Is a Marital Trust Termination a Gift?
Examining Estate of Anenberg v. Commissioner
Table of Contents
Intro
In a prior article on marital trusts, I explained some of the mechanics behind the gift and estate tax marital deduction. Generally, a marital deduction is intended for permanent transfers of title to a spouse. The transfer of “terminable interests,” which are not permanent due to termination of the interest at a spouse’s death (or possibly during life), generally does not qualify for the gift or estate tax marital deduction.
But, as discussed, marital trusts are trusts that are structured in a way that they are respected as “deductible terminable interests” that are eligible for the marital deduction. Although the transfers are not permanent transfers of title to the spouse, the creation of the trust equivalent of a life estate for the spouse creates a marital deduction if it is coupled with either (1) a general power of appointment, or (2) a qualified terminable interest property (QTIP) election.
From a valuation perspective, a traditional life estate – representing an income or use interest for life – has a lower value than a fee simple ownership interest in the underlying property. The value is instead, under principles of IRC Section 7520, split into an income interest and remainder interest. So, if one were to transfer their income interest, the value of the transfer would be the present value of the income interest. But, the value transferred would not include the remainder, because the remainder is already vested and cannot be disturbed (unless there is an intervening power of appointment).
It stands to reason, then, that if the life estate was converted to fee simple ownership in the hands of the life estate holder, this would in effect be a transfer of the remainder to the life estate holder. This could result in a gift in reverse of what we would usually see – from remainder holders to the life estate holder.
But, does this dynamic hold true in the case of the marital deduction? The IRS unsuccessfully tried to argue otherwise. Before looking at their flawed argument, it is important to discuss the downstream effects of a marital trust when compared to a traditional life estate.
Marital Deduction and Tax Deferral
The marital deduction generally acts as a deferral mechanism for estate and gift taxes. It may also defer the application of GST tax, or allocation of GST tax exemption.
If we were to give a spouse a qualifying life estate, the marital deduction is claimed for the entire property – representing the sum of the spouse’s income interest, and the remainder interest passing at the spouse’s death. So, it stands to reason that if the spouse gets rid of the life estate, the transfer would not just be of the spouse’s income interest. Instead, it would include the value of the entire property (since there was a marital deduction for the entire property). But, we would not add the value of the income interest, because the values of the income interest and remainder interest are two separate components of the entire property to which the marital deduction was applied (and for which gift or estate tax is deferred).
For a general power of appointment marital trust, this dynamic is reflected in IRC Sections 2514 and 2041 – treating an exercise, lapse, or release of a spouse’s general power of appointment as a gift of all property subject to that general power of appointment.
But, in the case of a QTIP marital trust, this same dynamic has to be manufactured through IRC Sections 2044 and 2519. Without this Code Section, a spouse could transfer their life estate during life at a lower gift tax cost than if outright title to the property had been transferred to the spouse. Also, at death, arguably there would be nothing to be included in the gross estate since the spouse’s income right has no value after death – meaning the value of the remainder at that point really equals the entire value of the property in which the spouse held a life estate.
To avoid this valuation loophole, IRC Section 2044 generally provides that property previously subject to a QTIP election will be included in the surviving spouse’s gross estate at death, as if it were personally-owned by the surviving spouse at that time. This has the effect of taxing the surviving spouse on the transfer of the remainder interest in QTIP-elected property (valued at 100% of the underlying property), since estate tax on such remainder was deferred through the marital deduction.
Likewise, if a spouse was to transfer their interest in QTIP-elected property during life for less than full and adequate consideration, IRC Section 2519 treats this as a transfer of the underlying property (effectively, the remainder interest – then valued at 100% of the underlying property) instead of a transfer of the spouse’s income interest. Again, this avoids a bypass of gift tax on the value of the remainder on which estate tax was deferred.
What happens, however, if the property in the marital trust was instead transferred outright to the spouse – ending the life estate equivalent and converting the distributed property into fee simple ownership in the hands of the spouse? Arguably, this would be different from the example above for a traditional termination of a life estate, because the spouse is still treated as the gift/estate tax “owner” of the remainder interest (thus meaning no gift back to the spouse from remainder beneficiaries). And, in such a case, it stands to reason that for QTIP-elected property the outright distribution would cancel the application of IRC Sections 2519/2044 (instead replacing them with IRC Section 2033).
This issue and dynamic was front and center in a recent Tax Court case.
The Case and Facts
The Tax Court’s recent opinion in Estate of Anenberg v. Commissioner, 856-21 (T.C. May 20, 2024) discussed the gift tax consequences of a termination of a marital trust, followed by a gift and sale of the property previously held by the marital trust.
In this case, a deceased spouse’s estate plan had created a marital trust for the survivor. A QTIP election was made by the deceased spouse’s estate to claim the estate tax marital deduction. But, the survivor and remainder beneficiaries (their two children) later petitioned the Superior Court of California to terminate the marital trusts and allow an outright distribution of the marital trust property to the surviving spouse, as income beneficiary. This relief was granted, and termination/distribution of the trusts was ordered. The survivor received title to the trust property in a terminating distribution, mainly consisting of stock in a family business.
A few months after the trusts were terminated, the survivor gifted some of the shares to trusts for her children. The following month, the survivor sold the remaining shares to various trusts for children and grandchildren in exchange for a 9-year promissory note bearing interest at the AFR. These transfers were timely reported on a federal gift tax return.
After the survivor’s death, the IRS issued a notice of gift tax deficiency to the survivor’s estate, arguing that the termination of the marital trust itself was a “disposition of the spouse’s qualifying income interest for life” triggering gift tax on the entire distributed principal. The estate petitioned the Tax Court, and filed a motion for partial summary judgment arguing that IRC Section 2519 did not apply to create a deemed gift on either the termination of the marital trust, or subsequent sales of stock received in the terminating distribution from the marital trust.
Tax Court Analysis
Termination of Marital Trust
On the termination of the marital trust, the Court noted that this could technically have been a “disposition” of the qualifying income interest for life under IRC Section 2519(a). But, the Court disagreed that this disposition would be one that results in gift tax.
In effect, one cannot make a gift to themselves, which is technically what the survivor did here. But, the Court takes it a step further by noting that the gift tax only applies to a “gratuitous transfer” under IRC 2501. To find a gratuitous transfer, the donor must give away more than they receive in return under IRC Section 2512, and must also part with dominion and control over the transferred property under IRC Section 2511. The Court held that none of these outcomes applied.
In effect, the income interest disposed of under IRC Section 2519(a) was in the nature of an exchange. And, reinvoking some of our valuation principles above, the value of the relinquished interest (the income interest) was actually less than the value of the property received in exchange (the stock received in the terminating distribution from the marital trust). While not directly noted by the court, in a traditional life estate, this would in effect be a gift from remainder beneficiaries to the spouse – for which the IRS was ironically trying to impose a gift tax on the spouse. So, there could be no gift by the spouse due to the lack of a gratuitous transfer. (Note that there was no income tax argument of an exchange under IRC Section 1001 here.)
Even if there was a gratuitous transfer, the Court notes that the conversion of the income interest to fee simple ownership of property gives the spouse dominion and control over the distributed stock. Since a gift is not complete under IRC Section 2511 unless or until the donor relinquishes dominion and control over the transferred property, the Court notes that even if this was a “gift” for gift tax purposes that the “gift” would be incomplete and thus not subject to gift tax.
Sales of Stock
Since the income interest was already deemed to have been disposed of when the marital trust terminated, the Court concluded that it could not again be treated as being disposed of at the time of the sales of stock. And, even if there was no prior application of IRC Section 2519, the Court reasoned that the termination of the marital trust terminated the survivor’s income interest – which would also prevent subsequent application of IRC Section 2519 because holding an income interest at the time of the sale was a ticket to entry under that Code Section in the first place.
Election Out of QTIP Regime
The IRS tried to argue that the termination of a marital trust is an “election out” of the QTIP regime, thus immediately triggering gift tax on the value of the QTIP property. (Interestingly, this argued-for outcome does apply to a qualified domestic trust – QDOT – but in the form of trust-level withholding to prevent the IRS from losing taxing jurisdiction over assets transferred to a non-citizen spouse. But, the trust in question was not a QDOT, so there was no policy risk of losing out on future collection of estate or gift tax.)
The Court struck down the position of the IRS that 2519 imposes gift tax itself, instead concluding that this is a valuation rule to determine the amount of a transfer if and when a spouse’s income interest in QTIP property is disposed. If, as noted above (but which wasn’t the case here) there is a greater transfer by the spouse than exchange consideration received by the spouse under the valuation rules of IRC Section 2519, then there could be a gratuitous transfer resulting in gift tax under the separate gift tax provisions. But, the gift tax would not be imposed by IRC Section 2519 itself.
Instead, the Court noted that the receipt of the QTIP assets, and the promissory notes themselves, preserves the value of those assets in the survivor’s hands for future gift or estate taxes. There is no acceleration of the timing of these taxes under IRC Section 2519.
Taking it a step further, the Court described the terminating distribution from the marital trust as having the same outcome as an exercise of a power of appointment in favor of the survivor. This theory is addressed in Treas. Reg. 25.2519-1(e), which notes there is no “disposition” under IRC Section 2519 if a power of appointment is exercised in favor of the spouse. The Court also noted that an example of gift tax applying under Treas. Reg. 25.2519-1(a) could not be read to conclude that 2519 itself independently applies gift tax.
Later, the IRS tried to assert that the receipt of shares for the income interest could not be “full and adequate consideration” for a deemed gift under IRC Section 2519 because the survivor was already deemed to own such shares, and that the survivor technically depleted her estate through the disposition of the income interest (citing Commissioner v. Weymuss, 324 U.S. 303 (1945)). But, the Court noted that the IRS was conveniently looking at this from one side without examining both sides of the exchange.
Substance Over Form?
To me, it looks like the IRS was perhaps trying to assert a substance-over-form or step transaction argument without actually doing so. But, doing so would not have necessarily changed the outcome as long as the notes were respected (which is not what was being argued for the sales).
The IRS did, however cite the case of Estate of Kite, T.C. Memo 2013-43, in an attempt to equate the two outcomes between this case and that case. But, in Kite, there was an attempt to avoid subsequent estate tax on QTIP assets by (1) terminating the trust, and (2) the spouse selling assets for a deferred lifetime private annuity which was never paid due to the spouse’s intervening death before payments kicked in (thus creating nothing to be included in the gross estate). In Kite, the Court held that substance over form prevailed so that the QTIP regime could not be avoided. But, the Court noted in the present case there was no attempt to avoid subsequent gift or estate taxation of the QTIP property.
Conclusion and Takeaways
As mentioned above, to me this looked like a twisted way to argue substance over form or a step transaction without actually doing so. But, even if the gifts and sales had been made directly from the QTIP trust without termination, the result would have been the same under IRC Section 2519. So, to me, the odd twist was the IRS attempting to equate the definition of transfer and value under IRC Section 2519 with some sort of deemed gift tax similar to what we might see with a QDOT.
The great irony is that, even if the IRS had prevailed on that argument, they would have to address future estate tax and the potential double-tax – which could back them into a corner. After all, if the transfer of shares to the spouse generated gift tax and those shares were still owned by the spouse at death, there would have been gross estate inclusion. And, if the gift tax had been paid within three years of the spouse’s death, it would have been included in the gross estate under IRC Section 2035. Luckily, a plain reading of IRC Section 2519 avoided this outcome.
For now, remember that IRC Section 2519 simply defines the value and substance of a transfer – it does not create additional gift tax. A good corollary might be IRC Section 2036, which defines the estate tax value and substance of a transfer in which a grantor retains possession, enjoyment, or control until death (without itself imposing estate tax).