Law Firm Seeks Clarification on Donor Spouse's Power of Control Under Lifetime QTIP Trusts

Mitch Gans and I have discussed this topic with George who recommended we write to both of you about it. Mitch and I are writing for ourselves and not on behalf of any organization with which we are affiliated.

We are writing about section 2523(b)(2) of the Internal Revenue Code and, in particular, we seek an official clarification that a spouse (the "donor spouse") who creates a lifetime QTIP trust described in section 2523(f) for his or her US citizen spouse (the "donee spouse") may retain the power to determine after the donee spouse dies the disposition of the trust corpus without causing the trust to fail to qualify for the marital deduction under section 2523(f). Mitch Gans, our friend and colleague Diana Zeydel, Esq. of Greenberg Traurig in Miami and I spend quite a bit of time trying to figure out the scope of section 2523(b)(2), which has been in the Code since the inception of the marital deduction in 1948. We have written an article, entitled "The World's Greatest Gift Tax Mystery," which was published last April in Tax Notes. We enclose a copy of that article. We are also enclosing commentary by Richard B. Covey contained in the April 2007 issue of Practical Drafting about the issue. We and Dick come essentially to the same conclusion. Although we would like to see the scope of section 2523(b)(2) clarified such as by the promulgation of a clarifying regulation, we do not think final resolution of the complete scope of section 2523(b)(2) is necessary to resolve the question of whether a spouse who is the grantor of a lifetime QTIP trust may retain a power of disposition over the property if the power may be exercised only after the death of the spouse for whom the lifetime QTIP trust was created.

As you know, section 2523(b) contains the terminable interests rules for the gift tax marital deduction purposes. Section 2523(b)(1) is very similar to section 2056(b), which sets forth the terminable interest rule for estate tax marital deduction purposes. However, section 2523(b)(2) contains a special terminable interest rule not reflect in section 2056(b). Section 2523(b) states:

In addition, there are at least two private letter rulings (which, of course, under section 6110(k)(3) cannot be cited or used as precedent) that are consistent with that legislative history. Specifically, PLR 200406004 and PLR 9437032, a copy of each of which is enclosed, conclude that a married person may create a lifetime QTIP trust under section 2523(f) even though he or she holds a power of appointment over the trust after the donee spouse dies.

At least one commentator does not seem so sure of our conclusion or at least did not before we wrote our article and Dick Covey wrote his commentary. Jeffrey Pennell, in his BNA Tax Management Portfolio (No. 843) on the marital deduction, writes at footnote 542, "Notice that § 2523(b)(2) precludes the donor from retaining any power to appoint an interest in an inter vivos QTIP trust, even if that power is not exercisable until after the donee's death. As a consequence, although it hardly makes sense that a retained interest may be permissible but a retained power not, it is not advisable that the donor retain any power to control or appoint the inter vivos QTIP trust." (Emphasis added.) Note, however, that Professor Pennell points out that the possible result he describes makes no sense. In light of the legislative history about QTIP trusts, it does seem that the donor spouse may retain a power to control the property placed into a lifetime QTIP trust after the donee spouse dies. A copy of the page from Professor Pennell's BNA also is attached.

Now, of course, this conclusion does not answer the question of what the scope of section 2523(b)(2) is. We have not been able to find anyone who is still around who was involved in the project of drafting section 2523(b)(2). We nonetheless conclude that section 2523(b)(2) will deny the marital deduction only in the limited circumstance where the power of appointment held by donor spouse was created by a third party. In other words, we think section 2523(b)(2) was intended to apply only where the power of appointment was created in the donor spouse by someone other than the donor spouse.

We base our conclusion upon the legislative history to the Revenue Act of 1948, the gift tax regulations that were in effect when Act was being drafted, as well as Reg. § 2523(b)-1(d), which is the only part of the regulations that deals with section 2623(b)(2). Copies of this regulation and the relevant portions of the legislative history that we have found are enclosed with this letter. As you can see, each of these sources deals only with powers of appointed granted by third parties,

To be sure, the fact that the examples in the legislative history and the one example in the regulations deal with powers of appointment granted by third parties does not necessarily limit the scope of section 2523(b)(2) to such cases. But what to us "seals" the matter and limits the scope of the section to powers of appointment granted by third parties, as is expressed in Lownes Kramer & McCord, is that it seems quite apparent that, for Federal estate and gift tax purposes, an individual cannot grant himself or herself a power of appointment, Reg. § 20.2041-1 (b)(2) provides in part that "[f]or purposes of sections 20.2041-1 to 20.2041-3, the term 'power of appointment' does not include powers reserved by the decedent to himself within the concept of sections 2036 through 2038. (See sections 20.2036-1 to 20.2038-1.)" Similarly, Reg. § 25.2514-1(b)(2) provides in part that "For purposes of sections 25.2514-1 through 25.2514-3, the term 'power of appointment' does not include powers reserved by a donor to himself." Although both Reg. § 20.2041-1(b)(2) and Reg. § 25.2514-1(b)(2) provide that a taxpayer cannot create a power of appointment in himself or herself for purposes of those sections, it is only those sections that deal with powers of appointment for wealth transfer tax purposes. Hence, because it seems that a "power of appointment" for wealth transfer tax purposes may only cover a power created in the taxpayer by a third party, we conclude that the reference in section 2523(b)(2) to powers of appointment includes only powers created in the donor spouse by a third party,

Please note also that, when the Act was being drafted and was enacted, Reg. § 86.2(b), the predecessor to § 25.2514-1(b)(2), stated in pertinent part that "[s]ection 1000(c) [which in now section 2514] does not apply to a power reserved, directly or indirectly, by a donor upon a transfer, as distinguished from the possessor of a power of appointment received from another person." A copy of this regulation is enclosed.

What we have not been able to discover is why the framers of the marital deduction provisions of the Revenue Act of 1948 wanted to cover powers of appointment. Suppose, for example, that a taxpayer's parent creates a ten-year term in property for the taxpayer and provides that, after the ten-year term, the property will pass to the taxpayer's then living descendants, per stirpes. If the donor gives the ten-year term interest to the donor's spouse (if a U.S. citizen) that gift qualifies for the gift tax marital deduction. But if the parent provides that, after the ten-year term, the property will pass to the taxpayer's then living descendants as the taxpayer appoints, then section 2523(b)(2) forecloses the allowance of the marital deduction. It seems certain from the legislative history to the Revenue Act of 1948 that what is now section 2523(b)(2) covers limited as well as general powers.

We do not understand why the retention of a limited power in these circumstances should result in a disallowance of the marital deduction. Perhaps we will never know. (I am attaching a few pages from a Harvard Law Review article by Professor Stanley Surrey, who indicates that a specific power of appointment rule was needed because a power of appointment is not a property right -- perhaps, he meant for Federal estate and gift tax purposes, which seems consistent with the quotes above from the section 2041 and 2514 regulations). In any case, regardless of the reason, it seems relatively certain to us that section 2523(b)(2) covers only powers of appointment created by third parties. Consequently, the grantor of a lifetime QTIP trust may retain a power of appointment over the property if the power may be exercised only after the spouse for whom the trust was created dies.

I hope you will consider confirming our conclusion and will consider issuing a formal position of the Internal Revenue Service to that effect if not also clarifying the scope of section 2523(b)(2) by regulation. We have taken the liberty of preparing a draft of what could constitute a revenue ruling on the topic.

Mitchell and I will take the liberty of arranging a call with the two of you sometime over the next few weeks. We thank you for the opportunity to work with you on this matter.