Gifts of Remainder Interests under McDougall v. Commissioner
Where is the puck hidden, and should we skate to it?
“The Commissioner observes that ‘[t]his is a valuable property interest that became part of [the remainder beneficiaries’] estates at that time, and with respect to which they agreed to an immediate transfer to [the spousal income beneficiary] pursuant to the Nonjudicial Agreement.’”
Estate of McDougall v. Commissioner, 163 T.C. No. 5 at p. 12 (2024)
Table of Contents
Intro
Earlier this year, in the case of Estate of Anenberg v. Commissioner, a QTIP marital trust was terminated by court order with the consent of the (then living) beneficiary spouse and children (as remainder beneficiaries). As a result, all QTIP-elected assets were distributed to the spouse. After the beneficiary spouse’s death, the Service determined a gift tax deficiency based on the theory that the termination of the QTIP trust itself was a gift to the spouse, due to an opt-out from the QTIP regime (which treats the spouse as the estate tax owner of QTIP-elected assets under IRC Section 2044, and the gift tax owner of the principal of the QTIP-elected assets under IRC Section 2519).
However, the Tax Court disagreed with the Service’s assessment. In Anenberg, the Tax Court concluded that no gift occurs on the termination of the QTIP trust followed by a distribution of principal to the beneficiary spouse. While there was a lengthy analysis which I discussed here, the holding boiled down to:
the definition of a “gift” requires the spouse to give up more than is received in return, which in this case did not occur since the value of what was given up (the income interest in the QTIP trust) was less than what the spouse received in return (the principal of the QTIP trust, which arguably includes the right to income from the principal as direct owner);
even if there was a gift on termination of the QTIP trust itself, the spouse’s retained right to control disposition of the distributed assets (and income therefrom) creates an incomplete gift; and
IRC Section 2519 does not in and of itself create a gift, but instead closes the loop on the QTIP fiction (whereby trust principal is deemed to be owned by the beneficiary spouse as a condition to the deferral of estate and/or gift taxes through the marital deduction) if and when there is a transfer of an income interest in the QTIP trust by instead treating this as more of a valuation rule (by treating the spouse as the deemed estate and gift tax owner of the remainder interest in the QTIP trust).
However, there was one gap left in the analysis. In a commutation of a trust, the principal is actuarially allocated between income beneficiaries and remainder beneficiaries. This was not the case in the facts above, where all trust principal is distributed to the income beneficiary (the spouse). The Tax Court in Anenberg recognized in a footnote, but did not opine on, whether such a terminating distribution could be treated as a gift from the remainder beneficiaries, of the actuarial value of their remainder interest. And, as I will explain below, there were important differences between the remainder interests in Anenberg and the remainder interests in McDougall.
There is both some good news, and bad news. The good news is that the Tax Court recently took up this issue, under similar facts, in Estate of McDougall v. Commissioner, 163 T.C. No. 5 (2024) and determined that there is indeed a gift from the remainder beneficiaries. The bad news is that, as with many of these types of cases, the Tax Court refused to opine on the actual value of this gift. But, as discussed below, there could be good reason for this refusal.
McDougall Facts and Background
[To preface, Paul Hood and Ed Morrow put together a thorough analysis of this case in a recent LISI article (which is behind a paywall, but if you follow Paul on LinkedIn, you can find his post with the article). The following reflects my take on some of the facts and holdings from a gift and estate tax perspective, but my analysis will be light compared to theirs – especially with respect to Judge Halpern’s concurring opinion, and possible income tax effects.]
In McDougall, a residuary trust was created at the death of one spouse for the survivor, and a QTIP election was made over the trust assets – resulting in an estate tax marital deduction of approximately $54 million. Later, when the assets of this trust had “more than doubled,” the survivor (as income beneficiary) and children (as remainder beneficiaries) entered into a nonjudicial settlement agreement whereby the trust would be terminated and all principal (and accrued but undistributed income) would be distributed to the survivor.
Where things took an interesting turn was in a specific provision of the NJSA, under which it was acknowledged that (1) through the application of IRC Section 2519, the commutation of the trust would result in a gift of the remainder interest from the survivor to the children as remainder beneficiaries, and (2) through the distribution of all principal to the survivor, there would be a “reciprocal gift” of the remainder interest from the children (as remainder beneficiaries) to the survivor.
On the effective date of the NJSA (after the last signature), the survivor sold the principal of the trust received in the distribution to children’s trusts (for the remainder beneficiaries) in exchange for a promissory note. A similar transaction occurred in Anenberg, and we will discuss the implications of this transaction below.
The survivor, and children, all filed gift tax returns reporting the transactions – including net zero taxable gifts under the “reciprocal gift” theory – and the Service issued a gift tax deficiency. The Tax Court was petitioned by the three of them, and cross-motions for summary judgment were filed by them and the Service.
Analysis
In this case, the Tax Court noted that the Service was trying to assert a similar argument as in Anenberg – that the terminating distribution from the trust to survivor was a deemed gift of the trust principal in and of itself due to the application of IRC Section 2519 due to the disposition of the survivor’s income interest. However, due to the application of Anenberg (without recitation or repetition), the Court concluded that no deemed gift to the spouse occurred as a result of the terminating distribution – either of the principal, or the spouse’s income interest, since the conversion to outright ownership by the spouse aligned ownership to the deemed tax treatment under the QTIP fiction.
However, the quote from the top of this article is telling. The Tax Court concluded that the two children, as remainder beneficiaries, made a gift of their remainder interest in the QTIP trust when the terminating distribution to the beneficiary spouse was made. Thus, the QTIP fiction applied only to determine the estate and gift tax outcome with respect to the beneficiary spouse. It did not apply to any other beneficiary, including the remainder beneficiaries. And, while the remainder beneficiaries argued that a reciprocal gift had occurred – thus washing out the value of the gift of the remainder interest – the Tax Court did not agree because, under Anenberg principles and the QTIP fiction of IRC Section 2519, no deemed gift could have been made from the spouse to the remainder beneficiaries since the QTIP assets were all distributed to the spouse.
How Is The Remainder Treated?
When examining this outcome, I want to remind you of the Tax Court’s admonition, “The Commissioner’s argument is well taken.” This was in response to our opening quote – that the interests of the remainder beneficiaries “became part of their estates.”
This stood out to me, because many trusts – QTIP trusts included – can terminate in one of two ways (or sometimes a hybrid of the two). Traditionally, remainder interests were distributed outright. However, the trend is towards providing that remainder interests will continue to be held in trusts for beneficiaries. And, while outright distributions do indeed add property to a beneficiary’s estate, a beneficial interest in trust usually does not. In fact, the only ways we see gross estate inclusion with respect to a beneficiary of a third-party trust (i.e., a trust not created by the beneficiary) is through (1) holding a general power of appointment at death, (2) exercising a limited power of appointment in a way that triggers the Delaware tax trap, or (3) through the QTIP fiction which, as we have now seen through Anenberg and McDougall, applies only to the beneficiary spouse.
When we compare these two cases, it turns out there is a difference. In Anenberg, the facts noted the following:
Trusts created for the benefits of [the remainder beneficiaries] had contingent remainder interests in the corpus of the Marital Trusts.
Contrast this with the facts in McDougall, which provided:
Upon [the beneficiary spouse’s] death, to the extent that he did not exercise his power of appointment, the remainder of the [QTIP] Trust was to be divided “into equal shares, one share for each of [the testator’s] children who is then living and one share for each of [her] children who is then deceased with descendants then living… [The testator’s] will provided that, upon the termination of any trust created under the will, the trustee was to distribute the trust assets among its beneficiaries.
Long story short, as covered in prior articles, it is possible that giving up a current interest in a discretionary trust could be at least a nominal gift. [Note that giving up a mandatory income interest is, indeed, a gift based on the actuarial value of a life estate or term interest as we will discuss below.] But, these prior holdings have not applied to a vested or contingent remainder interest in a discretionary trust. While in footnote 18 of the Anenberg opinion, the Tax Court stated, “We express no view on whether the other beneficiaries of the Marital Trust could be treated as making a gift to [the beneficiary spouse] for gift tax purposes,” perhaps this is due to the possibility that this gift in theory is difficult if not impossible to value under our current post-1976 gift tax laws.
Contrast this an outright distribution of a remainder interest which is, indeed, capable of valuation. While the Tax Court in McDougall left the factual question of value “open for decision in future proceedings.” (see footnote 7 of the opinion), we do have guidance in other areas as to this value. Typically, under guidance of IRC Section 7520, the present value of a remainder interest in a QTIP would be the value of the trust assets, minus the present value of the beneficiary spouse’s deemed life estate applying the life estate factors set forth in IRS Table S (2010 CM).
While raises the question – why did the Tax Court not tackle this question of value?
The answer can likely be found in the existence of a testamentary power of appointment held by the beneficiary spouse over the QTIP trust in McDougall. While this power was not exercised (and could not have been exercised since the QTIP trust was terminated), it is possible that this power could be used to reduce, or even eliminate, a remainder beneficiary’s interest. In footnote 10 of the McDougall opinion, the Tax Court notes (with respect to this spousal power of appointment):
The import (if any) of these terms for the value of Linda’s and Peter’s remainder rights remains to be decided. See supra note 7.
In short, while the Tax Court left open the door to the possibility that an intervening power of appointment could reduce the gift tax value of the remainder interest, it impliedly refused to expressly adopt of the remainder beneficiaries that this would indeed be the case.
Which brings us full circle to a broader question pondered in a number of my prior articles and content on powers of appointment. Does the possibility of reduction, or elimination, of a remainder beneficiary’s interest (whether vested or contingent) keep it from being a recognized property interest for tax or state law purposes or, perhaps, even for purposes of the trustee’s duty to inform and report? The answer continues to be maybe yes, maybe no, depending on the context. But, the form of remainder interest (outright distribution versus distribution to a discretionary subtrust) matters. For a good example of this, see the Colorado Supreme Court’s opinion of in re Balanson, in which an outright remainder interest subject to an intervening power of appointment was treated as marital property (for purposes of a Colorado rule treating appreciation in the value of inherited property during the marriage as marital property).
We must also question whether the remainder beneficiaries’ written consent to the terminating distribution in McDougall played a significant role in their deemed gift. After all, the Tax Court noted that through “the implementation of [the Nonjudicial Settlement] agreement, which required their consent, [the remainder beneficiaries] had given up those valuable rights by agreeing that all of the [QTIP] Trust assets would be transferred to [the beneficiary spouse].” Of course, this raises the question of state law rights – including beneficiaries’ rights to be informed – and whether their express or implied consent affects the gift tax posture. It is easy to assume that this favors decanting over any sort of judicial or nonjudicial modification or termination - but such an assumption is dangerous.
I also think it is helpful to note that gift and estate taxes are not the only taxes to be considered. One must consider the effects of IRC Section 1001(e) on trust interest from an income tax perspective, as well as the broader GST tax effects. These issues are best left for future articles.
Conclusion
We live in a planning environment where substantial wealth will be transferred in trust, at least for the immediate next generation following the generation of the wealth creator. Given broad expectations for (and skillsets dedicated to) outright ownership of wealth, there will probably be an increasing wave of trust terminations. And while I have previously written about why such terminations are not a good idea, we now have a new negative data point about possible gift tax outcomes – especially with respect to remainder beneficiaries who stand to receive an outright distribution at the termination of the interests of the current income beneficiary or beneficiaries.
But, valuation is and will remain to be difficult. It is possible that powers of appointment (held by current income beneficiaries) could affect valuations, but we still have no certainty. And while there are commonly-accepted guidelines for valuing split interests under IRC Section 7520, the gift tax value of these interests can vary from the estate tax value. In fact, we run into a different possible set of rules under IRC Sections 2701-2704 when looking at the gift tax effects with respect to the transferor of certain interests, and the rules of IRC Sections 2035-2038 which can create different estate tax outcomes for the transferor for such interests (at least with respect to interests described in IRC Sections 2701 and 2702). Sections 2701-2704 create their own fictions that may not always extend to transferees.
For now, I think it is important to pump the brakes when examining any transaction involving a modification, decanting, commutation, or nonconforming termination (i.e., one that, like in Anenberg and McDougall, does not result in terminating distributions that are actuarially split between current income beneficiaries and remainder beneficiaries). While it is easy to assume you know the tax rules, both of these recent cases cast doubt on any certainty. And, in our line of business, the only certainty (beyond death and taxes) is that uninformed certainty can get you in trouble.