reply that the election relates back and thus qualification is determined at death. The Service also
argues that the property did not pass from the decedent, but the courts reply that it passed directly
under the will.
After three losses at the appellate level, the Tax Court has finally conceded. Estate of Clack v.
Commissioner, 106 T.C. No. 6 (1996). In that case the majority opinion (joined in by nine
judges) simply stated that with three appellate opinions against it, the Tax Court would accede to
the appellate courts without attempting to determine which circuit follows the appropriate
rationale. Three concurring judges thought the result was correct, but would adopt the Sixth
Circuit's rationale in Spencer. There were three other concurrences, one of which was only to
contradict certain arguments made by one of the two dissenters.(4) On July 15, 1996, the Service
issued AOD 1996-011, in which it acquiesced in result only in Clack and stated that the Service
would no longer disallow the marital deduction in Clack type situations for decedents dying
before March 1, 1994 (the effective date of the final regulation). While the Service has indicated
in private conversations that the result will probably not be different for decedents dying on or
after March 1, 1994, the AOD still speaks only in those terms.
Two letter rulings demonstrate that the rule advocated by the Service in Clayton, et al. is not
without exception. PLR 8631005 involved a disposition in which the assets would be allocated to
Trust A with the income payable not less often than annually to the surviving spouse if the QTIP
election were made, but if the election were not made, the assets were to be allocated to Trust B,
which did not contain mandatory income distribution to the spouse. The spouse was the sole
executrix and trustee. The spouse elected to qualify the entire property eligible for the election
and thus only Trust A was funded. The Service held that the creation of an income interest which
is solely at the discretion of the surviving spouse is a qualifying income interest. This raises some
interesting planning possibilities for achieving discretionary distributions of income if the QTIP
election is not made without running the risk of losing the marital deduction. This letter ruling, of
course, leaves open the question as to whether a partial election would qualify if indeed a portion
of the gift was allocated to Trust B. This PLR is correct because the will does not permit the
spouse to do anything that could not have been done by disclaimer.
In a later ruling, a similar dispositive scheme was involved (but evidently the spouse was not the
personal representative). The will did contain, however, a savings clause providing that the
executor was not to fund Trust B if such funding would cause a loss of the marital deduction.
The executor made a partial election, but did not transfer any assets from Trust A to Trust B.
The Service held that the savings clause was effective to preserve the marital deduction,
distinguishing this situation from that in Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944),
cert. den. 393 U.S. 756 (1944). The Service felt that the bequest in this case was complete no
matter what the tax consequences, whereas the gift in Procter was to be void if subject to gift tax.
- . Making the QTIP Election. As noted above, qualification of qualified terminable interest
property for the marital deduction is not automatic, but results from the executor's election.
- Who May Make the Election. The statute provides that the election is to be made by the
executor on the return of tax required by §2001. §2056(b)(7)(B)(v). The final regulations
make it clear that the election shall be made by the executor as defined in §2203 and the
regulations under that Section whether or not the executor is in possession of the qualified
terminable interest property. Only if there is no executor duly appointed, acting and qualified
within the United States can the person in possession of the QTIP property make the election.
Regs. §20.2056(b)-7(b)(3). Thus, in a funded inter-vivos trust with a pour-over will, even
though the bulk of the assets are in the trust, the executor of the will (if it is admitted to
probate) still makes the QTIP election.
- How the Election is Made. Although there has been substantial difficulty in the past making
the election, it can now be made with relative ease.
- Made on Return. The statute and regulations provide that the election is to be made on the
return required by §2001, and that the election, once made, is irrevocable. §2056(b)(7)(B)(v).
(1)Timing. The regulations provide that the election is to be made on the last estate tax return
filed by the executor on or before the due date of the return (including extensions), or if no timely
return is filed, then on the first estate tax return filed by the executor after the due date. Regs.
§20.2056(b)-7(b)(4)(i). Thus, the election can be made on a delinquent return if no timely return
has been filed. In fact, even if a timely return has been filed, the regulations very clearly state that
the election is the one made on the last timely return filed before the due date including
extensions. Regs. §20.2056(b)-7(d)(4)(ii). See TAM 8523006. If the estate fails to make an
election on its original return, it cannot make the election on an amended return if the time for
filing the original return has passed. Robinson v. U.S., 90-2 USTC ¶60,045 (S.D. Ga. 1990). It
should be standard practice, particularly in an optimal marital where no interest cost is involved,
to wait the full fifteen months (including a six month extension) so that the determination as to
whether to make the election can be made with as many facts as possible. Not only could this
avoid a potential "stacking" of the estates, but it could also generate a TPT credit under §2013.
A life estate can trigger the credit in the survivor's estate. Rev. Rul. 59-9, 1959-1 C.B. 232.
(2) Identify on Schedule M. There was previously a box which had to be checked in order to
make a QTIP election, and the taxpayer was previously required to identify QTIP property
separately. The return has now been greatly simplified. If the property interest is identified on
Schedule M, and if the deduction is taken on Schedule M and shown on Page 3, then the QTIP
election is deemed to be made. This solves a lot of problems and removes hyper-technical traps
for the unwary. Since it may not be possible to ascertain at the date of filing the return what
property is to be used to fund the qualified terminable interest property trust, the Service permits
the elected property to be identified simply as that passing under the provision of the will creating
the QTIP, along with the amount of such property. TAM 9116003.
- Defective Election. With the removal of many technical requirements, the problems with
defective elections are much reduced. In fact, the problem may well be that the election is so
easy that it may be inadvertently made when it is not necessary. The taxpayer is then in the
position of trying to figure out a reason that the election was not available.
- Protective Election. The final regulations provide for a protective election but limit the
circumstances under which it can be made to situations in which the executor reasonably
believes that there is an issue as to whether an asset is includible in the estate or as to the
amount or nature of the property the surviving spouse is to receive. The protective election
must identify either the specific assets or trust to which the election applies and the basis for
the election. The protective election, once made, cannot be revoked. For example, if a
protective election is made based upon whether an asset is included, if that asset is included,
then the election is applicable. Regs. §20.2056(b)-7(c). Although the language of the
regulations seems restrictive, it is hoped that this provision will be broadly interpreted. Since
the taxpayer is hung with the election once the issue is resolved, there is no room for playing
games. The election should always be made if the value of the assets is subject to question and
if the estate desires to avoid tax if the values are increased. See PLR 9520038 in which the
Service granted an extension of time to file under Treas. Regs §301.9100-1.
- Other Property to Which Election Applies. Although the classic QTIP property is that placed
into a trust, there are other types of transfers which constitute qualified terminable interest
- Usufructs. The statute was amended retroactively to provide that a Louisiana usufruct interest
is qualified terminable interest property. §2056(b)(7)(B)(ii)(I). See PLR 8835015.
- Life Estates. Legal life estates qualify for qualified terminable interest property treatment.
Regs. §20.2056(b)-7(d)(2) specifically permits legal life estates to qualify provided that they
meet the income tests set out in Regs. §20.2056(b)-5(f). A power of sale in the life tenant
would clearly qualify the interest. The regulations state, by example, that an unrestricted right
to use a principal residence qualifies for QTIP treatment. Regs. §20.2056(b)-7(h), Example
(1). Perhaps those regulations need to be clarified to spell out what rights a life tenant must
have. A life tenancy deliberately created by will should spell out the burdens and benefits
accruing to the life tenant. See also, PLR 8444099. However, the burdens must not be in
excess of those imposed under state law. Estate of Novotny, 93 T.C. 12 (1989). Tangible
personal property such as works of art may also be QTIPed. PLRs 9242006, 9237009, AND
8952024. While one commentator suggests that local law be allowed to fill in the duties and
burdens of the life tenant, I think that the better approach (so that disagreements among the life
tenant and remainderman can be minimized) is for the draftsman to spell those duties out, being
careful not to exceed local law. A savings clause may be helpful here.
- Joint and Survivor Annuities. Joint and survivor annuities did not qualify for QTIP treatment in
most cases because of the difficulty in meeting the "all income" test, especially if the annuity
was for a term certain with a refund feature. Code section 2056 was amended in 1988 by the
addition of §2056(b)(7)(C) which provides that the interest of the surviving spouse in a joint
and survivor annuity qualifies for the marital deduction if no other than the surviving spouse
has the right to receive payments before death. In an interesting variation on the election
requirements, this interest automatically qualifies unless the executor elect out on the federal
estate tax return. This election once made is, of course, irrevocable. Note that there is no
requirement that the annuity payable to the surviving spouse must come up to any standard
other than that such spouse receive all the payments thereunder during such spouse's life.
- Includability in Surviving Spouse's Estate (§2044). Section 2044(b)(1)(A) provides that
property in which the surviving spouse had a qualifying income interest for life is included in
the surviving spouse's estate if a deduction was allowed under 2056(b)(7) or §2523(f) to the
estate of the first spouse to die. The regulations clarify that two requirements must be met -
that the deduction was allowed and that the interest was a qualifying income interest for life.
Regs. §20.2044-1(a) and 1(d). It would simplify everyone's life, and would actually benefit the
government, if the rule were that if the first estate got the deduction, whether erroneously or
not, the second estate must include the property. Game playing should not be the order of the
- Passed From. Section 2044(c) provides that property included in the estate of the surviving
spouse under §2044 is deemed to have passed from that surviving spouse for purposes of the
estate tax and the GST tax. The regulations specifically refer to special use valuation
provisions (§2032A), the charitable deduction (§2055), the marital deduction (§2056) and
installment payment of tax (§6166). It is also considered to have passed from the surviving
spouse for purposes of the basis adjustments under §1014, IRC, thereby eliminating a problem
as to whether or not such property received a basis adjustment at the death of the surviving
spouse. Regs. §20.2044-1(b). It is not deemed to have passed from the surviving spouse for
purposes of the reverse QTIP election under the generation skipping transfer tax. §2652(a)(3).
- Presumption of Deduction. If the interest held by the surviving spouse was qualified
terminable interest property, then it is presumed that a 100% marital deduction was taken on
the appropriate estate tax return or gift tax return for that transfer, thereby causing inclusion
under §2044. Regs. §20.2044-1(c). The burden is on the executor to show that no deduction
(or only a partial deduction) was taken. While the proposed regulations did not give any
guidelines as to how the executor is supposed to rebut the presumption created therein, the
final regulations provide that the presumption can be rebutted by producing a copy of the
return on which the deduction was or was not claimed, or by showing that no return was
required. It is to be hoped that the Service will assist with producing a copy if one cannot be
CAVEAT: Some credit shelter trusts may qualify for the QTIP election, and thus it would be
necessary for the executor to show that no QTIP election had been made with respect to such
interest. Obviously, the executor must use reasonable diligence in obtaining proof that the
election was not made.
- Amount Includible. The amount includible under §2044 with respect to qualified terminable
interest property as to which the election was made is the value of that property at the date of
death of the surviving spouse. If the value was incorrect, and such error is discovered before
the trust is funded, then the amount includible under §2044 is the corrected value. PLR
9019001. The regulations further provide that if the election was made with respect to only a
portion of the property which was eligible for the election, then only that portion is includible
at the death of the surviving spouse. Regs. §20.2044-1(d)(1). Unless the elected share is
segregated, if distributions from the estate are made during the lifetime of the surviving spouse
out of the elected share, and if only a portion of the trust was made subject to the election,
then re-evaluation must occur at the date of such distribution to determine the new fraction to
be used in computing the amount includible at date of death. For example, the total trust was
valued at $1,000,000 at date of death and an election was made with respect to 50% of such
trust. During the lifetime of the surviving spouse, a distribution of $100,000 was made from
the elective share at the time the entire trust was valued at $1,100,000. The new fractional
share subject to inclusion under §2044 would be 45% ($550,000 - $100,000/
$1,100,000-$100,000). Regs. §20.2044-1(d)(3) and Regs. §20.2044-(1)(e), Example (4). This
problem is very similar to the problems raised in the administration of fractional share bequests
when there are partial non prorata distributions of the fractional share bequest.
- Calculation and Payment of Tax. The tax on §2044 inclusion is based upon the incremental
rate at which such property is taxed. The estate tax is calculated with the §2044 property and
without it, and the difference between the two is the amount of tax attributable to such
property. The executor of the surviving spouse's estate is allowed to recover the tax from the
trustee of the QTIP trust unless the surviving spouse "otherwise directs by will." §2207A(a).
No specific reference to §2207A is necessary to override its operation. The authorities differ
on whether a direction in the survivor's will to pay the taxes out of the residue is sufficient to
constitute such a direction. See, e.g., Firstar Trust Company v. First National Bank of
Kenosha, 531 N.W.2d 325 (Wis. 1995) and Matter of Gordon, 510 N.Y.S.2d 815 (Surr.
1986). Compare Estate of Miller, 595 N.E. 2d 630 (Ill. App. 1992) and Estate of Vahlteich v.
Commissioner, 95-2 USTC ¶60,218 (6th Cir. 1995 - not for publication).
- . Partial Elections. Partial elections must be made as to a "specific portion" of the property.
§2056(b)(7)(B)(iv). The regulations require that partial elections relate to a "fractional or
percentile" share of the property so that the elective part will reflect its proportionate share of
the increment or decline in the whole of the property for purposes of applying §2044 or §2519.
- Formula Clause. A partial QTIP election may be made with a formula provision similar to that
used in drafting the pecuniary marital bequest under a will. This means that any change in
valuation upon audit or the choice of taking deductions on the estate tax or income tax returns
would not affect the marital deduction if the formula clause were designed to reduce the tax to
the lowest possible tax. Regs. §20.2056(b)-7(h), Examples 7 and 8. See also PLR 9043015.
- Division into Separate Shares or Trusts. In a partial election, the marital and non-marital trust
can be segregated if authorized under the governing instrument or otherwise permitted under
local law. If the trust has not been divided by the time the return is filed, the intent to divide
must be "unequivocally signified" on the return. This division must occur, however, no later
than the close of the administration of the estate. Regs. §20.2056(b)-7(b)(2)(ii)(A).
Presumably, if the settlement of the estate occurred through a revocable trust, that division
could occur at the time the administration would have been closed had those assets been
subject to probate. The regulations also make it clear that specific assets may be allocated to
the elective and nonelective shares so long as the fiduciary is required either by state law or by
the governing instrument to divide the trust according to the fair market value of the assets of
the trust at the time of the division.(5) Thus, a complete fractionalization of each asset is not
required when the trusts are severed. Regs. §20.2056(b)-(7)(b)(2)(ii)(B) and (C) and Regs.
§20.2056(b)-(7)(h), Example 14. In the case of legal life estates, an election may be made on
an asset by asset basis. PLR 9043029.
- Invasion of Marital Share. The marital share may be invaded for the benefit of the surviving
spouse prior to the invasion of the nonmarital share, and such invasion may even be subject to
different standards. Regs. §20.2056(b)-7(h), Example (9).
- Definition of Specific Portion. In Estate of Alexander v. Commissioner, 82 T.C. 34 (1984),
affirmed "for the reasons expressed by the Tax Court majority," (4th Cir. 1985) (unpublished
opinion), the Tax Court held that the regulations at §20.2056(b)-5(c) were invalid in limiting
the "specific portion" language to a fractional or percentage share. In that case, Mrs.
Alexander was given a testamentary power of appointment "over that portion of this trust
which shall be equal in amountto my wife's share..." (emphasis added). Thus the effect that
Mr. Alexander sought to achieve was to eliminate the appreciation of the marital share from
taxation in his wife's estate. The Tax Court relied on Northeastern Pennsylvania National
Bank and Trust Company v. U.S., 87 S. Ct. 1573 (1967). In the Energy Policy Act of 1992,
the Congress added §2056(b)(10) and a new sentence to §2523(e) to codify the language of
the proposed regulations. §2523(f)(3) was also amended to make the rules of §2056(b)(10)
applicable. In its final QTIP regulations, the Service recognized that Alexander was the law
prior to October 24, 1992, the effective date of the Energy Policy Act of 1992. Regs.
§20.2056(b)-7(e). Those rules apply to decedents dying on or before October 24, 1992, with a
transitional rule for property passing to a spouse under documents in existence on October 24,
1992, and unchanged thereafter: (i) if the decedent was under a mental disability from which he
never recovered, and if the decedent did not dispose of "such property," or (ii) if the decedent
died before October 24, 1995. Regs. §20.2056(b)-7(e)(5).
CAVEAT: Examples 11 and 12 of Regs. §20.2056(b)-7(h) no longer represent interests as to
which a QTIP election is allowableunless the transitional rule applies. Because the specific
portions are not expressed in fractional or percentage shares, they cannot qualify after October
24, 1992. However, there is no cautionary note in the regulations. Example 11 begins, "D dies
prior to October 24, 1992." Example 12 begins, "The facts are the same as in Example 11..."
Because of the date of death, the old rules apply. Mighty peculiar for regulations written in 1994!
- . Reverse QTIP Elections. §2652(a)(3) permits a separate QTIP trust to be created to which
GSTT exemption can be allocated so that the surviving spouse will not be treated as the
transferor for GSTT purposes. The reverse QTIP trust must be a separate trust and the
regulations prescribe the method for severing the trust into separate trusts if the instrument
does not do so. Treas. Regs §26.2654-1(b). If the trust is a pecuniary trust, it may be funded
either at date of distribution values (if appropriate interest is required to be paid) or under the
"fairly representative" standard. Treas. Regs. §26.2654-1(a)(1)(ii). The allocation of GSTT
exemption must be made on a timely filed return or the exemption will be automatically
allocated under§2632(c). This would mean that a portion of the exemption would be
automatically allocated to other gifts and the reverse QTIP trust will have an inclusion ratio of
more than zero and less than one. Relief for a late allocation may be available under Treas.
VI. FUNDING THE MARITAL BEQUEST
At the conclusion of the administration of the estate, the executor must distribute assets to and
among the beneficiaries. In the good old days, the executor only had to take into consideration
such things as the type of bequest with which the executor is dealing, the general composition of
the property, and the funding standard set forth in the will. Now, in many situations, the most
critical factor to be considered is the valuation of the assets used to fund the trust, particularly in
those situations in which discounts have been taken in valuing the asset on the estate tax return or
might be allowed (or imposed) upon funding of the various trusts. This section will proceed from
the simple to the terribly complex and sometimes unfathomable.
- . Types of Marital Bequests. Most marital deduction bequests fall into some sort of formula
category. There are basically three types of formulae which are used in establishing an optimal
marital deduction or maximum marital deduction bequest. Pecuniary marital bequests are most
frequently used in smaller estates for reasons discussed below.
- Pecuniary Marital. This is probably the most common type of formula used. The essence of a
pecuniary bequest is the bequest of an amount rather than a share of assets. In essence then,
the formula marital deduction pecuniary bequest provides that the marital is to be funded with
the smallest amount equal to that which would produce the lowest or zero federal estate tax.
- Pecuniary Exemption Equivalent. This is the flip side of the pecuniary marital. This bequest
generally provides that the exemption equivalent or credit shelter portion of an optimal marital
formula is funded with the smallest amount equal to that necessary to bring the taxable estate
up to the point where it produces a zero estate tax after taking into account the unified credit
and the state death tax credit (if the use of that credit does not produce an additional estate
tax). As is discussed more fully below, the funding of a pecuniary bequest may carry with it an
income tax impact to the estate if appreciated property is used to fund the bequest. Therefore,
many commentators feel that the pecuniary exemption equivalent should be used in larger
estates to minimize the effect of the income tax cost on appreciation of assets. A natural result
of that choice is to shift all of the appreciation to the marital share. The reverse is, of course,
also true. If the estate depreciates in value, then all of the depreciation is borne by the marital
- Fractional Share. The third type of bequest is a fractional share. This is also a formula
bequest, but rather than dealing in amounts, this deals in fractional or percentile shares.
Although fractional shares were once the most popular kind of bequest, they fell into disuse
because of administrative problems created by disproportionate distributions. However, partial
QTIP elections have tended to create many fractional share type problems, and attorneys and
executors are becoming more familiar with how to deal with such problems. The fractional
share is income tax neutral and spreads the appreciation and depreciation ratably between the
marital and non-marital share.
- . Funding Standards. While the funding of a marital deduction bequest is normally an income
tax problem, it can have estate tax implications also. The funding standard selected can be
income tax neutral or can create an income tax.
- "True Worth". The true worth funding standard is one which utilizes date of distribution
values in determining the assets used to fund the pecuniary gift. If the assets have appreciated,
then income tax is generated upon the funding of the pecuniary bequest.(6) Thus, for income tax
purposes, the bequest is treated as if the estate had sold the assets and then used the cash
proceeds to fund the bequest. Therefore, the estate recognizes gain. Treas. Regs.
§1.1014-4(a)(3). The gain is calculated as the difference between the fair market value at date
of distribution and the income tax basis of the asset as determined for federal estate tax
purposes, because the asset achieved a new basis under §1014. Further, any gain is
automatically long term capital gain. §1223(11). Obviously, since the distribution is based on
the value of the asset at the date of distribution, all assets to be allocated to the pecuniary gift
must be revalued at such time. Except for a true fractional share bequest, this is true of all
other funding methods also. Distribution of assets in satisfaction of a pecuniary bequest also
carries out distributable net income (DNI) with the bequest. Thus, the estate recognizes taxable
gain on the distribution of appreciated property, but gets an income tax deduction to the extent
of the lesser of its DNI or the value of the assets distributed. Even though specific bequests
normally do not carry out DNI, the Revenue Service has long taken the position that a
pecuniary marital distribution is not sufficiently specific under §663(a)(1) to avoid that result.
But see Rev. Rul. 86-105 1986-36 I.R.B. 15, holding that a bequest similar to a marital
deduction bequest does not carry out DNI. Further, if property constituting income in respect
of a decedent (IRD) under §691 is distributed in satisfaction of a pecuniary bequest the IRD is
accelerated upon distribution, causing all of the IRD to be treated as income in the year of
distribution even though it would not be required to be recognized then absent such
distribution. But see PLR 9630034, in which a disclaimer of an interest in an IRA, construed
to be a pecuniary disclaimer, did not accelerate IRD.
- Federal Estate Tax Value. A second standard funds the trust at the value of the assets at the
date of the decedent's death (or the alternate valuation date, if applicable). Under this method,
no income tax is generated on the distribution. The bequest still carries out DNI and, if IRD is
used to fund the bequest, it will accelerate the IRD. If the assets in the estate have
appreciated, this method of funding causes the pecuniary bequest (whether it is the exemption
equivalent or marital bequest) to be over funded. If the marital is the pecuniary bequest, there
exists a true potential for abuse by selecting assets which have depreciated in value and using
them to fund the marital while shifting the gain away to the non-marital bequest. In order to
avoid this abuse, the Revenue Service promulgated Revenue Procedure 64-19, 1964-1 C.B.
682. As a prerequisite to obtaining the marital deduction, this Revenue Procedure requires
that the assets be valued at date of distribution values, or, if valued at federal estate tax values,
then the assets used to fund the marital and non-marital share in a pecuniary bequest must be
"fairly representative" of the appreciation and depreciation of all of the assets of the estate.
Thus, another judgment of the executor is required. The Revenue Service can challenge the
funding of these bequests based upon whether it believes that the distribution meets the fairly
representative standard. Because of such standard, the entire estate must be revalued so that
the executor can make the determination of what aggregate appreciation and depreciation has
occurred. This makes distributions under this standard very inflexible, and many executors
simply choose to allocate assets on a ratable basis, thus converting this type of bequest more to
a fractional share than a true pecuniary. Lack of flexibility and administrative burdens render
this method difficult to use.
- Minimum Worth Funding. This third method once again avoids an income tax on the funding
of pecuniary bequests, but still carries out DNI, and accelerates IRD. This method requires
that pecuniary bequests be funded at the lower of federal estate tax values or date of
distribution values and, in my opinion, can only be used when the marital is the pecuniary gift.
It requires the revaluation only of the assets distributed in satisfaction of the marital bequest,
and relieves the executor of trying to apply the fairly representative standard. However, the
marital is almost guaranteed to be over funded. The executor has tremendous latitude to
benefit the surviving spouse at the expense of the other beneficiaries (if any). Depending upon
the asset mix, the minimum worth funding standard could result in a complete abatement of the
exemption equivalent gift.
- Fractional Share Funding. As mentioned earlier, the funding of a fractional share bequest
requires the allocation of an undivided interest in each asset to the respective shares. While
this bequest still carries out DNI, it does not accelerate IRD, nor does it produce an income
tax. However, most draftsmen do not give sufficient attention to drafting the fractional share
bequest, and thus fail to specify what happens to the fractions after a significant event occurs
during administration; e.g., after the taxes are paid. For instance, assume a $4,000,000.00
estate with a fractional share of 50% to a third party and 50% to the spouse. The taxes of
$1,000,000.00 are to be paid out of the non-marital share. The fraction at date of death is
50% to the marital share and 50% to the non-marital share. Once the taxes are paid, the
fraction shifts to 1/3 to the non-marital share and 2/3 to the marital share. The question then
becomes whether the income should be allocated 2/3 - 1/3 from date of death, whether it
should be 50/50 from date of death until the taxes are actually paid and thereafter 2/3 - 1/3, or
whether the fraction should never change. There is little law on this type of bequest in most
jurisdictions, and the problems become even more complex if the values change or if income
distributions are made disproportionately throughout the course of administration.(7) Thus, one
can see the difficulty in administering fractional share bequests, especially when the instrument
does not give guidance as to the allocation of income. Further, the guidance must comport
closely enough with the marital deduction rules so that the value of the marital is not reduced
because of the inability of the spouse to receive income from the date of the bequest. A
detailed discussion of fractional share funding and the allocation of postmortem gains and
income is beyond the scope of this paper. For an excellent and still timely treatise on this
work, see Cantrill, "Fractional or Percentage Residuary Bequest: Allocation of Postmortem
Income, Gain and Unrealized Appreciation", 10 University of Notre Dame Estate Planning
Institute, Chapter 4 (1985).
- Pick and Choose Fractional. A variation on the standard fractional share bequest is a fractional
share bequest which allows the executor to allocate specific assets to either share. This looks
and feels very much like a pecuniary bequest, and could conceivably result in gain whereas the
normal fractional share funding does not. It may further result in an acceleration of IRD. In
funding this type of bequest, it would seem that the entire estate would have to be revalued,
and the fraction applied to the new value. Note that the QTIP regulations permit a pick and
choose fractional approach in severing the elective and non-elective share of a QTIP trust,
thereby sanctioning this approach.
- §643(e) Problem. Section 643(e) of the Internal Revenue Code provides an election for the
executor when appreciated property is distributed from the estate. This section does not apply
to a pecuniary bequest, because a distribution in satisfaction of a pecuniary bequest is treated
as in-kind funding of the bequest automatically triggering gain or loss, rather than as a
distribution. The section does, however, apply to distributions in-kind in satisfaction of
fractional share bequests or other residuary bequests. The executor can elect to recognize
gain, in which case the beneficiary receives a stepped-up basis in the asset. If the executor
does not elect to recognize gain, then the beneficiary receives a carryover basis in the asset.
The estate will receive a distribution deduction, and the beneficiary will recognize income to
the extent the estate has DNI equal to or less than the lesser of the fair market value of the
asset or its basis in the hands of the estate (adjusted by any gain recognized if an election was
made). The election cannot be made on an asset by asset basis, but must be applied to all
distributions during a taxable year. Given bracket compression and the high rates on estates,
this election is virtually useless in today's environment.
- . Miscellaneous Funding Problems. There are many problems and considerations in actually
funding a marital bequest other than those dealing with type of bequest, choice of assets and
the valuation problems discussed below. They vary so widely from estate to estate that it is
impossible to catalog them all here. A few of the more common, however, do bear some
discussion. There are many factors to consider in drafting an estate plan, and even experienced
attorneys in the area may occasionally overlook some things. However, the facts of life are that
there are many attorneys drafting optimal marital deduction plans from form books who do not
take the time (or perhaps they do not have the expertise in many cases) to anticipate problems
which are likely to arise and to elicit all of the facts necessary to advise their client properly.
- Vanishing Residue. One of the most common problems which will be encountered in future
years is what I refer to as the vanishing residue. This can arise in many ways. Assume a
pecuniary marital bequest with an exemption equivalent residue. The will, using the old
incantation, provides that the debts and taxes are to be paid from the residue of the estate,
thereby probably waiving the application of the state tax apportionment statute which would
apply if the will were silent.(8) Since the marital bequest is a formula designed to produce the
lowest possible estate tax, if there are other specific bequests or assets passing outside the will
which absorb all of the unified credits, then there is no residuary estate under the will from
which debts and taxes can be paid. For example, assume the decedent has an IRA and/or a life
insurance policy payable to children of a prior marriage. If that asset is worth $600,000 or
more, then the pecuniary marital will absorb all of the probate estate,(9)leaving no residue from
which to pay debts or taxes. In such a situation, because of the mandate in the will, there is
nothing but the marital share to bear the tax, and the marital share is reduced by the maximum
amount of tax that could be paid out of the marital share, since that amount of tax constitutes a
terminable interest. PLR 8517036. Regs. §20.2056(b)-1(b) defines terminable interests as
those which will "terminate or fail on the lapse of time or on the occurrence or the failure to
occur of some contingency."
- Life Insurance. Assume that all taxes are to be paid from the residue which is the marital
share, and that the decedent (either before or after drafting the will) decided to buy a
$1,000,000.00 life insurance policy payable to someone other than the surviving spouse. The
executor, under §2206, is entitled to recover "such portion of the total tax paid as the proceeds
of such policies bear to the taxable estate." §2206. In this fact situation, the taxes are all to be
paid from the residue, so that the right of recovery is arguably waived. Note that §2206
speaks to a right of recovery, rather than a primary obligation on the part of the recipient of the
life insurance policy to pay the tax. Thus, it can be argued that the primary responsibility for
the payment of the tax falls on the estate and the property held by the executor, and therefore
the possible failure of the executor to secure recovery of the tax on the life insurance proceeds
from the beneficiary thereof is the kind of contingency referred to in the terminable interest
regulations. Thus the portion of the marital share which could be used to pay taxes is a
terminable interest and does not qualify for the marital deduction. The "tax on the tax" effect
could substantially deplete the marital share. This problem was successfully avoided through
the creative use of disclaimers. Boyd v. Commissioner, 819 F.2d 170 (7th Cir. 1987).
- Specific Bequests. The vanishing residue could also be created by specific bequests under the
will which, when the will was drafted, did not use up the exemption equivalent, but at the date
of death of the decedent aggregate more than the exemption equivalent in value. Thus, the
pecuniary marital would absorb the entire estate and there would be no residuary estate. In
that case, if there were other specific bequests and if the debts and taxes clause were not
carefully drafted so as to impose on other specific bequests any tax which might be due after
the residue is exhausted, the taxes would be payable at least in part out of the marital share.
- Adjusted Taxable Gifts. Another situation in which the vanishing residue might be created is
the making of adjusted taxable gifts which exceed the exemption equivalent in value. While my
clients would never do this, testators have been known to make gifts without informing the
lawyer that drafted their will, thereby creating the problem after the drafting is done. Or
perhaps the attorney simply failed to inquire as to the amount of taxable gifts. The Service has
consistently maintained that it has the authority to revalue gifts even after the statute of
limitations on the gift has run. Under §2504(c), the statute of limitations for revaluing gifts for
the purposes of increasing the tax rates on future gifts runs only if there has been a payment of
the tax. The Service has long maintained that the use of the credit is not the payment of a
tax(10) and that the use of the credit is mandatory.(11) Therefore, the statute of limitations on
revaluing the gift for subsequent gift tax purposes has not begun to run. Likewise, the Service
contends that even if the statute had run for gift tax purposes, §2504(c) does not apply to
adjusted taxable gifts, and that it can revalue such gifts for estate tax purposes. Smith Estate v.
Commissioner, 94 T.C. 872 (1990), acq. 1990-2 C.B. 1.(12) A gift near the exemption
equivalent amount, if revalued for estate tax purposes, could create an adjusted taxable gift,
thereby creating a tax to be paid in the optimal marital situation when no tax was anticipated.
- Closely-Held Stock. The surviving spouse must be given the power to cause non-income
producing property to be converted to income producing property, or to require that the lost
income be satisfied out of other assets of the trust. Regs. §20.2056(b)-5(f)(5). That being the
case, if the QTIP is funded with stock in the family business, the power in the surviving spouse
(particularly in a second marriage) to cause the stock to be converted to income producing
property could well prove disastrous to the economic well being of the family as a whole.
Thus, care must be taken in deciding whether or not to provide QTIP treatment if the principal
asset will be non-income producing and if the spouse may elect to require that such property
be converted. See also the valuation problems raised by this particular class of asset discussed
- Allocation of Income to Pecuniary Bequests. During the administration of the estate, the
question arises as to how to allocate the income among the various gifts, and particularly what
effect that allocation might have upon the marital deduction. If the marital is an outright
pecuniary bequest, the Regulations provide that such bequest will not fail to satisfy the
conditions for obtaining the marital deduction "merely because the spouse is not entitled to the
income from estate assets for the period before distribution of those assets by the executor."
Regs. §20.2056(b)-5(f)(9). But then the Regulation goes on to add, ". . . as to the valuation of
the property interest passing to the spouse in trust where the right to income is expressly
postponed, see §20.2056(b)-4." The cited Regulation provides in part as follows: "In
determining the value of the interest in property passing to the spouse account must be taken
of the effect of any material limitations upon her [sic] right to income from the property."
[Author's note: The sexist and chauvinistic reference in the Regulation is that of the Internal
Revenue Service and not that of the author.] In many states, pecuniary bequests earn interest
after some reasonable period of time, rather than sharing in the income of the estate. So long as
income is paid in accordance with state law, and begins to accrue without unreasonable delay,
there should be no impact on valuation. If the will provides for an extended delay in income to
the marital share, there should not be a qualification issue, only a valuation issue. (See
discussion of Estate of Hubert, below.)
- Failure to Fund. In the real world, all too often, the marital trust (as well as the exemption
equivalent trust) might never be funded. This is especially true where the spouse is the
executor and the income beneficiary of both trusts and in states with independent
administration rules which do not require a detailed final accounting and UPC states. In other
cases, there may be at least a partial failure to fund, due many times to valuation errors.
- Total Failure. If the marital gift is never funded, then how is the executor of the estate of the
surviving spouse to measure the QTIP trust for §2044 purposes? This problem is compounded
if the surviving spouse has remarried and has failed to keep the property brought into the
second marriage segregated. If the beneficiaries of the two trusts are not identical, still further
problems are present.
- Partial Failure. A Revenue Ruling and a case illustrate some of the problems created if the
marital bequest is under funded. In Rev. Rul. 84-105, 1984-2 C.B. 197, the Service ruled that
the under funding of the marital trust did not cause a reduction in the marital deduction, but
rather was a gift from the surviving spouse to the non-marital takers under the will. This gift
occurred when the statute of limitations ran on the ability of the spouse to sue for the shortfall,
which was clearly shown on the final accounting approved by the court without any objection
by the spouse. Would the result be the same if there were a spendthrift trust provision? Does
this ruling present some delayed partial election opportunities? And finally, who asks for
rulings like this anyway?
In Bergeron v. Commissioner, T.C. Memo 1986-587, the question took on a slightly different
twist. In this case, the under funding fell into the bypass trust, of which the spouse was the
income beneficiary. Thus, the value of the gift was the value of the interest reduced by the value
of the retained income interest of the spouse. (Obviously, this was a gift of a future interest as to
which no annual exclusion was available.) The consequence of this result, however, was to make
the spouse a grantor as to part of the bypass trust, with the retained income interest causing a
partial inclusion in the spouse's estate.
VII. THE PANDORA'S BOX OF VALUATION PROBLEMS
As indicated earlier, perhaps the most significant series of decisions to be made by the executor
are those decisions concerning the valuation of the assets of the estate. This has always been an
area rife with controversy. In fact, the legislative history of ERTA estimated that approximately
500,000 disputes involving valuation existed at the time of the passage of ERTA. H.R. Rep. No.
201, 97th Cong., 1st Sess. 243 (1981). It is in this area that the executor must exercise the
utmost care and diligence in assuring that the valuations reported on the federal estate tax return
are valid. See Formal Opinion 335 (February 2, 1974) which, while dealing with securities
transactions, can easily be applied to the estate tax area. Among the most difficult of assets to
value is the decedent's interest in closely-held business entities. The discussion below relates to
such valuation problems.
- . A Little Historical Perspective. As with many issues of its kind, the valuation problems can
also be viewed as opportunities, but opportunities fraught with great risk both from a tax and
fiduciary liability standpoint. As will be discussed more fully below, the discounts which may
now be available to taxpayers in the gift tax area could become dangerous weapons for the
Service in the estate tax area, and perhaps even in the income tax area. Over the past decade
or so, Congress and the Service have worked diligently to eliminate many of the estate
planning opportunities that we knew and loved. The game has now boiled down to the
greatest rewards being available in valuation, both by inter-vivos and post-mortem strategies.
With the advent of family limited partnerships and increased emphasis on the concept of
control premiums and minority discounts, this area has become an even more fertile ground for
planning and disputes. The misguided and not lamented §2036(c), and the terribly complex
and dangerous Chapter 14 are examples of legislation in this area.
The issues in this area revolve around valuation discounts for a minority interest and valuation
premiums for control. Different standards are applied in the gift tax area than in the estate tax
area. The gift tax focuses solely on the value of the transfer in the hands of the donee. However,
the estate tax valuation has two components, the value for inclusion in the gross estate and the
value at the funding of the bequests.
- .Valuation for Gift Tax Purposes. The valuation issues in the gift tax area, as noted above,
revolve around the value of the transfer in the hands of the donee.
- Minority Discount - Rev. Rul 93-12. Taxpayers have long contended that a transfer of a
minority interest in a closely held business was entitled to a discount even though the transfer
was to a family member; i.e., no aggregation should occur, but rather the transferred interests
should be valued without reference to the relationship of the transferor to the donee(s), or the
donees one to the other. After a series of losses in the courts,(13) the Service apparently
conceded the issue in Rev. Rul. 93-12, 1993-7 I.R.B. 13. In that ruling, the Service revoked
Rev. Rul. 81-253 and abandoned its long held position that gifts to family members were not
entitled to a minority interest discount, stating that it would no longer apply aggregation in
determining the value of interests transferred among family members. In that ruling, Donor
owned 100% of the stock of a corporation. He transferred 20% of such stock to each of his
five children. The Service ruled that each block was to be valued separately and since no block
represented control, each was entitled to a minority discount. See also TAM 9449001
(3/11/95) reaching the same result with respect to gifts to 11 donees. However, one should
not be too smug in one's belief that the ruling really signals a surrender by the Service, which
has indicated that 93-12 is limited to its facts.(14)
- Control Premium. The corollary to the minority discount is the control premium. If a minority
interest is entitled to a reduced value for lack of control, then a controlling interest carries with
it a proportionately larger value. For an egregious attempt to avoid the application of a control
premium and to establish a minority discount, see Estate of Murphy, T.C. Memo 1990-472, in
which the decedent made a death bed transfer of a minute percentage of her controlling interest
in the family businesses.
- "Swing Vote" Premium. In one of the first major limitations on Rev. Rul. 93-12, the Service
promulgated TAM 9436005 (5/26/94). In that situation, Donor was the owner of 100% of the
stock of a corporation. He transferred 30% of the stock to each of his three sons, 5% to his
wife, and retained 5% for himself. He took a minority interest discount in valuing the transfers
to his spouse and children. The Service ruled that in addition to a minority discount, each
transfer of a 30% interest carried with it a "swing vote" premium since any two, banding
together, could create a control block. This theory does not rely on the relation of the
shareholders, but rather on the fact that a willing buyer in possession of all relevant facts would
know who the other shareholders are and how the voting balance lines up.(15)
The TAM relies heavily on Estate of Winkler v. Commissioner, TCM 1989-232, in which the
decedent owned a 10% block of stock, and the other two shareholders owned 40% and 50%
respectively. The court found that while a minority discount was appropriate, there was also a
10% premium for the fact that the decedent's block held control for one shareholder and a
deadlock for the other. The Service also relies on Estate of Bright, supra, n. 13. That reliance is
misplaced in that Bright did not uphold the swing premium concept, but merely discussed the fact
that some early cases recognized it.
The taxpayer argued that a gift of one 30% block would not carry the "swing vote" premium.
The Service responded that the second gift would carry control through the "swing vote," and
that transfer constituted an indirect transfer to the first donee.
If the "swing vote" theory is accepted, it raises several issues. (1) Suppose 93-12 had been gifts
of 40%-20%-20%. Would all three blocks carry a premium? The two 20% blocks alone could
do nothing, but either combined with the 40% gives control. (2) The logical extension would be
that any minority shareholder would have a premium added to the value of his stock if it could
combine with another minority block to give control (Winkler). (3) It would seem that there is
some sort of "compulsion to buy" in this situation, since there is an assumption that the willing
buyer ultimately will be one of the other shareholders in order to protect or increase the value of
his block. This contravenes the hypothetical willing buyer element of fair market value. Would a
third party pay a premium on the chance he could combine with another shareholder to create a
control block? I think not. Also, it assumes, incorrectly, that a hypothetical willing buyer would
get involved at all in a closely-held family situation.
- .Estate Tax Issues.
- Valuation in the Gross Estate. In contrast to a gift, for gross estate purposes, the decedent's
interest in the property is valued without regard to the identity of the beneficiary.
- Minority Discounts. In Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981), the
decedent and her husband owned a 55% block in a corporation as community property. The
estate took a minority discount in valuing the stock, asserting that the estate owned only a
27-½% interest in the corporation. The Service argued that in valuing the stock under the
willing buyer-willing seller formulation, the willing buyer would recognize that the balance of
control was owned in an individual capacity by the trustee of the testamentary trust owning the
estate's interest. The Court rejected this argument, holding that the identity of the legatee was
immaterial. The only relevant inquiry is the value of the property actually included in the
estate.(16) Thus any discount for gross estate purposes must be based upon the decedent's
interest. See TAM 9449001.
- Blockage Discount. Because a large block of stock (even in a publicly traded corporation)
may be more difficult to sell, a discount is allowed, which is a separate discount from the
minority interest discount.
- Control Premium. The corollary to the minority discount is the control premium, and this too
is determined at the estate level. If a minority interest is entitled to a reduced value for lack of
control, then a controlling interest carries with it a proportionately larger value.
- Aggregation of Interests to Create Control. The Service has taken the position that the
interest owned by a decedent outright must be aggregated with an interest in the same entity
held in a QTIP trust for Decedent. In TAM 9140002, decedent owned 62-1/2% of certain real
property in his own right, and 37-1/2% was held by a QTIP trust. Relying on old
contemplation of death cases under §2035 and Rev. Rul. 79-7, 1979-1 C.B. 294, the Service
reasons that the decedent is treated as the owner of the property in the QTIP trust because it is
included in his estate. However, the analogy between §2044 and §2035 is flawed. §2035
depends on the prior ownership of the interest by the decedent and a transfer by the decedent
within the proscribed time frame.(17) The decedent never owned the §2044 property in his own
right and therefore could never have made a transfer of the property. The property is included
under §2044 solely because the decedent had a qualifying income interest for life in the
property and a deduction was allowed under §2056(b)(7) or §2523.
The Service reiterated that position in TAM 9550002, in which the QTIP trust created under the
will of Decedent's spouse held 150 shares of the 500 shares outstanding in a corporation.
Decedent owned an additional 200 shares outright, thereby giving Decedent and the QTIP trust
together 70% of the corporation's outstanding stock. In addition to its secondary reliance on Rev.
Rul. 79-7, the Service primarily reasons that §2044(c) causes the assets in the QTIP trust to be
treated for purposes of the estate tax and generation skipping transfer tax as having passed from
the decedent.(18) Regs. §20.2044-1(b) treats the property as passing from the decedent for specific
purposes -- the charitable deduction, the marital deduction, special use valuation under §2032A,
and the §6166 payout. The Service states that the property is treated for estate tax purposes as
having passed from Decedent's spouse to Decedent, and then from Decedent to the beneficiaries
of the QTIP trust, thereby causing the Decedent to be treated as the outright owner. However,
neither §2044 nor the regulations indicates that the decedent is to be treated as the "owner" for
purposes of valuing the assets in the QTIP trust. Decedent never owned the property and his
control over the passage of the property is limited by the terms of the QTIP trust.
The Fifth Circuit ringingly rejected the government's position in Estate of Bonner v. U.S., 84 F.3d
196 (5th Cir. 1996). Mrs. Bonner devised her undivided interest in certain property to a QTIP
trust. At the death of Mr. Bonner his estate claimed an undivided interest discount of 45% for his
interest in the assets in the QTIP trust. The government sought to aggregate those interests,
thereby denying an undivided interest discount. The Fifth Circuit, relying on Estate of Bright,
emphatically rejected the government's arguments:(19)
...Although §2044 contemplates that the QTIP property will be treated as having passed from
Bonner for estate tax purposes, the statute does not require, nor logically contemplate that in so
passing, the QTIP assets would merge with other assets. The assets in the QTIP trust could have
been left to any recipient of Mrs. Bonner's choosing, and neither Bonner nor the estate had any
control over their ultimate disposition....
...The estate of each decedent should be required to pay taxes on those assets whose disposition
that decedent directs and controls, in spite of the labyrinth of federal tax fictions.
Id., at 198-199.
The court simply rejected the argument that "treated as property passing from the decedent" in
§2044(c) equates to ownership for valuation purposes.
- Valuation When Funding Specific Bequests. The problems that may be encountered in funding
specific bequests and the valuation of assets were highlighted in Chenoweth v. Commissioner,
88 T.C. 1577 (1987). The decedent's will gave 51% of the shares of stock in his corporation
(in which he owned all the stock) outright to his spouse. Although the Service and the estate's
representatives agreed on the value of the corporation, they disagreed on whether the spouse's
51% of the shares were entitled to a control premium for valuation purposes when calculating
the marital deduction. The Tax Court denied the Service's motion for summary judgment,
holding that the spouse's 51% was entitled to a control premium and remanding to determine
the amount. The Tax Court declined to follow Provident National Bank v. United States, 581
F.2d 1081 (3d Cir. 1978) in which the court held that the value for inclusion purposes and for
the marital deduction must be the same. Instead, the Tax Court chose to follow Ahmanson
Foundation v. United States, 674 F.2d 761 (9th Cir. 1981), in which the court held that the
value of a charitable deduction consisting of entirely non-voting stock was less than the prorata
interest in the corporation. Thus, a marital gift involving a controlling interest can be valued at
more than its pro rata value in funding the marital deduction. The reverse side of Chenoweth
can be seen in TAM 9050004 in which the son's trust received 51% of the stock and the
marital trust received 49%. In calculating the marital deduction, the Service ruled that the
estate must discount the minority value assigned to the wife's trust. To the same effect, see
TAM 9403005, which held that the gross estate valuation of both common and preferred
combined was higher than the valuation of either share because as a block they had more value
than each share alone. Thus, when the will bequeathed the preferred stock to the bypass trust
and the common stock to the marital share, the marital deduction was required to be computed
at a reduced value reflecting the loss in voting power.
To understand the impact of Chenoweth, a specific example may be helpful. This example will be
carried forward into future discussions also. Assume that the corporation in Chenoweth had a
total value of $2,000,000 with 10,000 shares outstanding, thereby producing a value per share of
$200. At this point, because the decedent owned all the shares, no discount or premium issues
arise beyond those inherent in the basic valuation.(20) But, once the funding occurs, then these
issues arise. Assume for purposes of this illustration that the control premium and the minority
discount are both 30%.(21) Applying these assumptions to the Chenoweth rationale, the following
Bequest of 51% of $2,000,000 to spouse $1,020,000
Control premium (30%) 306,000
Value of marital deduction $1,326,000
Bequest of 49% of $2,000,000 to son $ 980,000
Minority discount (30%) 294,000
Value of minority interest $ 686,000
Total "value" distributed $2,012,000
The basis in the hands of the wife should be $1,326,000 while the basis in the hands of the son
should be its discounted value since arguably those values are the values included in the gross
While the Chenoweth court stated that the total value after applying control premiums and
minority discounts could not exceed the value included in the gross estate, that would seem to
depend upon the discounts and premiums applied. There is a certain logical appeal to the
proposition that the whole cannot be greater than the sum of its parts, or vice-versa and thus
some modification to the above example may be required.
- Where Does All This Premium and Discount Leave Us? While the use of premiums and
discounts in funding bequests is not entirely new, it has suddenly assumed center stage, and the
extensions of the rationale originally urged by taxpayers will certainly take some unanticipated
twists and turns. In a world in which "be careful what you wish for, you may get it" must be
the watchword, we have really wished ourselves into a mess. Some of the issues which may
- Funding of Pecuniary Bequests.(22) In all of the cases and administrative interpretations, the
premium or discount arose from a specific bequest of a control or minority interest. But, does
the will itself have to direct the apportionment of control and minority interests, or are the
values of the marital and non-marital share affected by the funding decisions of the executor?
Both Ahmanson and Chenoweth would hold, correctly, that the decisions of the executor in
distributing assets would not affect the amount of the marital deduction except as to a
distribution in satisfaction of specific bequests. However, even though the executor's funding
decisions would not be relevant in valuing the bequest, it would affect the funding of
pecuniary bequests. Thus, if there were a pecuniary marital bequest funded with a "true
worth" (date of distribution) value, the allocation of 51% or more to the marital share should
result in more assets (other than the closely held stock) being diverted to the exemption
equivalent share because less of the other assets would be needed to fund the marital share.
Conversely, if the credit shelter or bypass gift is the pecuniary gift, funding the gift with less
than control should cause a minority discount to apply to the stock, thereby enabling more of
the other assets of the estate to be shifted to the credit shelter gift and away from the residuary
marital gift. While at first blush this does not seem like the correct result, it follows logically
from the control premium and minority discount analysis. Note that in both cases, the marital
share, when valued at the death of the surviving spouse, contains a control premium unless
some post-mortem planning is done.
CAVEAT: While all the tax considerations described below are important, the asset being
manipulated (for lack of a better word) may well be a principal source of the family unit's
wealth and income, and considerations of control from a business standpoint should
probably predominate over tax considerations.
Using the same corporation and premium and discount as in the above example, also assume an
optimum marital deduction plan, with a true worth funding clause, but the decedent owns only
60% of the entity, and no allocation of that interest is made by the will. The fact that the decedent
owned less than 100% puts an interesting spin on the analysis. The basic calculation of value for
inclusion in the gross estate should be:
CALCULATION FOR INCLUSION
Total value of corporation $2,000,000
Percent owned by decedent 60%
Value includible before premium $1,200,000
Plus 30% premium(23) 360,000
Total value includible in gross estate $1,560,000
Value per share ($1,560,000/6,000 shs) $260/share
Now, some further assumptions are necessary to indicate the effect on funding of the marital and
bypass gifts. For purposes of this analysis, it does not matter whether the marital deduction gift is
outright or in trust. Assume that the taxable estate before the marital deduction in an optimal
marital deduction plan, exclusive of the closely held stock, is $3,000,000. The calculation of the
marital deduction would be as follows irrespective of whether the marital share is pecuniary or
CALCULATION OF MARITAL DEDUCTION
Assets other than closely held stock $3,000,000
Closely held stock @ $260/share 1,560,000
Less: Bypass gift -600,000
Marital deduction gift $3,960,000
If the bypass share is the pecuniary gift, then funding such gift with anything less than 51% of the
stock will (should?) arguably cause the stock to be valued at a discount, thereby shifting value
away from the marital share by increasing the value of other assets to be allocated to the bypass
gift. To analyze this, we must return to the basic example of $2,000,000 as the value of the
corporation as a whole with 10,000 shares outstanding. Thus, the unadjusted value per share is
$200. If there is a 30% discount for a minority interest, then the discounted value per share is
$140. If the bypass is fully funded with shares of stock, two minority blocks are created. Under
the example, 4,285 shares at the discounted value of $140/share are required to fully fund the
bypass ($600,000 ÷ $140/share = 4,285 shares), with the following result in funding the marital
Value of shares allocated to marital share:
Total shares in estate 6,000 shs
Shares used to fund bypass 4,285 shs
Shares allocated to marital deduction 1,715 shs
Multiplied by discounted value per share $140/sh
Value of shares allocated to marital gift $240,100
When the funding of the marital deduction is calculated, it is apparent that substantial value has
been shifted away from the marital deduction share. This will make no difference until the marital
share is valued upon the death of the surviving spouse.(24) But that's really the name of the game.
Value of shares allocated to marital gift $ 240,100
Value of other assets 3,000,000
Total value of marital share $3,240,100
Marital deduction allowed 3,960,000
Value which has "vanished" $ 719,900
While the result may seem a bit bizarre, it is consistent with the gift tax analysis discussed above.
In valuing the gross estate, how the property passes is not considered, but in funding pecuniary
bequests, the value of the property passing to each bequest is taken into consideration. While the
regulations limit the marital deduction to the property actually "passing" to the spouse, this
change in value should be treated no differently than other adjustments in market value.(25)
If, on the other hand, the marital share is the pecuniary gift, transferring at least 51% or more of
the stock to the marital share will (should?) arguably cause the premium that was used in valuing
the stock in the decedent's estate to be used in valuing the marital gift, thereby preventing an
over-funding of the marital deduction. Assume that all the stock in decedent's estate were
allocated to the pecuniary marital deduction gift:
Marital deduction $3,960,000
Value of stock 1,560,000
Non-stock assets required $2,400,000
Non-stock assets available 3,000,000
Assets available to fund bypass $ 600,000
Note that the allocation of the stock with a control premium to the marital deduction does not
allow more value to be shifted to the bypass. It simply avoids underfunding the bypass trust, as
would be the case if stock with less than control were allocated to the pecuniary marital gift
because more "other assets" would be required to be allocated to the marital share. This funding
approach will, as noted above, place stock with a control premium in the survivor's estate. Some
planning should thereafter be done to dispose of the control block during the survivor's lifetime.
Then, at the survivor's death, isn't the inclusion that of a discountable minority interest (assuming
no aggregation with stock owned by the surviving spouse) so that in effect the control premium
has disappeared, and a discount has been created? Under the rationale of Rev. Rul. 93-12, even if
the beneficiary of the exempt trust and the QTIP trust at the survivor's death is the same, so that
control is reestablished, they should not be aggregated.
Note, also, that if stock carrying control premium is not allocated to the marital deduction share,
an underfunding of the bypass will result. In fact, in the above example, if the discounted value is
correct, less than 51% cannot be allocated to the marital deduction because the other assets will
not fully fund the marital.(26)
Marital Deduction $3,960,000
4,950 sh @ discounted value of $140/sh 693,000
Amount of other assets to fund marital 3,267,000
Other assets available 3,000,000
Shortfall $ 267,000
When the shortfall is made up from stock, over 51% is then allocated to the marital deduction
share, creating a control premium and producing the result of funding the bypass at $600,000.
If the standard for funding the pecuniary bequest is federal estate tax value, the answer is even
less clear. Logically, the generated discount should be treated as any diminution in value, and the
Rev. Proc. 64-19 standard should take care of any problems. If the standard for funding the
pecuniary bequest is minimum worth, then it would appear that the discount for minority interest
would always cause the marital to be over funded.(27)
Suppose the gift to be funded is a fractional gift. The value of the estate as to which the fraction
is determined is the value at date of death, which includes the control premium. In funding a true
fractional share, using the above examples, if the fraction going to the bypass causes more than
10% of the stock to pass to that share, the marital share will automatically have a discounted
value at the second death (again assuming no aggregation). If, however, the fractional is a pick
and choose fractional, then you may well get the same result as a pecuniary bequest.
- Can the Whole be Different from the Sum of Its Parts? It would seem that if the controlling
interest passes to multiple beneficiaries, each of which receives only a minority interest, the
whole can be greater than the sum of its parts. This possibility is implied in Ahmanson and
specifically acknowledged in Chenoweth, and can be graphically illustrated in a situation similar
to PLR 9403005. The estate contains as its sole assets (in excess of the exemption equivalent
amount) two blocks of stock which together constitute control, but which separately constitute
minority interests. If one block is bequeathed to charity and the other is bequeathed to the
surviving spouse, then both the charitable deduction and the marital deduction are reduced by
minority discount. Thus, where both gifts are fully deductible, a tax is nonetheless created. To
say this logically cannot be so is probably correct. To say, "It ain't so, Joe" may not be.
Can the converse be true -- i.e., can the sum of the parts is greater than the whole? How is this
possible? If you assume that a decedent owned 80% of the stock of a company, and that the Tax
Court's "average" control premium of 35% is applied, how can the 80% interest be worth 108%
of the value of the company? The answer to that logical conundrum lies in the fact that there is
almost always a blockage or lack of marketability discount (as opposed to a minority discount)
applicable to a control block, and that discount must be taken with the control premium to
produce something less than 100% of the value. See, e.g., Lewis G. Hutchens Non-Marital Trust
v. Commissioner, 66 T.C.M. 1599 (1993).
- The Community Property Problem. The survivor would always own an interest in the entity in
his or her own right in a community property situation. Under the Bright rationale, such
interest in the estate of the decedent would always be eligible for a minority discount, thereby
causing both the gross estate and the funding of each gift to be discounted. This situation is
further complicated by the fact that the minority discounts may vary depending upon the size
of the minority block; i.e., a 10% block may carry a greater discount than a 49% block.(28)
Another problem which apparently has surfaced in California deals with basis in a non-taxable
community property estate. There, an agent in an income tax audit has apparently asserted a gain
based upon the fact that the community interest in the estate of the decedent should have been
discounted under Bright, thereby changing the basis in both halves of the community, and
reducing the value of the stock below its undiscounted fair market value. If Bright is good law
(and I would argue that it is) doesn't this mean that in every community estate there is a discount
required to be taken to determine basis of any asset constituting an undivided interest or minority
- Basis Problems. For purposes of income tax basis, §1014 provides that the basis of property
passing from the decedent shall be the fair market value at date of death.(29) Since the property
passing to the spouse in these situations may have either a control premium or a minority
discount at date of death, the fair market value used for basis should be its date of death value
and not "funding" value. This is consistent with the treatment of any asset which changes
value during the course of administration.
If the funding is of a pecuniary bequest so that it is an event which causes a recognition of
income, can there also be a loss on funding because of the reduction in value below the gross
estate value if the bequest is to a trust? One would suppose so since §267 apparently does not
apply to a transaction between the estate and a trust. See Rev. Rul 56-222, 1956-1 C.B. 155.
Suppose a taxpayer and spouse own 100% of a corporation as community property. Husband is
terminal and wife makes a gift of 1 share to husband before his death. He would then own a
majority interest subject to a control premium (since valuation would not be dependent on the
community or separate character of the stock). Would his wife's interest then receive a step-up
based upon that value in the estate?
As a final note on this matter, it must be observed again that the complications of dealing with
closely held business interests is only in part a tax issue. The greater issue is the business reality
of control of the enterprise.
- . Penalties. As if the problems were not already difficult enough, there are substantial penalties
imposed for undervaluations for estate and gift tax purposes. § 6662(g). Although subject to
a reasonable cause exception in §6664(c)(1), there is little or no guidance as to how the
penalty provisions will be applied in discount situations.
VIII. ANNUITIES AND QUALIFIED PLANS
- . Statutory Scheme for Annuities. There are three separate subsections of §2056(b)(7) dealing
with annuities, one which deals with the qualification of an annuity for QTIP treatment, a
second which deals with joint and survivor annuities, and a third which deals with charitable
- Qualification as QTIP. §2056(b)(7)(B)(ii) states, "To the extent provided in regulations, an
annuity shall be treated in a manner similar to an income interest in property (regardless
whether the property from which the annuity is payable can be separately identified)." The
drafters of the final QTIP regulations have requested comments on how the Energy Policy Act
definition of separate portion affects the treatment of an annuity. Space is reserved for such
regulations. The opinion has been expressed that the proposed regulations had it right with
respect to annuities: that the value of the property necessary to fund the annuity is the correct
measure of the deduction. See Prop. Regs. §20.2056(b)-7(c)(2). The separate portion rule
would not seem to be particularly applicable in this context.
- Joint and Survivor Annuities. §2056(b)(7)C) provides that joint and survivor annuities,
wherein husband and wife are the only permissible beneficiaries while either is alive, qualify for
QTIP treatment. The election is deemed made unless negatived. Future regulations will be
issued. The same is true of the corresponding gift tax section, §2523(f). There is some fear
that this provision could lead to an abuse where the annuity to the surviving spouse is more
illusory than real; e.g., a payment of $10/year for life. Presumably this issue will be dealt with
in the final regulations concerning QTIP annuities.
- Charitable Remainder Trusts. §2056(b)(8) provides that a charitable remainder trust qualifies
for the QTIP election where the spouse is the sole income beneficiary, thereby statutorily
decreeing that a qualifying annuity or unitrust interest is a qualifying income interest for life.
Although the trust will be included in the spouse's estate, there will be an offsetting charitable
The Service has requested comments in T.D. 8522 as to how a unitrust or annuity interest should
be treated for QTIP purposes. Thus it may ultimately be possible for a QTIP with an intervening
non-charitable beneficiary to qualify.
- . Qualified Plans and IRAs. Once again, there is no help. Example 10 in Regs.
§202056(b)-7(h) is carried over unchanged from the proposed regulations. It tracks Rev. Rul.
89-89, 1989-2 C.B. 231, which contains an extremely unrealistic scheme, which nobody (I
hope) follows. The reality is that tailoring withdrawals from qualified plans is difficult if the
employer is of any size, and if the employer is small, there is a real possibility of its
disappearing after the death of one or more of the principals, thereby causing the plan to
terminate. Thus, almost all of the authority in this area deals with IRAs. But the good news is
that the Service has been more reasonable in its rulings. So long as the distribution equals the
income from the IRA (without regard to substantially equal principal distributions), the IRA
will qualify for QTIP treatment. There are some factors to be considered and dealt with:
- Under the PLRs the distributions should be the greater of the required minimum distribution
under §401(a)(9) or the income from the IRA. Since the accounting in IRAs (particularly the
custodial IRAs) is not usually done with regard to allocations between income and principal,
the required formulation is easy to draft but may require some fancy footwork in its
- Notwithstanding the Service's position that the distribution from the IRA must be all the
income, the marital deduction rules themselves require only that the spouse have the right to
require that all the income be distributed. Treas. Regs. 20.2056(b)-5(f)(8). Thus, at least one
commentator has suggested that requiring that the IRA distribute only the minimum required
distributions while giving the spouse the right to direct the trustee to distribute all the income
will give a great deal more flexibility while still qualifying. Under a reading of the relevant
provisions, this formulation should be correct. However, the spouse clearly has a power of
appointment over the income of the IRA, and this may cause the entire amount of income to be
taxed currently to the spouse. Is that really all bad, however, if the spouse can afford to pay
the tax? This would seem to be the IRA equivalent of a defective grantor trust, resulting in the
ability to defer distributions from the IRA, thereby leaving assets in a tax deferred
CAVEAT: While this plan maximizes the ability to leave assets in the income tax deferred
environment of an IRA, that may or may not be the best overall planning in light of the possible
increase in the spouse's taxable estate and the IRD problems on distribution, not to mention the
excess distribution and excess retirement accumulation taxes. A complete discussion of those
problems is best left for other times.
- An election must be made with respect to the trust. Some commentators believe that an
election must also be made for the IRA. Who knows? Some draftsmen customize the IRA so
that it is itself the QTIP trust. That type of approach is not suggested for the uninitiated, even
if a form could be obtained.
For guidance on qualifying IRAs for QTIP treatment, see PLRs 9537005, 9416016, 9245033,
9232036 and 9229017. See also PLR 9348025 in which the trustee was required to distribute the
greater of the income, plus IRA-related expenses incurred by the trustee, or the minimum required
distribution. Any excess distributions from the IRA are to be treated as principal. Note that the
speed with which the trustee withdraws the IRA would greatly affect the income distributions of
the spouse by lowering future minimum required distributions. The spouse would, of course, be
entitled to the income on the portion allocated to principal.
IX. PURCHASE OF REMAINDER INTEREST IN QTIP TRUST
Under §2519, the transfer by the surviving spouse of his or her income interest creates a gift of
the remainder interest, and that this may have some appeal in some planning situations. A device,
for lack of a better term, that has now been circulating for several years, is the suggestion that the
surviving spouse might purchase the remainder interest in the QTIP trust using his or her own
assets. Since the entire value of the QTIP trust will be included in the estate of the survivor, the
result of this transaction, if successful, would be to remove the survivor's own assets while not
incurring a transfer tax. For example, assume that the fair market value of the QTIP is
$8,000,000 and the actuarial value of the remainder interest is $2,000,000. The surviving spouse
buys the remainder interest from the remainderman, and as a result, the $2,000,000 purchase price
and all the income therefrom and the appreciation thereon has been removed from the survivor's
estate. Plus, the remainder beneficiary now has $2,000,000 currently rather than having to wait
until the death of the survivor. It has a seductive simplicity about it, and there is no clear
statutory or regulatory prohibition. However, surely this cannot work!
- . Spendthrift Clause. The availability of the sale of a remainder interest may well depend upon
the presence vel non of a spendthrift clause, and even the language thereof.
- If There is a Spendthrift Clause. In a standard spendthrift clause, the beneficiary is prevented
from alienating or encumbering the beneficiary's interest in the trust. Thus, whether the
remainder is "held" by a trustee of a trust other than the QTIP trust, or by individuals, the
remainder interest cannot be validly alienated, and the transaction is impossible to execute.
The simple answer is to have the decedent plan for this and eliminate the spendthrift clause in
the QTIP, but that would then expose the trust to the claims of creditors. QUAERE: Would a
spendthrift clause that operated against only individuals (assuming the holder of the remainder
interest was a trustee) work, or could you permit alienation, but only to a limited class such as
ancestors? There is also a problem if the spendthrift would prohibit the surviving spouse from
collapsing the QTIP.
- If There Is No Spendthrift Clause. If the QTIP contains no spendthrift clause, then the
remainder beneficiaries could sell their remainder interest, valued actuarially, to the spouse.
The QTIP trust would then terminate under state law in many states because the life estate and
remainder would merge. Can it be argued that the termination of the trust is a "disposition"
under §2519, resulting in a gift of the value of the entire property? After all, the qualifying
income interest has terminated, but it has done so in favor of the spouse.(30) How can a
purchase be a disposition?
If this happens long enough before the second spouse's death, then perhaps the question will just
never come up. However, Question 6 of part 4 of the 706 asks: "Does the gross estate contain
any section 2044 property...from a prior estate?" It then refers to page 5 of the instructions which
defines section 2044 property as that for which a QTIP marital deduction was allowed. (More on
the definition later also.) In light of that, would the preparer have to answer yes? Also, the name
and social security number of the first spouse to die must appear on page 2 of the return of the
survivor. I do not know whether the Service routinely checks the prior spouse's return, but it's a
possibility. This approach raises the term "audit lottery" to new heights.
Suppose, however, that for some reason the QTIP trust cannot be "collapsed." (That is the
phrase found in the literature, not my choice.) Then the trust is there to be taxed. But is it taxed
under §2033 or §2044? Professor Jeff Pennell suggests that there is no reason that it could not be
taxed under both sections. After all, he reasons, §2033 deals with ownership, while §2044 is a
payback provision. "The value of the gross estate shall include the value of any property...if --a
deduction was allowed with respect to the transfer of such property to the decedent --under
section 2056 by reason of subsection (b)(7) thereof..." §2044(b). The Service would say, "We
gave you a deduction in the first estate, you owe taxes in the second estate." There is, he reasons,
nothing that would prevent both sections from operating because they are triggered by two
different events -- ownership and payback. The thought that the same property could be "double
counted" is almost too frightening to contemplate. Since the estate tax is a tax on the right to
transfer property, could it be argued that the same transfer is not being taxed twice since §2044 in
reality taxes the transfer from the first spouse? The value of the transfer is simply measured at the
second death, and the tax which was not paid at the first death is paid from that property unless
the survivor directs otherwise. See §2207A.
- . The Contingent Interest Problem. If there is a contingent remainder interest, then such
interest has value and must be purchased if the trust is to be collapsed. This was indeed what
happened in Olsten. If such interest is not purchased, then the trust cannot be collapsed.
- . The Adequate Consideration Analysis. At least one commentator has argued that the
purchase of a remainder interest in a QTIP cannot be for full and adequate consideration
because it diminishes the estate of the surviving spouse, and therefore must be a gift. Hesch,
"Purchasing the Remainder Interest in a QTIP Trust: An Analysis of Olsten v. Commissioner,"
21 Tax Management Estates, Gifts and Trusts Journal 115 (1996). This analysis proceeds
from the proposition that the spouse "owns" the entire value of the QTIP trust under §2044.(31)
Although condemning the result in Gradow(32) and its progeny, he argues that the analysis of
adequate consideration requires that there be no diminution in the estate of the transferor, and
in this case the transferor is the surviving spouse whose estate is diminished by the amount of
the transfer of the purchase price of the remainder interest which would be included in the
estate of the surviving spouse but for the transfer.(33) Even conceding that the surviving spouse
is the transferor (which is not necessarily the case since at least nominally the spouse is the
transferee of the remainder interest), the conclusion that any transfer which diminishes the
estate is for less than full and adequate consideration is open to question.
- .§2702 Problem. Perhaps this transfer is reachable under §2702, thereby treating the entire
transfer (less the consideration received) as a gift from the remaindermen. But what have the
remaindermen "retained", particularly in light of §2702(d) which treats the transfer of
remainder interests as a separate transfer?
The Service might try to attack this on some grounds such as lack of substance or having no
effect other than on taxes. However, those should not avail since there is economic substance to
this transaction. Here, the survivor parted with real dollars and took a real economic risk. For
an example of the Revenue Service's activity in the, "You may be technically right, but we're
gonna get you" arena, see Notice 94-78, 94-32 I.R.B. 15, dealing with somewhat aggressive
charitable trust income tax planning.
- . Income Tax Effect. If the transaction is done shortly after the death of the decedent, so that
no appreciation has occurred, then a portion of the basis is allocated to the remainder, and the
remaindermen should recognize no gain or loss on the transaction. The spouse should have a
basis equal to fair market value when the income interest and remainder combine. Note that
there is no basis allocable to the income interest if sold alone. §1001(e). See also Regs.
- . Is Anybody Really Doing These Things? Yes. There is at least one real transaction out there
like this, and it's a BIGGIE! In Estate of Olsten, N.Y.L.J., July 8, 1993, p. 28, the Surrogate's
Court approved the surviving spouse's purchase of the remainder interest in a QTIP trust,
which remainder interest was payable to a children's trust. The estate contained $105,000,000
(Yes, that's 105 MILLION DOLLARS) in a publicly traded stock, most of which will have to
be sold to pay taxes when the survivor dies. The trustees sought court approval to participate
in a plan whereby the survivor would purchase the remainder interest with a note, the trust
would be collapsed, and the survivor would use the property distributed to pay off the note.
The surrogate believed that the family was entitled to have the Service, and possibly the
courts, review the plan.
The Internal Revenue Service asserted a gift tax liability for the full amount of the purchase price
of the remainder interest, asserting both §2519 and §2511, as well as generation skipping transfer
tax liability. The taxpayer filed a petition on the Tax Court, Docket No. 96-1572 contesting the
tax and the valuation. It is my understanding that the case was settled because the future
appreciation of the stock used to pay the purchase price was expected to be substantial, and the
removal of the future appreciation from the QTIP still resulted in a substantial tax savings.
X. ALLOCATION OF ADMINISTRATION EXPENSES TO INCOME.
There has been a spate of activity recently concerning whether administration expenses should be
deducted on the federal income tax return rather than on the federal estate tax return. Taxpayers
were displeased with the idea that the administration expenses provided no tax benefit when
deducted on the Form 706 in optimal marital deduction planning, whereas they would provide an
immediate income tax deduction if such expenses could be claimed on the estate's federal income
tax return. However, there was the nagging issue as to whether taking the income tax deduction
would decrease (or perhaps even cause the bequest not to qualify for) the marital or charitable
deduction. The resolution of that issue depends upon the effect such choice will have on the
marital deduction or the charitable deduction since the highest federal income tax rate is only
slightly more than the lowestmarginal federal estate tax rate after considering the unified credit.
The Code permits the executor to deduct the reasonable expenses of administration (§2053) and
losses incurred during administration (§2054) from the gross estate. Certain of those deductions,
commonly known as "swing items," can be deducted on either the income tax return for the estate
or the estate tax return.(34)
- . If the Deductions Are Taken on the Federal Estate Tax Return. Traditionally, even in
optimal marital plans, administration expenses have been deducted on the federal estate tax
return. The results are certain and the calculations are easy.
(i) In an optimal marital plan, the deductions will reduce the marital share because the exemption
equivalent share will always equal the exemption equivalent amount, whether it is the residuary or
(ii) In other than optimal marital plans, the deductions will reduce the share to which allocated,
either by the will, by statute or common law of the decedent's domicile.
- . If the Deductions Are Taken on the Income Tax Return. If the decision is made to seek a
current income tax deduction for all or part of the administration expenses on the income tax
return, then the considerations become much more complex, and the tax results differ markedly
depending upon whether the expenses, although deducted for income tax purposes, are
charged to income or principal.
- Deductions Charged to Principal. If the deductions are charged to principal, then the
document or state law will govern the bequest to which such expense is charged. In an optimal
marital plan, the document should charge such item to the credit shelter share. While this
reduces the amount passing estate tax free at the survivor's death, it does not generate an
immediate estate tax. If the document or state law charges the expense to the marital or
charitable share, the marital or charitable share is reduced and a tax (or increased tax) is
created, and (assuming that taxes are also charged to the marital or charitable share) this in
turn creates more tax because the share is further reduced by the taxes to be paid therefrom.
Thus, an interrelated algebraic computation must be performed to calculate this tax on a tax.
- Deductions Charged to Income. If the deductions are charged to income, and if that charge is
effective for federal estate tax purposes, then an immediate income tax deduction is achieved
with no concomitant increase in estate tax or decrease in the credit shelter share. The Treasury
Department has taken the position that if the deductions are charged to income, the marital
share must be reduced by the amount of such charge.
It would seem that the income of the estate could be, and logically should be, burdened with that
portion of the administration expenses necessarily incurred to earn that income. If the income
were turned over to the trustee to invest, the trustee would clearly charge the income account
with a portion of its fees. As a matter of policy, a portion of the executor's fees should be
allocable to income while the executor is serving as a surrogate trustee.(35) The deduction of
certain fees as income tax expenses is the flip side of the proposition that certain trustee's fees and
certain trust administration expenses are deductible for federal estate tax purposes under §2053.
Treas. Regs. §20.2053-3(b)(3) and §20.2053-8(a). Estate of Hubert, infra,gives credence to this
argument. However, this is not the issue with which the courts have dealt directly.
- . The Confusion in the Courts. While the Tax Court has been consistent, the appellate courts
have been all over the map with different rationale.
The Tax Court has consistently taken the position that if either the instrument or state law permit
the charge of certain administrative expenses against income, then the election to take those items
on the 1041 and to charge them against income will not cause a diminution of the charitable or
marital deduction, particularly if the document contains a savings clause. Estate of Street v.
Commissioner, T.C. Mem. 1988-553 (1988) reversed in part and affirmed in part, 974 F.2d 723
(6thCir. 1993). See also, Estate of Horne, 91 T.C. 100, in which the executor's commissions were
paid out of income and deducted on the estate's income tax return in an attempt to increase the
estate tax charitable deduction while decreasing the estate's income tax liability. The Tax Court
disallowed the allocation based on South Carolina law.
In Estate of Richardson v. Commissioner, 89 T.C. 1193 (1987), the Tax Court held that interest
on unpaid taxes could be charged to income. In Estate of Street, the appellate court affirmed the
Tax Court's position in Richardson as to interest on taxes, but held that other administration
expenses could not be charged to income, directions in the instrument or state law
notwithstanding. The Revenue Service has now determined that interest on death taxes may be
deducted for income tax purposes without diminution of the marital deduction even if state law
requires that such expense be paid from the marital share. Rev. Rul. 93-48, 1993-25 I.R.B. 9.
See also PLR 9326002. What is bizarre, however, is the appellate court's basis for that distinction
when it "reasoned" that "[A]dministrative expenses accrue at date of death, but interest expenses
accrue after death." HUH? The Tax Court, in Estate of Hubert v. Commissioner, 101 T.C. 314
(1993), dealt with this absurd argument in holding that estate expenses could not accrue at date of
death, and that state law governed the allocation subject to the valuation requirement in the
regulations. See also, Estate of Allen, 101 T.C. 351 (1993) applying Oklahoma law, and
maintaining the Tax Court's position that the issue is controlled by state law and the instrument.
In Burke v. United States, 994 F.2d 1576 (Fed. Cir. 1993), the court enunciated a fairly clear
rationale for the disallowance of what it termed a "double deduction." The residuary beneficiary
in Burke was a charity. The estate charged the bulk of the administration expenses to the
post-mortem income of the estate. Burke found that the source of payments is irrelevant, and all
administrative expense deductions must be charged to the gross estate and accounted for with
respect to the gross estate. Additionally, the court states that the same deduction is being allowed
twice - the deduction for administration expenses under §2053, which the estate elected to take
on the income tax return, and the charitable deduction under §2055. What this line of reasoning
ignores is the fact that the income tax and the estate tax do not stand in pari materia. The former
is a tax levied on gross income and the latter is an excise tax on the right to transfer property.
The availability of a deduction under one tax does not affect the ability to deduct that item under
the other unless the statute and the regulations specifically so provide. In this area, the ability to
deduct administration expenses for income tax purposes should not affect the specific deductions
allowed under §§2055 and 2056. Burke also gives a clue as to why the Street court (which issued
its opinion first) felt the need to deal with the issue as to when administration expenses accrue.
The legislative history of the marital deduction in 1948 provides that the marital deduction cannot
be increased by paying claims from income. S. Rep. 1013, 80th Cong., 2d Sess., 11-6. Claims,
of course, accrue before death and may be deductible for both estate tax and income tax purposes
depending upon the nature of the claim.(36)
The Street court adopted a different rationale, saying, "Instead, Treasury Regulations
§20.2056(b)-4(a) controls the tax treatment of administrative expenses paid from income
regardless of state law or the dictates of decedent's will." Id., at 729. Those regulations provide
in pertinent part:
The marital deduction may be taken only with respect to the net value of any deductible
interest...as if the amount of a gift to the spouse were being determined. In determining the value
of the interest in property passing to the spouse account must be taken of any material limitations
on her right to income from the property. An example...is a bequest of property in trust for the
benefit of the decedent's spouse but the income from the property from the date of the decedent's
death until distribution of the property to the trustee is to be used to pay expenses incurred in the
administration of the estate. (Emphasis added).
The Street court then held that the marital bequest must be reduced dollar for dollar.
In Estate of Hubert v. Commissioner, 63 F.3d 1083 (11th Cir. 1995), the court relied on the
above quoted regulation in finding that there was no material limitation on the spouse's right to
receive income and thus no reduction of the marital deduction. The court's analysis was that the
income reduction to the spouse because of the administration expenses was not material in
relation to the income which would be generated over her life expectancy. Thus, the court found
that the issue was one of fact, and that an automatic dollar for dollar reduction was not
contemplated. The American College of Trust and Estate Counsel took this position in an amicus
curiae brief filed with the United States Supreme Court. The case was argued before the Supreme
Court on November 12, 1996.
In analyzing the results of these cases, there are some points which come clear. If one assumes
that the spouse will consume all the income, then, if the spouse lives several years, she will
eventually receive more income because the principal is larger. If the spouse is to reinvest all
income, then ultimately she will come out better since the first year total of income and principal
will be larger because of the income tax deduction. There is almost no scenario, other than a very
short survival period by the spouse, which will result in her receiving materially less. And indeed,
if the income tax deduction causes the imposition of an estate tax, the amount to the spouse will
be smaller because of the tax on a tax calculation.
It is worthy of note that this issue arises only when the marital deduction gift is in trust. It
matters not, except for the deduction, if the gift is outright.
XI. FORMATION OF LIMITED PARTNERSHIP
Because of the discounts available in transferring limited partnership interests, the creation of a
limited partnership is often viewed as an inter-vivos planning device. However, there is no reason
that they cannot be used after death as well. The surviving spouse could form a limited
partnership with the trustee of the QTIP trust as well as perhaps other family members which
could produce a huge savings at the death of the surviving spouse. The final regulations make it
clear that the QTIP is included in the estate of the survivor at its fair market value at the date of
the survivor's death. Regs. §20.2044-1(d). There is no trigger under §2519 for the sale or
transfer of assets so long as it does not result in a disposition. It is this kind of situation, however,
in which the requirement that the spouse must have the right to require the trustee to make
property productive arises. Some care must be exercised in the drafting, and there may be a
necessity for the protection of the trustee to get the court to bless the transaction, depending upon
the identity of the remaindermen. After all, there may be a real question of prudence if the trustee
exchanges fee interests in assets for a limited partnership interest. And all of the arguments
available to the Internal Revenue Service concerning the creation of Family Limited Partnerships
is available here. As noted above, counsel must always be aware that tax planning techniques
sometimes create fiduciary liability problems which must also be solved.
What seemed extremely simple a decade and a half ago has, not surprisingly, proved a good deal
more complex. Some of the problems not contemplated by the original draftsmen of the statute
have surfaced, and each passing day brings an increased realization to how multi-faceted the
unlimited marital deduction and the QTIP provisions are. Further, the administration of marital
deduction bequests and the elections required in such administration abound with uncertainties,
and traps for the unwary executor proliferate. In the administration of estates, we have only
begun to scratch the surface of the problems, especially in light of the growing instability of the
family unit and the increased focus on fiduciary liability. Added to all of the other problems is the
fact that tax reform constantly impacts marital deduction planning either directly or indirectly. All
of the problems, all of the complexities proclaim the need for an ever-increasing degree of
proficiency and professionalism, inevitably demonstrating that in the fast changing world of tax
and probate law, nothing is certain but uncertainty.
1. 1 All references to section numbers are to the Internal Revenue Code of 1986 unless otherwise
2. In Shelfer, the Tax Court acknowledged the final regulations at Regs. §20.2056(b)-7(d)(4),
but held them inapplicable since the survivor died prior to their effective date on March 1, 1994.
What the Tax Court will do in the case of a decedent dying after that date remains to be seen.
3. 3 Note, however, that there is no indication in the ruling as to the valuation of the gifts at that
4. There was also an issue in Clack as to whether the appeal would lie to the 5th Circuit (where
the decedent resided) or to the 7th Circuit which was the domicile of the personal representative.
The dissent by Judge Parker and the concurring opinion by Judge Beghe discuss this issue at
5. 5 See, e.g., Texas Probate Code §378A(b).
6. 6 This method is especially useful if §2032A property is involved in a pecuniary marital
situation, since the sizeof the marital bequest is determined using the special use valuation, but
funding occurs at fair market value. Note that the opposite result may be produced if the
pecuniary gift is the exemption equivalent; i.e., all the "excess value" could fall into the marital
7. In 1993, Texas enacted Texas Probate Code §378B which deals with allocation of income
during the administration of the estate if the instrument makes no provision therefor. That statute
seeks to answer this difficult question by mandating the executor to reallocate income after a
significant event, but leaving it in the executor's discretion as to when and how often such
reallocation should take place.
8. See, e.g., Texas Probate Code §322A, which is an example of an equitable allocation statute
9. 9 The same problem is present in an inter-vivos trust which separates into the marital and
non-marital shares at the death of the first spouse.
10. See Rev. Rul. 84-11, 1984-1 C.B. 201.
11. See Rev. Rul. 79-398, 1979-2 C.B. 338.
12. The Service acquiesced in the court's holding that the gift tax paid credit must be increased
for the tax that would have been paid had the gift been correctly valued on the 709. See also
Evanson v. U.S., 94-2 USTC ¶60,174, rev'g and remanding unreported D.C. opinion; Levin v.
Commissioner, 93-1 USTC ¶60,128 (8th Cir. 1994), cert den. 114 S. Ct. 66 (4th Cir. 1993); and
Robinson Estate v. Commissioner, 101 T.C. 499 (1993). But see Boatmen's First National Bank
v. United States, 705 F. Supp 1407 (W.D. Mo. 1988), the lone court which has applied §2504(c)
to adjusted taxable gifts.
13. 13 Bright v. U.S., 658 F.2d 999 (5th Cir. 1981), Propstra v. Commissioner, 680 F.2d 1248
(9th Cir. 1982), and Estate of Andrews v. Commissioner, 79 T.C. 938 (1982).
14. See LeFrak v. Commissioner, 66 TCM 1297 (1993), which was decided after the issuance of
Rev. Rul. 93-12.
15. See also TAM 9449001 (3/11/95) in which the Service held that the value of a gift was
determined in the hands of the donee. The Service notes, "The percentage of control represented
by the block transferred to the donee (including potential swing vote value) ...." (Emphasis
16. The Court also (correctly, I think) rejected the Service's argument that the entire 55% block
should be valued and then one-half the value should be included in the estate.
17. "...[T]he value of the gross estate shall include shall include the value of all property to the
extent of any interest therein of which the decedent has at any time made a transfer...during the
3-year period ending on the date of the decedent's death." §2035(a).
18. The TAM also applies that section to the gift tax, but the statute does not.
19. The Court remanded to the district court to determine the size of the discount.
20. The Chenoweth court assumes that the valuation of a 100% interest carries a control
premium but then goes on to indicate that an additional control premium attaches when the stock
is split into its component parts.
21. In the reported cases, the minority discount is usually greater than the control premium.
Additionally, although a discussion of valuation methods is beyond the scope of this paper, it
should be noted that the size of the block can impact the premium or discount; e.g., a 2/3 block
may carry a higher premium than a 51% block because, under the laws of many jurisdictions, it
takes a 2/3 vote to dissolve the corporation or to sell substantially all the assets of the
corporation. Blockage discounts and lack of marketability discounts also play into the ultimate
22. See the discussion of funding marital bequests, supra.
23. While it may at first blush seem strange that a 100% interest is calculated without a control
premium when a 60% interest carries such a premium, that analysis is the very essence of this
valuation approach, in that the whole is 100%, but its component parts may be more or less than
that, because the value per share varies with the relation of the size of the block.
24. The same is true if a control block happens to end up in the marital share.
25. See PLR 9113009, discussed supra. See also TAM 8642007, TAM 8649002, and PLR
8826078 dealing with whether a pecuniary bypass using true worth funding would permit the
residue to qualify for the marital deduction.
26. In fact, unless the stock constitutes the principal asset of an estate, this result will appertain
even in smaller estates.
27. It is unlikely that the minimum worth standard will continue to be used because of the GSTT
28. One commentator suggests the use of two marital trusts with the stock split between them to
create two minority interests. Would that be effective, and even if it were, would they remain
minority interests or be aggregated at the death of the survivor? Would it make a difference if the
beneficiaries were different? This device is beyond my risk tolerance level.
29. 29 See Regs. §1.1014-3(a).
30. Could this be analogized to a commutation of the survivor's interest which specifically
triggers the treatment of the transaction as a disposition. See Regs. §25.2519-1(f).
31. As noted above, Bonner would seem to refute the argument that the surviving spouse should
be treated as the owner for transfer tax purposes.
32. 897 F.2d 516 (Fed. Cir. 1990)
33. A complete discussion of the full and adequate consideration cases is beyond the scope of this
paper, the author cannot help but add his voice to those of other commentators who decry the
reasoning - or lack thereof - in those cases in which there has been a sale of remainder interest, all
of which seem to have bad facts. In Estate of D'Ambrosio v. Commissioner, 105 T.C. 522
(1995), the sale of the remainder interest was in consideration for a private annuity and Mrs.
D'Ambrosio died well before her life expectancy. While neither of those factors should be
relevant, they cannot help but give the transaction a tax avoidance flavor. In Pittman v. U.S., 878
F.Supp. 833 (E.D.N.C. 1994), the sale of several remainder interests were made with what can
only be called "funny money." See also, Estate of Magnin v. Commissioner, T.C. Memo.
34. To be deductible for income tax purposes, the deduction must be one allowable under either
§165 or §212. Treas Regs. §1.212(g)-1. The executor is required by regulations to file an
election under §642(g) to take the deductions on the income tax return, and that election is
irrevocable and waives the right to claim such amounts on the estate tax return. Treas. Regs.
35. Texas law, for example, follows this common sense approach by permitting "fees of an
attorney, accountant, or other professional advisor, commissions and expenses of a personal
representative, court costs, and all other similar fees and expenses relating to the administration of
the estate" to be allocated between income and principal as the executor determines to be just and
equitable. Texas Probate Code §378B(a).
36. The Burke court rejected the holding in a Fifth Circuit case which is probably confined to its
facts. After contentious litigation in which literally millions of dollars of legal fees were paid, the
court permitted the parties, by settlement agreement which settled the entire lawsuit, to allocate
charges to income and principal without reducing the charitable bequest. Estate of Warren v.
Commissioner, 981 F.2d 776 (5th Cir. 1993).