Over the years, the US Tax Court has clarified the gift tax consequences of terminating qualified property with a finite interest (QTIP). Two new cases in 2024, Estate of Sally J. Anenberg v. Commissioner AND McDougall v. Comm'rhave helped to confirm our understanding of these often complex transactions.
Background on QTIP Trusts
QTIP trusts are popular estate planning tools that allow grantors to provide for a surviving spouse while retaining control over the final disposition of assets. When properly structured, these trusts qualify for the marital deduction, deferring estate taxes until the death of the surviving spouse. To qualify, the trust must give the surviving spouse a binding right to all lifetime income, prohibit anyone from naming property away from the spouse during his or her lifetime, and require a QTIP election in a tax return filed on time.
Gift tax considerations for QTIP trusts are complicated and have far-reaching implications. If a surviving spouse makes an inter vivos gift of any portion of their income interest in a QTIP trust, it triggers special gift tax rules under section 2519(a) of the Internal Revenue Code, treating it as a transfer of all interests in the trust except the qualified income interest. (The gift of a qualifying income interest is separately subject to the gift tax under IRC Section 2511.) This provision is designed to prevent circumvention of the QTIP rules and ensures that the gift is valued at the fair market value of the entire interest in the gift. of the trust minus the value of the surviving spouse's qualifying income interest. Thus, even partial transfers of interest can potentially result in a deemed transfer of the entire trust.
The exhaustible interest rule forms the basis of QTIP trust taxation, ensuring that property that qualifies for the marital deduction on the death of the first spouse does not escape taxation on the death of the second spouse. This rule and other provisions create a comprehensive system to maintain the integrity of the unlimited marital deduction and to ensure that QTIP trust assets remain in the transfer tax system. These assets are either included in the surviving spouse's estate at death (under IRC section 2044) or subject to gift tax if disposed of during their lifetime (under sections 2519 and 2511), effectively preventing tax avoidance while coordinating with the tax of wealth to avoid double taxation.
Annenberg: Setting the scene
Annenberg centered around the termination of a QTIP trust created by Alvin Anenberg for his wife, Sally. After Alvin's death in 2008, substantial assets were placed in a QTIP trust for Sally's benefit, with Alvin's children from a previous relationship as residuary beneficiaries.
In 2011, with the consent of all beneficiaries, the trustee filed to terminate the trust and distribute its assets to Sally. After the distribution, Sally donated some of these assets to trusts for Alvin's children and sold most of her remaining interests in trusts for Alvin's descendants in exchange for promissory notes.
Analysis of the Tax Court in Annenberg
The Tax Court rejected the Internal Revenue Service's position that the termination of the QTIP trust and subsequent sale resulted in a taxable gift under section 2519. The Court emphasized that a transfer alone is not sufficient to create gift tax liability, citing US Supreme Court precedent defines a gift as arising from “detached and disinterested generosity” or similar impulses. The court compared Sally's interests before and after the termination of the trust, concluding that she received more than she gave up after gaining full ownership and control of the assets. The court also found that Sally retained dominion and control over the assets, making any potential gift incomplete under Treasury Regulations section 25.2511-2(c).
The court likened the termination of the trust to an exercise of a power of appointment in Sally's favor, noting that the appointment of QTIP assets to the surviving spouse is not treated as a disposition under section 2519 and therefore does not trigger the gift tax. Importantly, the Tax Court distinguished this case from Kite's fortunein which the termination of the QTIP trust was part of a scheme to avoid estate and gift tax. IN Annenbergthe value of the distributed assets remained in Sally's estate for future gift or estate taxation, preserving the integrity of the QTIP regime.
The court focused only on whether Sally made a gift as a result of the termination of the QTIP trust and subsequent transactions. He did not consider or rule on the potential gift tax implications for the remaining beneficiaries (Alvin's children and grandchildren).
McDougall: Building on Annenberg with a twist
The most recent case of McDougallissued on September 17, further clarified the gift tax treatment of QTIP trust transfers. This case involved Bruce McDougall and his children, Linda Lewis and Peter McDougall, following the death of Clotilde McDougall in 2011.
After Clotilde's death, her estate passed into a residuary trust in which her husband, Bruce McDougall, had an income interest and their two children had residuary interests. As representative of the estate, Bruce elected to treat the trust property as a QTIP under IRC Section 2056(b)(7), allowing a marital deduction on Clotilde's estate tax return.
In 2016, Bruce and his children entered into a non-judicial agreement to move and terminate the QTIP trust, distributing all assets to Bruce. Bruce then sold some of these assets to new funds set up for the benefit of Linda, Peter and their children, receiving promissory notes in return.
The parties filed separate gift tax returns for 2016, claiming that these transactions resulted in offsetting mutual gifts without gift tax. However, the IRS challenged this position, issuing notices of deficiency both Bruce and his children. The IRS claimed that the change of faith resulted both in gifts by Bruce to his children under section 2519 and in gifts by the children to Bruce of their remainder interests under section 2511. Most importantly, the gift-to-children-to-parents aspect of McDougall does not appear to have been asserted by the IRS at Annenberg.
The decision of the Tax Court in McDougall
The Tax Court, after its previous decision in Annenbergruled in Bruce's favor regarding his potential gift tax liability. The court held that Bruce did not make taxable gifts to his children under section 2501, even if there was a transfer of property under section 2519 when the QTIP trust was replaced. The court reasoned that Bruce did not make gratuitous transfers and the exchange of trust property for the promissory note did not constitute a gift.
However, the Tax Court agreed with the IRS that Linda and Peter made taxable gifts to Bruce of their remainder interests in the trust under section 2511. The Court rejected the taxpayers' argument that the transactions resulted in offsetting reciprocal gifts, noting that while section 2519 may be considered a transfer, it is not considered a gift by Bruce to his children.
This ruling clarifies the gift tax treatment of QTIP trust rollovers and highlights the potential gift tax liability for residual beneficiaries when those trusts are terminated early. It underscores the importance of careful planning and consideration of gift tax consequences when modifying or terminating QTIP trusts.
Implications for Estate Planning
These recent decisions provide several important steps for estate planners and QTIP trust beneficiaries:
- Trust terminations of QTIP trusts that include a distribution of property only to the surviving spouse do not, by themselves, appear to cause any gift tax consequences to the surviving spouse, as shown in both Annenberg AND McDougall.
- The substance of the transactions is paramount in determining the tax consequences of gifts. Both cases highlight the importance of looking beyond the form of transactions to their economic reality.
- Careful structuring of subsequent transactions is essential to avoid inadvertent gift tax exposure. McDougall, in particular, it emphasizes the need to consider the tax implications of any transaction after trust termination and indicates that the remainder beneficiaries of the QTIP trust may be subject to gift tax on termination distributions to the surviving spouse because they opt out without payment from an interest in trust property without receiving full and adequate consideration for it in money or money's worth.
- Residual beneficiaries may face gift tax consequences when they consent to the early termination of the trust. This aspect of McDougall adds a new dimension to the planning process for QTIP trust terminations.
- If the QTIP trust has a broad standard for distributions, such as best interests or “as the trustee determines,” a trustee's exercise of that discretion to distribute assets to a spouse to allow them to engage in lifetime tax planning should not be subject to questioning by residual beneficiaries.
- If the standard is ascertainable, such as for health and support, and the trustee nevertheless distributes the QTIP trust assets to the spouse to engage in tax planning, then the IRS may assert that the remainder beneficiaries made a gift to the spouse by failing to object to the exercise of the discretion trustee.
Annenberg AND McDougall underscore the importance of considering all aspects of trust terminations, from the initial distribution to each subsequent transaction, and the potential gift tax implications for all parties involved. As the legal landscape continues to evolve, these cases serve as essential reference points for professionals navigating the complex world of estate planning and QTIP trust terminations.