IRS Confirms Safety of QTIP and Portability Elections. by Vanessa L. Kanaga and Letha Sgritta McDowell, CELA 1.

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1 IRS Confirms Safety of QTIP and Portability Elections by Vanessa L. Kanaga and Letha Sgritta McDowell, CELA 1. Introduction In Revenue Procedure (released September 27, 2016) the IRS announced that it would not disregard a qualified terminable interest property (QTIP) election made on a federal estate tax return, if the decedent's executor also elected "portability" of the Deceased Spousal Unused Exclusion Amount (DSUEA) under Section 2010(c)(5)(A) of the Internal Revenue Code (referred to herein as the "Code"). This is an important clarification of a potential conflict between the ability of an executor to make a QTIP election in tandem with a portability election, and the IRS position, announced in Revenue Procedure , that it would treat a QTIP election as "null and void" if the election was unnecessary in order to reduce the federal estate tax liability of the estate to zero 2. The 2016 Revenue Procedure also establishes a revised process for requesting relief under Revenue Procedure Part I of this article provides a brief summary of Revenue Procedure , and discusses the concern, addressed by the IRS position announced in Revenue Procedure , regarding its effect on a QTIP election made on behalf of an estate that would not otherwise be subject to federal estate tax. Part II examines the particular importance of Revenue Procedure to elder law attorneys and other estate planners who represent clients unlikely to be affected by the federal estate tax. 1 The authors wish to thank Jonathan Blattmachr for his thoughtful and constructive comments on this article. 2 The importance of this development depends, of course, on the continued existence of a federal estate tax. The recent national elections, resulting in the election of Donald J. Trump as President of the United States, and the continuation of a Republican-controlled Congress, have caused many commentators to predict the repeal of the federal estate tax in If the federal estate tax is repealed, it is almost certain that the QTIP election, which is the subject of this article, will be irrelevant, subject to a later re-enactment of the federal estate tax and the marital deduction against that tax.

2 Part I: Portability and the Concern over Revenue Procedure Credit Shelter Planning and Revenue Procedure The provisions authorizing portability were added to the Code in 2010, and made permanent in However, the concept of portability had been discussed for several years prior to its enactment. 4 Prior to the enactment of portability, the primary method of ensuring that married couples with potentially taxable estates made full use of each spouse's unified credit against federal estate tax was to use a "credit shelter" plan. This type of plan provides for a separate disposition of the first deceased spouse's remaining applicable exclusion amount (the amount which could be transferred without incurring federal estate tax, after taking into account the unified credit, often referred to as the "estate tax exemption"); the remainder of the first deceased spouse's estate (referred to herein as the "spousal gift") passes in a manner that qualifies for the estate tax marital deduction. The spousal gift is often in the form of a trust for the benefit of the surviving spouse that is designed as a qualified terminal interest property (QTIP) trust, which will qualify for the federal estate tax marital deduction under Code Section 2056(b)(7), if the appropriate election (the "QTIP election") is made on the decedent's estate tax return. If executed correctly, such a plan results in no federal estate tax liability on the death of the first deceased spouse, while preserving the deceased spouse's federal estate tax exemption. However, an effective credit shelter plan not only requires proper planning during both spouses' lives, but also requires the deceased spouse's executor, filing trustee, or other personal 3 See Pub. L. No (Dec. 17, 2010), and Pub. L. No (January 2, 2013). 4 See, e.g., Gans, Blattmachr, and Bramwell, Estate Tax Exemption Portability: What Should the IRS Do? And What Should Planners Do in the Interim?, 42 Real Prop. Prob. & Tr. J. 413 (Fall 2007). 2

3 representative (referred to herein as the "executor") to properly execute the plan by correctly funding the credit shelter gift and spousal gift, and by making the necessary elections on the estate tax return. In some cases, if the credit shelter disposition is to a trust that is structured in the same manner as a trust that could qualify for the QTIP election, an unwary executor could foil the plan by making the QTIP election with respect to the credit shelter portion. The results of such an error could be very detrimental, in terms of the potential tax consequences. Property for which the QTIP election is made is included in the surviving spouse's taxable estate upon his or her subsequent death. 5 The surviving spouse may not have a sufficient amount of exemption against federal estate tax to shelter all of the remaining QTIP trust property from estate tax. Prior to the enactment of portability, if the first deceased spouse's federal estate tax exemption was not used with respect to the assets included in his or her taxable estate, the exemption was lost, and could not later be used to protect QTIP trust assets from estate tax on the death of the surviving spouse. The QTIP election also may have potential consequences for the surviving spouse, in terms of the gift tax, and generation-skipping transfer (GST) tax. 6 Accordingly, making the QTIP election with respect to property which could otherwise be sheltered from estate tax by the deceased spouse's remaining estate tax exemption could generate unnecessary transfer taxes, or result in the unnecessary use of the surviving spouse's unified credit or GST tax exemption. The same result may occur if the plan provides for the disposition of the entire estate to a trust that is eligible for the QTIP election, and the value of the first deceased spouse's estate, for federal estate tax purposes, does not exceed his or her remaining estate tax exemption amount. 5 See Code Section See Code Section 2519 (providing that the transfer of a spouse's income interest in a QTIP trust will result in the spouse being deemed to have transferred his or her entire interest in the QTIP trust corpus, for estate and gift tax purposes), and Section 2652 (under which the surviving spouse will be treated as the transferor of the QTIP property, for purposes of the GST tax, unless the "Reverse QTIP" election is made under paragraph (a)(3) of that Section). 3

4 In that situation, although it may be inefficient, the first deceased spouse's estate tax exemption could be used to shelter the entire disposition from federal estate tax, and no QTIP election is necessary. However, if the executor is not aware of this, and instead makes the QTIP election, the decedent's estate tax exemption will be wasted, and the QTIP election may result in unnecessary adverse estate, gift, or GST tax consequences. In order to provide some relief to a surviving spouse (and, certainly, an unwitting executor) due to such an ill-advised QTIP election, the IRS announced, in Revenue Procedure , that it would disregard, and treat "as null and void" any QTIP election which was not necessary to reduce the estate tax liability of the decedent's estate to zero. The Revenue Procedure also set forth a process by which taxpayers could seek such relief. However, the IRS did not indicate whether, in the absence of such a request by the taxpayer, it would take the initiative to treat the QTIP election as void. The Introduction of Portability In addition to the risk of incorrect administration, there are other potential drawbacks of credit shelter planning. One such drawback is the need to ensure that each spouse's taxable estate will include sufficient property to make maximum use of the spouse's federal estate tax exemption. This often requires re-titling property, so that the couple's assets are owned equally between them (or as equally as possible), which can be burdensome, and potentially problematic for other reasons, such as a client's desire to keep inherited property in the family line. Another potential drawback of credit shelter planning has become more apparent as the federal estate tax exemption amount has increased in recent years. 7 As the exemption has increased, more clients 7 The "basic exclusion amount" for 2016 is $5,450,000. See Rev. Proc

5 are in a position of uncertainty as to whether their taxable estates will exceed the exemption amount. In fact, far fewer couples ever will have combined assets of sufficient value to fully use both spouses' federal estate tax exemptions. Accordingly, in many cases, it may be preferable to transfer all of the first deceased spouse's property to the surviving spouse, or to a trust for his or her benefit, even if this will result in the property being included in the surviving spouse's taxable estate for federal estate tax purposes. This is because of the "step-up" in basis afforded to property passing from a decedent. 8 If the portion of the spousal gift remaining on the surviving spouse's death, combined with the surviving spouse's own property, is not valued in excess of the surviving spouse's federal estate tax exemption, the advantage of the additional step-up in basis on the death of the surviving spouse may outweigh the advantage of having the property excluded from his or her taxable estate. However, for some couples, the nature and value of their combined assets at the time their estate plans are executed are such that it is not possible to know whether the step-up in basis or the exclusion from federal estate tax will be more valuable. These were among the reasons many estate planners had advocated for the introduction of portability into the federal estate tax structure. Now, with the advent of portability, any unused portion of the first deceased spouse's federal exemption amount (the DSUEA) may be made available for use by the surviving spouse, if the deceased spouse's executor makes the portability election. 9 An effective "portability plan" allows the deceased spouse to transfer his or 8 See Code Section 1041(a), which provides that property acquired from a decedent has a basis equal to the fair market value of the property at the date of the decedent's death (or the alternate valuation date, if alternate valuation is elected under Code Section 2032). Note that this could also, potentially, result in a "step-down" in basis, if the property has declined in value from its original basis in the hand of the decedent. 9 The portability "election" is a bit of a misnomer, because it is made by timely filing a federal estate tax return. If the federal estate tax return is timely filed, the portability election will be made unless the executor affirmatively opts out of the portability election. See Treas. Reg (a)(2). 5

6 her estate to the surviving spouse without wasting the deceased spouse's federal estate tax exemption. Accordingly, it is now possible for married couples whose wealth is disproportionately divided between them to take advantage of both spouses' federal estate tax exemptions, even if the less wealthy spouse dies first. In addition, it is now possible to take advantage of a second step-up in basis on the death of the surviving spouse without sacrificing the deceased spouse's federal estate tax exemption. Revenue Procedure Certainly, there are some advantages of credit shelter planning that continue to make it an important estate planning tool, barring significant changes in the federal estate tax. In addition, there are certain risks and disadvantages of portability planning that should factor into the determination as to whether a traditional credit shelter plan or portability plan is more appropriate. 10 However, the introduction of portability, though it may not have simplified estate planning as some had hoped, has clearly added flexibility in the estate planning options available to clients and their advisors. Nevertheless, the introduction of portability caused some estate planners to be concerned about the interaction of the portability election and the IRS position, announced in Revenue Procedure , that a QTIP election could be disregarded, and treated as void, if it was unnecessary to reduce the estate tax to zero. For the reasons discussed above, in the postportability era, it may be advisable for some married couples to adopt an estate plan intended to pass the entire estate of the first deceased spouse to a QTIP trust for the surviving spouse, even if 10 For a detailed analysis of the relative advantages, disadvantages, and risks associated with portability, See Blattmachr, Bramwell, and Zeydel, Portability or No: The Death of the Credit-Shelter Trust?, Journal of Taxation, Vol. 118, No. 5 (May 2013). 6

7 the decedent's taxable estate does not exceed his or her federal estate tax exemption. The deceased spouse's remaining exemption amount may be transferred to the surviving spouse, if portability is elected, so it will not be wasted by making the QTIP election. However, there remained, for some, a question as to whether the IRS could choose to disregard a QTIP election made on an estate tax return in which portability was also elected, if the QTIP election was not necessary to reduce the estate tax to zero. In Revenue Procedure , the IRS confirmed that it would not disregard, and treat as void, any QTIP election which was unnecessary in order to reduce the estate tax to zero, if the portability election was also made with respect to the same estate. This should alleviate the concern that the IRS could potentially seek to disregard a QTIP election made for the purpose of implementing a portability estate plan. In addition, the IRS confirmed that it will continue to provide procedures by which it will disregard an unnecessary QTIP election, if the executor of the estate did not also make the portability election. The new process for seeking such relief is set forth in Revenue Procedure State Death Tax Planning, Portability, and Revenue Procedure An additional note bears mentioning regarding Revenue Procedure and its relationship to a certain technique for estate planning in jurisdictions that have a separate state death tax. Many of the states that impose a state death tax in addition to the federal estate tax also allow a state death tax exemption. However, this exemption is often lower than the federal estate tax exemption. In those states, prior to, married couples often had to make a choice between fully funding a credit shelter disposition with the deceased spouse's full federal exemption amount, potentially resulting in some state death tax liability on the death of the first 7

8 deceased spouse, or limiting the credit shelter disposition to the state death tax exemption, resulting in the loss of a portion of the first deceased spouse's federal estate tax exemption. The portability election has made this dilemma somewhat more bearable, as it is now possible to limit the credit shelter disposition to the state death tax exemption amount, while potentially preserving the first deceased spouse's remaining federal estate tax exemption through the portability election. However, an alternative estate planning technique has evolved in order to allow couples domiciled in states with a separate state death tax to avoid payment of both federal and state tax on the first deceased spouse's death, while preserving the decedent's remaining federal estate tax exemption. Often referred to as the "quadpartite" estate plan, this technique involves placing the excess federal exemption amount in a separate QTIP trust, with the intent that the QTIP election will be made with respect to such trust for purposes of the state death tax only. Because the QTIP election is not made for federal estate tax purposes, this "excess exemption" trust will use the portion of the deceased spouse's estate tax exemption not used by the credit shelter disposition, allowing it to continue to pass free of federal estate tax on the surviving spouse's death (although it will be included in the surviving spouse's estate for state death tax purposes). However, in states in which such a "state-only" QTIP election is not permitted, the only possible method of employing the quadpartite estate plan is to rely on the relief provided by Revenue Procedure to disregard the QTIP election with respect to the excess exemption trust, for federal estate tax purposes. 11 In addition to addressing the concern, discussed above, that the IRS might choose to disregard a QTIP election in an estate in which portability was also elected, Revenue Procedure also provides some comfort to estate 11 For additional information regarding the quadpartite estate plan, please see Gans and Blattmachr, Quadpartite Will: Decoupling and the Next Generation of Instruments, 32 Estate Planning, 3 (April 2005). 8

9 planners who employ the quadpartite estate planning technique, by confirming that the IRS will continue to provide the relief set forth in Revenue Procedure for estates in which portability is not elected. Part II: An Elder Law Attorney s Perspective For most elder law attorneys 12, and indeed, the estate planner for the middle class client, the concern about portability and minimizing estate tax at the death of the surviving spouse is only a passing thought, since the majority of their clients will not have a taxable estate for federal estate tax purposes, and the majority of states do not currently impose a state estate tax. 13 In a world where estate tax planning is no longer king, income tax planning becomes a critical consideration. For that reason, the concept of estate inclusion at the death of each spouse is an important factor when creating an estate plan. There are many non-tax estate planning reasons which exist for creating a QTIP trust at the death of the first deceased spouse. These may include the desire to control the ultimate disposition of assets at the death of the surviving spouse, a desire to provide an income stream for the surviving spouse, the desire to protect the principal from potential creditors of the surviving spouse, the need to plan for blended families, etc. For a variety of reasons, it is common for elder law attorneys to use QTIP trusts to help clients reach their non-tax estate planning objectives. The added advantage to planning with QTIP trusts is that the assets held within the QTIP trust would be considered as part of the taxable estate of the surviving spouse, allowing the assets in the trust to receive a step up in basis. As discussed above, the basis of an 12 For purposes of this article the term "elder law attorney" refers to attorneys who focus their practice in the fields of elder law and special needs planning

10 asset acquired from a decedent is the fair market value of the property at the date of the decedent s death. 14 Property acquired from a decedent includes property that is part of the decedent s taxable estate by virtue of Code Section In other words, if property is included in the taxable estate of a surviving spouse; upon the death of the surviving spouse, the ultimate beneficiaries may treat the property as if it were acquired from the deceased surviving spouse, giving the beneficiaries a basis in property equal to the fair market value of the property at the death of the surviving spouse. Unfortunately, Revenue Procedure called this technique into question for many clients. As discussed above, Revenue Procedure says that the IRS will disregard the election and treat it as null and void and that the property for which the election is disregarded will not be includible in the gross estate of the surviving spouse under Code Section 2044 if the election was not necessary to reduce the estate tax liability to zero. It is common for an elder law attorney planning for a non-taxable estate to recommend and implement the creation of a QTIP trust as part of the estate plan. In order to be considered a QTIP trust, and for the assets of the QTIP trust to be included in the estate of the surviving spouse, the executor must make the QTIP election on the estate tax return (IRS Form 706) of the first spouse to die. For many clients, their estates will fall beneath the federal exemption amount and their executors will not be required, by law, to file a Form However, if the estate plan involves a QTIP trust for the benefit of the surviving spouse, it will be necessary to file a Form 706 for the deceased spouse's estate in order to make the QTIP election, although the QTIP (a)(1) (a)(10) 16 See Code Section 6018(a). The "filing threshold" for filing an estate tax return is the basic exclusion from federal estate tax (i.e., an estate is required to file an estate tax return if the gross estate is in excess of that amount). 10

11 election is not needed to reduce the estate tax on the first decedent's estate to zero. The nullification of such a QTIP election under the terms of Revenue Procedure could have significant income tax consequences for future generations. Consider the example of a piece of commercial real estate which, at the death of the first deceased spouse, is valued at $1,000,000 and which provides annual income of $25,000. The first decedent wishes for her spouse to enjoy the net income from the property, but wants to ensure that the property passes to her children at the death of the surviving spouse, so she leaves the property to a QTIP trust for the benefit of the surviving spouse. If the surviving spouse lives for another 10 years, and assuming a 3.22% inflation rate, the property would be valued at $1,372,899 at the death of the surviving spouse. 17 If the property is sold for that exact value at the death of the surviving spouse and a valid QTIP election was made at the death of the first decedent, then the estate (or the beneficiaries thereof) would pay no capital gains tax upon the sale of the property, because of the step-up in basis on the death of the surviving spouse. However, if the QTIP election is considered null and void, and the property is sold for fair market value at the death of the surviving spouse, then the estate (or beneficiaries thereof) would pay a capital gains tax on the $372,899 gain. Based on today s maximum capital gains tax rate of 20%, that results in a capital gains tax of $74,580 that would have been avoided had the QTIP election been allowed to stand. Thankfully, the terms of Revenue Procedure allow many elder law attorneys to rest easy. If the process outlined in that Revenue Procedure is followed, the IRS will not employ Revenue Procedure to disregard the QTIP election. In order to ensure that assets left in

12 a QTIP trust are included in the estate of the surviving spouse, the first deceased spouse's executor should file a Form 706 making the corresponding QTIP election AND the portability election. While making the election to port the DSUE may be of little consequence or concern for the client (due to the fact that there is little chance of an estate tax liability), electing portability should ensure the protection provided by Revenue Procedure , so that the IRS will not disregard the QTIP election. Flexible Estate Plans One of the greatest challenges for an estate planning or elder law attorney is designing an estate plan for a married couple of moderate wealth. As mentioned above, the increase in the federal estate tax exemption in recent years means that many more clients will not be subject to federal estate tax. However, whether due to increase in value or changes in the estate tax rules, there are increasing numbers of clients whose assets are such that it is impossible to know whether the value of their taxable estates will be sufficient to generate federal estate tax. When planning, the attorney typically must decide whether the basic structure of the estate plan should be one that creates and funds a credit shelter trust at the death of the fist decedent, thereby ensuring the use of the first decedent's federal estate tax exemption, or one that leaves all of the first decedent's assets in a QTIP marital trust that qualifies for the federal estate tax marital deduction. The first option ensures that the assets in the credit shelter trust are not subject to estate tax at the death of either spouse, but foregoes the step-up in basis on the assets in the credit shelter trust at the death of the surviving spouse. The second option uses the marital deduction to avoid estate tax at the death of the first decedent, and results in a second step-up in basis with respect to all of the first decedent's assets upon the death of the surviving spouse. However, it may also result in estate tax liability at the death of the surviving spouse to an extent that could 12

13 outweigh the benefit of the step-up in basis. Due to the uncertainty relating to the estate tax,, it is ideal for estate planners to design flexible estate plans that allow the estate planner, the surviving spouse, and the first decedent's executor to re-evaluate the couple's assets, and determine the most beneficial structure, on the death of the first decedent. The most flexible structure may be one in which the first decedent's estate passes to a marital trust for the benefit of the surviving spouse that is designed to qualify for the QTIP election, but which provides that any portion of the marital share disclaimed by the surviving spouse under Code Section 2518 will pass to a separate "credit shelter" trust designed to preserve the first decedent's federal estate tax exemption. Alternatively, the first decedent's executor could be given the authority to determine whether all or a portion of the first decedent's assets should pass to a QTIP trust, or to a credit shelter trust, by directing that any assets over which the executor does not make the QTIP election will pass to the credit shelter trust. 18 Such a plan provides the greatest number of options in terms of post-mortem planning. The executor or surviving spouse could decide to fund the credit shelter trust, thereby using the first decedent's federal estate tax exemption at his or her death, allowing it to grow, tax-free, to be passed on to future generations. However, if at the first decedent's death, it appears unlikely that the couple's combined assets will ever be sufficient to use both spouses' federal estate tax exemptions, the executor or surviving spouse may decide to retain the first decedent's assets in the QTIP trust, in order to obtain the step-up in basis at the death of the surviving spouse. As discussed above, Revenue Procedure provides some comfort that the IRS will recognize the QTIP election, and the step-up in basis will be allowed on the death of the surviving spouse, if the first 18 This is commonly referred to as a "Clayton" plan, after the leading case confirming the effectiveness of the technique, Estate of Clayton v. Comm'r., 976 F.2d 1486 (5 th Cir. 1992). 13

14 decedent's executor also makes the portability election. If the executor does not make the portability election, there may be some risk that the IRS will treat the QTIP election as void, preventing estate inclusion and, accordingly, the step-up in basis, on the death of the surviving spouse. However, this may also create an opportunity for a surviving spouse to request that the IRS treat the QTIP election as void, under Revenue Procedure , if it would be beneficial to use the first decedent's federal estate tax exemption due to unexpected growth in the corpus of the QTIP trust, or the surviving spouse's assets. Conclusion The enactment of the portability provisions introduced a new element of flexibility in estate planning, particularly for clients of relatively modest wealth, and clients who wish to avoid the burden and complication of restructuring the ownership of assets. However, it also caused some concern regarding the interaction of the portability election with the IRS position of disregarding unnecessary QTIP elections, announced in Revenue Procedure Additionally, for elder law attorneys and other estate planners representing clients of more modest wealth, Revenue Procedure has been a source of unease, as a potential danger for clients wishing to make the QTIP election on the death of the first deceased spouse, in order to obtain the step-up in basis on the death of the surviving spouse, even though the QTIP election was not necessary to save estate tax. A similar concern existed for those representing clients with a more moderate amount of wealth, who may or may not benefit from credit shelter planning. In the event that a "Clayton" election or spousal disclaimer is not deployed to fund a credit shelter trust, because it is not necessary to use the first decedent's federal estate tax exemption at his or her death, it is important to ensure that the assets passing under the QTIP trust will receive the step-up in basis on the death of the surviving spouse. 14

15 Fortunately, the IRS has addressed these concerns in Revenue Procedure , and has clarified that the QTIP election will not be disregarded if made with respect to an estate for which portability is also elected, providing a path for ensuring that the QTIP election will not be nullified or ignored if portability is also elected. In addition, this new Revenue Procedure also provides some comfort to estate planners employing the quadpartite estate plan in a manner that relies on the relief offered in Revenue Procedure *Vanessa L. Kanaga is a Content Attorney for InterActive Legal. Letha Sgritta McDowell is a Certified Elder Law Attorney, practicing with the Hook Law Center, and serves as the Director of Legal Strategy for InterActive Legal. InterActive Legal s Suite of Drafting and Planning products allow attorneys practicing in these areas to Connect, Collaborate, and Create. 15