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An Alternative Strategy to Make Spousal Estate Tax Exemptions: Specially Designed QTIP Formed from the Revocable Trust of the Surviving Spouse
By Mitchell M. Gans, Jonathan G. Blattmachr, Michael L.
Graham and Austin Bramwell.
© 2007. All Rights Reserved.
Introduction
In the April 2005 Wealth Transfer Planning™ Newsletter, we
discussed how the estate tax exemptions of spouses could be made transferable, in essence, by allowing the surviving spouse to use any unused estate tax exemption of the spouse dying first.
This may occur by granting the spouse dying first (the “donee spouse”) a general (estate taxable) power of appointment over a sufficient amount of the assets in a revocable trust created
by the surviving spouse (the “donor spouse”)—a General Power of Appointment Strategy. For example, a spouse dies in 2007 with a gross estate of $1.1 million never having used any part of
his or her $2 million estate tax exemption. That means that $900,000 of that exemption would be wasted. But, as discussed in that Newsletter, the IRS has held, in private letter rulings, that
the entire exemption of the spouse dying first could be used by having the surviving spouse, effective at the death of the spouse dying first, grant a general (estate taxable) power of
appointment over a sufficient amount of the property held in a revocable trust created by the donor spouse. See, e.g., PLR 200101012, 200210051, 200403094, 200604028. Of course, private letter
rulings cannot, under Code Sec. 6110(k)(3), be cited or used as precedent. So relying on them may prove problematic if the IRS, as it sometimes does, changes its mind as expressed only in
private rulings.
Those rulings, in discussing this General Power of Appointment
Strategy, reach three holdings. First, they hold that the grant of the general power of appointment to the spouse who dies first is a gift by the surviving spouse that qualifies for the gift
tax marital deduction, if the spouse dying first is U.S. citizen. (Under Code Sec. 2523(i), no gift tax marital deduction is permitted for a gift to a spouse who is not a U.S. citizen.)
Second, they hold that the property over which the spouse dying first is granted at death a general power of appointment is included in the gross estate of that spouse, thereby allowing him or
her to use fully his or her estate tax marital deduction and, therefore, makes that spouse the transferor of the property over which the general power of appointment was granted. Third, they
hold, at least with respect to the particular facts involved, that the property over which spouse dying first is granted the general power is not entitled to a change in basis under Code Sec.
1014.
Wealth Transfer Planning™ provides, in the revocable trust
and the joint revocable trust, a drafting option for the General Power of Appointment Strategy. Simply put, a general power of appointment is granted (to the predeceasing spouse) over a
sufficient amount of the assets in that trust so the full estate tax exemption of the donee spouse may be used. (This is the first question under “Other Tax Issues” on the Tax Planning
screen for the Revocable Trust dialog.) These assets, either by exercise of the general power or in default of the exercise, presumably will pass into a so-called “credit shelter trust” of
which the surviving spouse (and descendants, perhaps) are beneficiaries but which will not be included in the gross estate of the surviving spouse.
The General Power of Appointment Strategy may also be used, as
discussed in the WTP Newsletter, in “making up” for assets that you want to leave outright to the spouse rather than to the credit shelter trust. There are often situations in which the
assets in the gross estate of the predeceasing spouse would be more efficiently disposed of other than to a credit shelter trust. For example, the gross estate of the donee spouse might
include an interest in a qualified (retirement) plan or individual retirement account (IRA). In many cases, it may be preferable for such assets to pass directly to the surviving spouse. If
they are made so payable, the surviving spouse may be able to “roll” the plan or IRA proceeds into his or her own IRA, postponing their income taxation for an additional period. Also,
because neither plan nor IRA proceeds enjoy a change in income tax basis at death under Code Sec. 1014, it may be preferable to fund the credit shelter trust with assets that will experience
such a change in basis or that have a higher basis or will face lower taxation (e.g., long-term capital gain taxation rather than the ordinary income taxation that plan and IRA proceeds
generally face). Since leaving those assets outright to the surviving spouse may result in not having enough remaining assets to fully fund the credit shelter trust, the General Power of
Appointment Strategy should be considered as a way to make up the difference.
Qualification for the Gift Tax Marital Deduction
As indicated, one risk posed by the General Power of Appointment
Strategy is that the donor spouse will be considered to have made a gift that does not qualify for the gift tax marital deduction. To qualify for the marital deduction under Code Sec. 2523, a
gift must be "to a donee who at the time of the gift is the donor's spouse.” Arguably, because the donee spouse is deceased at the moment that the gift becomes complete, the gift by the
donor spouse is not "to a donee who at the time of the gift is the donor's spouse.” A deceased person, after all, may not qualify as a "spouse.” Accordingly, if the gift is
considered to become complete as of the moment of death, the donor spouse may be treated as having made a taxable gift that does not qualify for the gift tax marital deduction.
On the other hand, the gift may be considered complete as of the
moment immediately prior to the death of the donee spouse. Johnstone v. Comm'r, 76 F.2d 55 (9th Cir. 1935) may provide support for this proposition. In that case, a donor created a revocable trust for an individual during the individual's
lifetime, also giving the individual a general power of appointment over the trust property at the individual's death. The court held that the assets of the trust were included in the
individual's estate at his death as he had a general power of appointment over the trust assets. The court was undeterred by the grantor's power to terminate the general power of appointment
at any time. According to the court, "at the time of his death the decedent was entitled to exercise the general power of appointment under the terms of the trust.” Implicit in the
court's reasoning is the premise that, by the moment of death, all contingencies which might prevent the exercise of the general power of appointment had been resolved. Despite Johnstone,
the donor spouse in the General Power of Appointment Strategy risks being treated as having made a taxable gift that does not qualify for the marital deduction.
Inclusion of Credit Shelter Trust Property in Gross Estate of Surviving Spouse
A second risk of the General Power of Appointment Strategy is that
the assets of the credit shelter trust will be included in the gross estate of the donor spouse. Under the step transaction or substance-over-form doctrine, the donor spouse rather than the
donee spouse might be viewed as the transferor of the property that passes to the credit-shelter trust. If so, then the property of the credit-shelter trust might be included under Code Sec.
2036 or 2038. For example, if the donor spouse is a discretionary beneficiary of the credit-shelter trust, he or she may be treated as having retained a right to the income of the credit
shelter trust under a Code Sec. 2036 creditors' rights theory. See, e.g., Rev. Rul. 77-378. Alternatively, if the donor spouse has a special power of appointment over the credit shelter trust,
he or she may be considered at death to have a power to alter or amend the enjoyment of the credit-shelter trust property under Code Sec. 2038.
Estate of Skifter v. Comm'r, 468 F.2d 699 (2d Cir. 1972), may support the argument that the donor
spouse should be viewed as the transferor of the credit-shelter trust on a step transaction type reason. Although it held there was no inclusion of property which the surviving spouse had
given his wife before her death, the court seems to base its holding that there was no prearrangement that the surviving spouse would regain control over that property. See, also, Rev. Rul.
84-179, 1984-2 C.B. 195. With the General Power of Appointment Strategy, such a prearrangement might well be found since the strategy is placed into effect when the donee spouse dies.
Nevertheless, in PLR 200403094, cited above, the surviving spouse
even had a special power of appointment with respect to the credit shelter trust. Yet, the Service still ruled the credit shelter trust would not be included in the gross estate of the
surviving spouse.
An Alternative Strategy that May be Safer
As described above, the General Power of Appointment Strategy may be
open to attack on at least two grounds: First, that the donor spouse made a taxable gift that does not qualify for the marital deduction, and, second, the credit shelter trust is includible in
the gross estate of the donor spouse. One way to protect against the first risk is to give the donor spouse a special power of appointment over the credit shelter trust. In this way, even if
the donor spouse is treated as having made a gift to the credit shelter trust (rather than the a gift to the first spouse to die), no taxable gift will occur because the gift will not be
complete until the death of the donor spouse. At the same time, however, having the donor spouse retain a special power of appointment will increase the second risk, for, if the donor spouse
dies with a power of appointment over the credit shelter trust, the Service may be more likely to argue for inclusion of the credit shelter trust in the gross estate of the surviving spouse
under Code Sec. 2038.
The preferable solution may not be to give the taxpayer's spouse a
general power of appointment but rather to create a revocable trust in which the spouse is entitled to all income within the meaning of Code Sec. 2056(b)(7)(B)(ii)(I). This strategy may be
called the "QTIP Strategy.” In the QTIP Strategy, as with the General Power of Appointment Strategy, the donor spouse's power to revoke is extinguished at the death of the donee spouse.
After the death of the donee spouse, the donor spouse would file a gift tax return and make an election Code Sec. 2523(f) to treat the property of the trust as qualifying terminable interest
property, or QTIP. If the election is successful, then the property of the trust will be included in the gross estate of the donee spouse under Code Sec. 2044, absorbing the remaining balance
of his or her estate tax exemption. These assets included in the donee spouse's estate may then pass into a credit shelter trust for the benefit of the donor spouse.
As with the General Power of Appointment Strategy, by giving the
donor spouse a special power of appointment over the credit shelter trust, it is possible to eliminate any risk stemming from the possibility that the donor spouse's gift will not qualify for
the gift tax marital deduction (because the gift would, in that case, be rendered incomplete). If the IRS successfully argues that the QTIP election is not effective (e.g., on the ground that
one cannot create a QTIP trust for one’s spouse upon the death of such spouse), then the property passes from donor spouse to the credit shelter trust without being included in the donee
spouse's estate. If the donor spouse has a special power of appointment over the credit shelter trust, then no completed gift occurs, as the surviving spouse will have retained dominion and
control under Treas. Reg. § 25.2511-2.
On the other hand, if the QTIP election is successfully made, then
the credit shelter trust cannot be included in the gross estate of the surviving spouse under either Code Sec.2036 or 2038. This result, which follows from Example 11 of Treas. Reg. §
25.2523(f)-1(f), makes the QTIP strategy especially effective. In Example 11, a decedent creates a lifetime QTIP trust for the benefit of the decedent's spouse; at the death of the decedent's
spouse, the trust is held for the benefit of the decedent. According to the Regulations, "because [the decedent's spouse] is treated as the transferor of the property, the property is not
subject to inclusion in [the decedent's] gross estate under § 2036 or § 2038.” See also PLR 200406004. Therefore, in the QTIP Strategy, the donor spouse rather than the surviving spouse must be treated as the transferor of the
credit shelter trust property, regardless of whether the credit-shelter trust may have been created as part of a prearranged plan between the spouses. In short, the Treasury Regulations
foreclose any argument that the credit shelter trust property is includible in the gross estate of the surviving spouse under Code Sec. 2036 or 2038.
The only other possible basis that the authors have thought of to
date for including the credit shelter trust property in the gross estate of the surviving spouse is Code Sec. 2041. If the surviving spouse is a beneficiary of the credit shelter trust, then,
under the law of most states, creditors may be able to reach of assets of the trust. The possibility that creditors may reach the assets may give rise to an inference that the surviving spouse
has a power to appoint the credit shelter trust property to his or her creditors within the meaning of Code Sec. 2041. However, it seems that even this risk may be eliminated. According to
Restatement (Third) of Trusts § 60 comment f, a creditor may reach the assets of a self-settled trust only to extent of "the maximum amount the trustee, in the proper exercise of
fiduciary discretion, could pay to or apply for the benefit of the settlor.” Thus, if the trustee's discretion to pay over or apply the trust property for the benefit of the donor spouse is
limited to an ascertainable standard, such as for the donor spouse's health, education, maintenance or support, then creditors may only reach the credit shelter trust to the extent of the
property subject to the standard. Under Code Sec. 2041(b)(1)(A), however, a power of appointment limited to an ascertainable standard is not a general power of appointment that causes gross
estate inclusion. As a consequence, even on a Code Sec. 2041 creditors' rights theory, the credit shelter trust cannot be included in the gross estate of the surviving spouse.
In sum, so long as the Service permits the QTIP election to be made
at the death of the first spouse, as in PLR 200406004, the strategy will be effective in preventing the credit shelter trust from being included in the gross estate of the donor spouse.
Moreover, there need not be any downside risk, for even if the Service does not permit a QTIP election, the donor spouse's special power of appointment will in that case prevent the donor
spouse from being treated as having made a taxable gift.
Conclusion
The QTIP Strategy may be a safer arrangement than the General Power of Appointment Strategy when the goal is to use property of the surviving
spouse to absorb the remaining balance of the estate tax exemption of the spouse first to die. Wealth Transfer Planning is revising its forms to permit the QTIP Strategy in revocable trusts
and joint revocable trusts created by married persons. WTP already offers a lifetime QTIP trust which permits the creation of a Supercharge Credit Shelter Trust™, which we think that may be
the best strategy of all for many married couples. The Supercharge Credit Shelter Trust™ is discussed in the April/May 2007 WTP Newsletter.
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