California Bar Members Propose QTIP Rule Changes

The QTIP trust provides for the welfare and benefit of the surviving spouse by providing lifetime income and, under certain circumstances, principal to the surviving spouse. Upon the surviving spouse's death, the corpus of the QTIP trust is distributed to the deceased spouse's beneficiaries according to the terms of the trust. The value of the QTIP property is included in the value of the surviving spouse's estate for federal estate and gift tax purposes.

Problems arise, however, when a surviving spouse, during his or her lifetime, transfers all or part of an income interest out of a QTIP trust. Under Internal Revenue Code ("IRC") § 2519, such a transfer would have serious -- and unintended -- consequences because the transfer of any portion of an income interest is considered a disposition of the entire property. Thus, if the surviving spouse gifts a portion of a QTIP income interest, he or she is considered to have disposed of the entire QTIP property, regardless of the fact that such disposition was neither intended nor desired. Moreover, if QTIP property is unintentionally sold for less than fair market value, thereby resulting in an unintended gift, IRC § 2519 would apply and the entire QTIP trust be deemed transferred for gift tax liability even though no gift was ever intended.

There are ways to reform IRC § 2519 to eliminate its drastic effects where the surviving spouse transfers a portion of a QTIP interest, either by gift or sale, without intending to transfer the entire QTIP interest. This paper suggests new regulations that can be enacted to reform IRC § 2519 so that its effect is fair and comports with the purpose and intent behind the marital deduction scheme.

IRC § 2056(a) provides the general rule that the value of a taxable estate is reduced by the value of any property passing to a surviving spouse. The policy behind this marital deduction is that "property passes untaxed from the first spouse to die to his or her surviving spouse but is then included in the estate of the surviving spouse."² The marital deduction does not eliminate the estate and gift tax on transfers out of the marital unit, but simply defers any such tax until after the death of, or gift by, the surviving spouse.³

Because the premise behind the marital deduction is that property passing pursuant to the deduction will be included in the surviving spouse's estate, the marital deduction does not generally apply to a transfer of terminable interest property.⁴ A terminable interest is any interest passing to a surviving spouse that will end or fail on the lapse of time, on the occurrence of an event or contingency, or on the failure of an event or contingency to occur.⁵ Thus, no marital deduction is permitted where: (1) an interest passing to the surviving spouse is a terminable interest; (2) the interest in such property passes or has passed from the decedent (for less than full and adequate consideration) to any person other than the surviving spouse; and (3) the third person will possess or enjoy any part of the property after the termination or failure of the interest passing to the surviving spouse.⁶ "The purpose of the terminable interest rule is to deny the marital deduction for transfers between spouses if the transfer has been structured to avoid estate tax when the surviving spouse dies."⁷

IRC § 2056(b)(7), however, provides an exception to the terminable interest rule. Under § 2056(b)(7), terminable interest property will qualify for the marital deduction if three requirements are met: (1) the property passes from the decedent; (2) the surviving spouse has a qualifying income interest for life in the property; and (3) the executor of the estate of the deceased spouse affirmatively elects to treat the property as QTIP property.

Under IRC § 2056(b)(7), a surviving spouse has a qualifying income interest for life if: (1) the surviving spouse is entitled to all the income from the property; and (2) no other person has a power to appoint any part of the property to any person other than the surviving spouse.

Thus, under IRC § 2056, QTIP property can be held in trust for the surviving spouse's lifetime, with the property passing to the deceased spouse's beneficiaries after the surviving spouse dies. Because the marital deduction is applied to the QTIP property, no estate or gift tax will apply to the QTIP property at the deceased spouse's death. Instead, after the death of the surviving spouse, the value of the QTIP property will be included in his or her gross estate.⁸

The enactment of the Economic Recovery Tax Act of 1981⁹ establishing the QTIP regime provided estate planners and their clients with a mechanism to capture -- and capitalize on -- QTIP property treatment by setting up separate trusts, commonly referred to as marital trusts or QTIP trusts, after the death of the first spouse in order to hold QTIP property for the benefit of the surviving spouse. The surviving spouse would receive all of the income from the marital trust -- and, under certain circumstances, principal as well. Upon the death of the surviving spouse, the assets of the marital trust would pass to the deceased spouse's beneficiaries, however, the value of those assets would be included in the surviving spouse's estate for estate and gift tax purposes as provided by IRC § 2044.

While IRC § 2044 addresses the issue of tax liability for QTIP property at the death of the surviving spouse, it does not address the issue of tax liability for transfers of QTIP property during the lifetime of the surviving spouse. Instead, that issue is handled under IRC § 2519. IRC § 2519(a) provides that "any disposition of all or part of a qualifying income interest for life in any property to which this section applies shall be treated as a transfer of all interests in such property other than the qualifying income interest." (Emphasis added.) IRC § 2519, by its own terms, specifically applies to QTIP assets held in a marital trust.

The problem with IRC § 2519(a), as outlined below, is that treating the disposition of a part of a qualifying income interest for life as an automatic disposition of the entire QTIP interest puts unreasonable and unfair restrictions on the surviving spouse's ability to gift income, principal or certain assets from the marital trust. Moreover, the rule can result in unintended gift tax liability even in circumstances where a surviving spouse never intended to make a transfer subject to IRC § 2519, such as where a surviving spouse sells a marital trust asset for what is erroneously believed to be fair market value. When what appears to be a simple rule can have such unintended consequences, a change is needed.

II. ANALYSIS

As noted above, IRC § 2519 provides that if a surviving spouse disposes of a portion of a qualifying income interest in QTIP property, then it is deemed that the surviving spouse has transferred all of his or her interest in the QTIP property. IRC § 2519 is too draconian in its "all or nothing" approach regarding transfers of QTIP property by a surviving spouse when such transfer is of only a portion of the QTIP income interest.

The inequity of such a statutory scheme becomes immediately apparent when one realizes that a transfer of an income interest includes any transfer of marital trust property for less than fair market value, even where there is no intent to make a gift. For instance, a surviving spouse has the right to demand that non-productive marital trust property be sold in order to convert it to income-producing property. However, if the property in question is sold for even one dollar less than fair market value, a transfer of an interest income has occurred and the entire marital trust is deemed disposed of under IRC § 2519.

Scenario #1: Decedent Husband dies, leaving Wife his separate property ranch as QTIP property in a marital trust. The ranch is quite large and incorporates an equestrian center, a stable, a feeding operation and open pasture. It is the largest property of its type in the area and has some unique features. The trustee (the Decedent's brother) has decided to sell the ranch because Wife has few assets of her own and needs cash to pay her high medical bills. The trustee obtains multiple appraisals of the property, but due to the singular nature of the property, the appraisals vary widely from each other. The trustee puts the property on the market and after several months with no offers, sells it for the first offer received as Wife's medical bills are piling up and immediate cash is needed. Later, at audit, the Service determines that the property was sold for less than the fair market value, and as a result, a portion of Wife's income interest has been transferred. Under IRC § 2519, such a determination would mean that the entire marital trust was disposed of, triggering a significant tax gift liability -- and thereby leaving far fewer funds available for Wife's medical bills and support.

Certainly, under the foregoing scenario there was no intent by Wife or the trustee to transfer an income interest in the marital trust. Nor was there any intent on the part of the trustee to transfer the marital trust property for less than fair market value. But the fact that the transaction was done in good faith and with the best of intent does not matter, because under IRC § 2519, there is no room for error.¹⁰ And the consequences of that unintended error can be devastating for the marital trust and its spouse beneficiary. Indeed, it is a "Catch 22" for a surviving spouse; the surviving spouse is given the power to demand that non-income producing QTIP property be sold in order to acquire income-producing property for her support, but if she exercises that right and the sale is later determined to have been for less than fair market value -- even if only by $1.00 -- then the surviving spouse is left with far less property for her support due to the imposition of gift tax under IRC § 2519. Thus, any sale of QTIP assets carries with it the potential to drastically harm the surviving spouse -- the very person whom the marital trust scheme was designed to protect. And since there is no good faith appraisal defense to IRC § 2519, there is no way to assure the surviving spouse that such a result will not occur, no matter how diligent the trustee or the surviving spouse's counselors may be in arranging the transaction. Thus, on the one hand, the tax scheme encourages a surviving spouse to arrange the QTIP property composition to maximize her support, but then punishes her severely if she does not get it exactly quite right.

Even where there is an intent to make a transfer of a portion of an income interest, only the most savvy of trustees is likely to understand that a transfer of even the smallest portion of the surviving spouse's income interest will be deemed a disposition of the whole marital trust, resulting in devastating tax implications. Since such an arrangement is counter-intuitive, an intended transfer of a small income interest can cause an unintended -- and unfair -- forfeiture of the marital trust protection.

Scenario #2: Decedent Husband leaves two residential real properties -- a fourplex and a small cottage -- to Wife as QTIP property in a marital trust. Wife is successor Trustee and administers the marital trust; she receives income from both properties. The couple's daughter has lost her job and is homeless. Wife, who supports herself from the income from the rents from the fourplex, decides to gift the cottage to her daughter so she will have a home to live in rent-free. Certain that she is doing exactly what her deceased husband would have wanted (and without any intent to evade gift tax), Wife deeds the cottage to her daughter. As a result of her generosity, Wife has now run afoul of IRC § 2519 and will be deemed to have disposed of the entirety of the marital trust interests, with the result that the marital deduction protection afforded the marital trust has now failed. Wife ends up incurring significant gift tax liability -- possibly forcing Wife to sell the fourplex to pay the gift tax and thus leaving her without income to support herself.

When applied in these scenarios, the punitive aspect of IRC § 2519 becomes clear. IRC § 2519's draconian impact not only contradicts the intent behind the statutory scheme permitting QTIP transfers, it is also inconsistent with other estate tax laws permitting Trustors to provide for multiple QTIP trusts in their trust declaration.

Example: Decedent husband bequeaths a 100% QTIP interest in rental property to the surviving spouse; all income to surviving spouse for life. Surviving spouse then transfers 10% of her interest in the rental income to a child. Under IRC § 2519, the surviving spouse has made a disposition of her entire interest in the rental property and has triggered tax on the entire value of the QTIP assets. Contrast this to the situation where the decedent husband bequeaths ten (10) interests of ten percent (10%) each in the same piece of rental property to ten QTIPs for the surviving spouse. The surviving spouse transfers her entire interest in the rental income of one of her 10% QTIP interests to a child. Under IRC § 2519, the surviving spouse has made a disposition of this QTIP interest only and still retains the other QTIP interests. Thus, under the first scenario, the surviving spouse has transferred 10% of her income interest in the rental property and, as a result, has triggered tax on 100% of her interest in the property. Under the second scenario, the surviving spouse still has transferred 10% of the overall income interest from the rental property, but has only triggered gift tax on the value of the 10% QTIP interest and avoids unintended gift tax on the other nine QTIP interests.

Such a disparate outcome is illogical. If there is a valid conceptual basis on which to hold that the transfer of a portion of an income interest triggers a transfer of the entire interest, then multiple QTIPs are inconsistent with that premise -- and yet they are allowed unequivocally under the tax code. The fact that they are allowed demonstrates that there is no valid basis underlying IRC § 2519's mandate that a transfer of a portion is a transfer of the whole.

Had the Husband in scenario #2 (from section a above) transferred the fourplex into one QTIP and the small cottage into another QTIP, the Wife could have transferred the cottage to her homeless daughter without destroying the fourplex QTIP upon which she depended for her own financial well-being. So long as the gift tax was paid on the transfer of the cottage, everyone would be treated fairly. The Service would receive gift tax as a result of the transfer of the cottage, the Wife would continue to receive the income from the fourplex QTIP without paying gift tax thereon, and the fourplex would be included in the Wife's estate at her death, and be taxed accordingly. Moreover, Husband's testamentary intent would have been satisfied. Instead, because Husband transferred his property to one QTIP instead of two, Wife's financial well-being has been compromised, perhaps irrevocably -the exact opposite of what Husband sought to accomplish with his estate planning. There is simply no logical basis for this disparate treatment.

Given the fact that a decedent spouse can provide for multiple QTIP trusts in his or her trust, one may ask why a "fix" is needed for IRC § 2519. The problem is twofold: First, the decision to include multiple QTIPs in an estate planning document must necessarily be made while both spouses are alive and therefore is little more than a hedge against unknown circumstances that the surviving spouse may or may not encounter at some uncertain point in the future, if ever. Thus, decisions as to the number of QTIP trusts needed and how they should be funded after the death of the decedent spouse are nothing more than guesswork and, once made, cannot be changed. Such a scheme denies the surviving spouse the flexibility he or she needs when faced with actual circumstances that would dictate a transfer of a particular QTIP asset. Moreover, should such circumstances never arise, the use of multiple QTIP trusts has bestowed no benefit and has resulted in extra layers of costly trust administration. Second, the ability to provide for multiple QTIP trusts in an estate planning document does not eliminate the issue of IRC § 2519's application to sales of trust property unintentionally made for less than fair market value.

III. SUGGESTED CHANGES

IRC § 2519 definitely has its place in the tax scheme. Certainly, there are times when a surviving spouse may wish to accelerate gift tax by making a transfer of a portion of a QTIP interest. When that occurs, it is a benefit to all involved. However, with a few minor changes, IRC § 2519's draconian effects can be modified so that it comports with the intention behind the marital deduction.

Since current law allows for multiple QTIP trusts to be established in a trust document drafted while both spouses are living, there should be no conceptual barrier to the suggested change. All the change accomplishes is to take multiple QTIP trust planning from the theoretical to the actual by giving the surviving spouse the flexibility to establish multiple QTIP trusts only when and if such flexibility is needed.

Allowing trust severance is a concept that is already in play in other parts of the Code. IRC § 2642(a)(3) permits the severing of an existing QTIP trust (inter vivos or testamentary) into multiple trusts for GST purposes if certain requirements are met. Thus, trust severance is an already-recognized mechanism for injecting flexibility where needed in the tax code.

The Service has already recognized the use of trust severance as a mechanism to avoid the harsh strictures of IRC § 2519. In a private letter ruling released on May 6, 2011,¹¹ the Service determined that a transfer of an asset from a QTIP trust severed after the death of the first spouse would result in the imposition of gift tax under IRC § 2519 only as to the assets in the resulting trust from which the transfer occurred. The other resulting trusts that came into the existence as a result of the severance would not be subject to gift tax under IRC § 2519 but instead would maintain their QTIP tax protection.

While this private letter ruling provides a window into the Service's current thoughts on this issue, private letter rulings are not binding on other, similar cases. Thus, the ruling does not provide any certainty on which practitioners and clients can rely. Indeed, it is the understanding of the drafters of this paper that there have been several tax cases that have raised the inconsistencies and problems with the application of IRC § 2519. While it is believed that all of those cases have settled, in many instances some tax was due. However, even if the Service is presently not implementing the draconian provisions of IRC § 2519 in every case, that is no guarantee that it will continue to refrain from doing so. As a result, practitioners are left with no firm guidance as to how IRC § 2519 will be applied in the future and no practical way of planning around it absent obtaining a private letter ruling which is cost prohibitive for many clients. Modifying IRC § 2519 to permit for trust severance will eliminate this confusion.

IV. CONCLUSION

Amending IRC § 2519 to provide for trust severance so that a surviving spouse could transfer a QTIP asset out of one resulting trust while maintaining QTIP tax protection for the other resulting trusts is a "win" for all. Surviving spouses wishing to transfer part of an income interest would have a mechanism to avoid unintended tax liability. Practitioners would have a clear understanding of the rule and how it is applied and can advise their clients accordingly. The Service would collect gift tax (if applicable) on the assets transferred but the remainder of the QTIP assets would continue in trust and be subject to estate tax liability upon the death of the surviving spouse, in accordance with the intent behind the marital deduction that property is subject to estate and gift tax only when it leaves the marital unit.

Amending IRC § 2519 to include a good faith appraisal defense similarly benefits all involved. Sales of QTIP assets would no longer pose the nightmare possibility of a total loss of QTIP protection despite the surviving spouse's best efforts to secure an accurate appraisal of the asset. To the extent that an asset has been transferred for less than fair market value, the Service would still collect a gift tax on the portion deemed to be a gift. The sales proceeds received by the QTIP trust would be included in the surviving spouse's estate upon his or her death, in keeping with the intent behind the marital deduction. Thus, there is no cause not to make the proposed changes and many noteworthy reasons to do so.

²Estate of Letts v. Commissioner, 109 T.C. 290, 295 (1997) affirmed by Estate of Letts v. Commissioner, 212 F.3d 600 (11^th Cir. Ga. 2000).

³Estate of Morgens v. Commissioner, 133 T.C. 402 (2009).

⁴ IRC § 2056(b).

⁵ IRC § 2056(b)(1).

⁶Ibid.

⁷Estate of Morgens, v. Commission, 133 T.C. at 410.

⁸ IRC § 2044.

⁹ Pub. L. 97-34, sec. 403, 95 Stat. 301.

¹⁰ This "all or nothing" approach is not applied in other areas of the tax code. For instance, in analyzing whether the transfer of an annuity to a family member was a sale or a gift, the court in LaFargue v. Commissioner (800 F.2d 936, 939 (1986) found that a taxable gift had been made because the annuity had been transferred for less than fair market value. The court then determined that the measure of the gift was the difference between the fair market value of the annuity and the annuity's present value. However, if the facts in LaFargue had been different -- had the annuity been held in a QTIP trust and thus subject to IRC § 2519 -- then the transfer of the annuity would have resulted in the entire annuity being subject to gift tax, regardless of the fact that only a portion of the asset was actually gifted.

¹¹ P.L.R. 201118007

¹² Or Trustee of the QTIP trust, if other than the surviving spouse.