Lifetime QTIPs: Why Should They Be Ubiquitous in Estate Planning?

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1 Lifetime QTIPs: Why Should They Be Ubiquitous in Estate Planning? Presented to: 65 TH ANNUAL TULANE TAX INSTITUTE NOVEMBER 11, 2016 NEW ORLEANS, LOUISIANA Richard S. Franklin McArthur Franklin PLLC 1101 Seventeenth Street NW Suite 820 Washington, DC Richard Franklin is a member of McArthur Franklin PLLC in Washington, DC. He focuses on estate planning, trust and estate administration, and beneficiary and fiduciary representation. He is a member of the District of Columbia and Florida Bars, is a Fellow of the American College of Trust and Estate Counsel, and is a Co-Chair of the ABA RPTE Section s Income and Transfer Tax Planning Group. He serves on the ACTEC Transfer Tax Study Committee. He has spoken at numerous estate planning programs (recent presentations, future presentations) and written on estate planning topics for the ACTEC Law Journal, Actionline, BNA Insights, Estate Planning, Journal of Multistate Taxation and Incentives, Probate & Property, Steve Leimberg s Newsletters, Tax Notes, The Florida Bar Journal, The Washington Lawyer, Trusts & Estates, and the Bloomberg/BNA Estates, Gifts & Trust Journal (recent publications). Richard is a DC Super Lawyer, is ranked in the editions of The Best Lawyers in America as a leading lawyer in the Trusts and Estates category, and rated AV Preeminent by Martindale Hubbell. These materials are for education purposes and are not designed or intended to provide financial, tax, legal, accounting, or other professional advice. The reader is cautioned that changes in law may be applicable, that these materials only provide a general discussion, that critical information may be omitted, and that these strategies may not be suitable for any particular individual University of Miami School of Law. This outline was prepared for the 50 th Annual Heckerling Institute on Estate Planning sponsored by the University of Miami School of Law, and published by LexisNexis. It is reprinted with the permission of the Heckerling Institute and the University of Miami.

2 Table of Contents I. Background on Lifetime QTIPs... 1 A Qualifying Income Interest for Life Income Requirement No Power to Appoint Optional Provisions... 4 a. Principal Distributions... 4 b. Special Testamentary Power of Appointment... 4 c. Assignment... 4 d. Spendthrift Trust Protection... 5 e. Remainder Structure Divorce... 5 B. Gift Tax QTIP Election... 5 a. No Late Filed Gift Tax QTIP Elections... 6 b. Rev. Proc Does Not Apply to Gift Tax QTIP Elections Section 2519 Dispositions... 8 C. Estate Tax Section 2044 Inclusion... 9 a. Passing From Donee Spouse... 9 b. Who is Responsible for Valuing the QTIP property? Section 2207A Right of Recovery D. GST Tax Allocation of GST Exemption by Donor Spouse and Reverse QTIP Election Allocation of GST Exemption by Donee Spouse Waiver of 2207A Right of Reimbursement Application of Move-up Rule to Lifetime QTIP E. Income Tax Grantor Trust During Donor Spouse s Lifetime After Divorce Section 1014 Basis Adjustment a. Automatic Basis Adjustment under Section 1014(a) b. Exception of 1014(e) F. The Deeming Rules of QTIP Trusts Deeming Rules Applicable to the Donor Spouse a. All Transferred b. Nothing Retained and Nothing Passing to Non-Spouse c. All Transferred d. Nothing Passing to Non-Spouse i

3 e. No Estate or Gift Tax Consequence for Donor s Retained Interests Deeming Rules Applicable to the Donee Spouse a. Donee Spouse is Transferor b. Deceased Donee Spouse is Transferor Deeming Rules in Action II. Specific Uses of Lifetime QTIPs A. Funding Testamentary use of Donee Spouse s Applicable Exclusion Amount B. Funding Lifetime use of Donee Spouse s Applicable Exclusion Amount C. Funding use of Donee Spouse s GST Exemption D. Funding Lifetime use of Donor Spouse s Applicable Exclusion Amount Formula QTIP Election Simulated FAC Gift Formula Disclaimer a. Decedent s Surviving Spouse v. Transferor s Spouse E. Grantor By-Pass Trust The Plan Described F. Minority Interest Planning Estate of Mellinger Action on Decision Same Result for Continuing QTIP for Donor Spouse s Estate after Section 2044 Inclusion in Donee Spouse s Estate Planning Concerns a. Trustee b. Special Powers of Appointment c. Separate QTIPs d. LLCs and LPs e. Fractional Interests in Real Property f. Important Difference Between Estate and Gift Taxes g. Fractional Interest Discounts in Artwork G. Donee of Excess Value under Formula Allocation Gift or Sale (a la Petter) No Procter Reversion Analogy to Estate Tax Credit Shelter/Marital Trust Formula Gift Tax a. Not a Contingent or Protective QTIP Election b. QTIP Election on Form Comparison to Using a Charity under FAC Comparison to using a GRAT under FAC ii

4 H. Sales to Defective Grantor Trusts I. Income Tax Basis Adjustment J. Creditor Protection Planning K. Elective Share Planning UPC Florida Illustrates a Twist L. Pre-Separation/Divorce Planning III. Practical Planning Implications A. Planning for Donor Spouse to be a Beneficiary after Donee Spouse s Death Estate Tax Pursuant to Sections 2036 and Estate Tax Pursuant to Section 2041 and the Rule Against Self-Settled Spendthrift Trusts Avoid Concerns by Establishing Lifetime QTIP in a DAPT State or Inter Vivos QTIP Trust Jurisdiction Avoid Concerns by Subsequent Transfer of Interests by Donor Spouse During Donee Spouse s Lifetime Avoid Concerns with Donor Spouse Retaining a Special Power of Appointment When Section 2041 is Not a Concern with Retained Backend Interest GST Tax and Backend Interests B. Planning to Reduce Estate Tax on Donee Spouse s Death Distribution of QTIP Assets to Donee Spouse to Make Gifts or Sales Funding Family LLC/FLPs Sales of Discounted Assets for Promissory Notes C. Section 2519 Concerns Risk of Transactions with Lifetime QTIP a. Deemed Gift b. Disclose Lifetime Marital Trust Sale DSUE and Section 2519 Technical Termination Approach Section D. Releases and Spendthrift Clauses E. QDOTs F. Divorce Issues Divorce and Income Taxation of the QTIP Trust Funded with Separate or Marital Property a. Separate Property b. Marital Property c. Marital Agreement iii

5 G. State Death Taxes IV. Appendix Inter Vivos QTIP Trust Jurisdiction Statutes... A-1 1. ARIZ. REV. STAT. ANN (E)... A-1 2. ARK. CODE ANN A-1 3. DEL. CODE ANN. TIT. 12, 3536(c)... A-2 4. FLA. STAT (3)... A-3 5. KY. REV. STAT. ANN. 386B.5-020(8)(a)... A-3 6. MD. CODE ANN., EST. & TRUSTS A-4 7. MICH. COMP. LAWS (4)... A-5 8. N.H. REV. STAT. ANN. 564-B: A-5 9. N.C. GEN. STAT. 36C-5-505(c)... A OHIO REVISED CODE (B)(3)... A OR. REV. STAT (4)... A S.C. CODE ANN (b)(2)... A TENN. CODE ANN (d)... A TEX. PROP. CODE ANN (g)... A VA. CODE ANN B A WISC. STAT. ANN (2)(e)... A WYO. STAT. ANN (f)... A-10 iv

6 Lifetime QTIPs -- Why Should They be Ubiquitous in Estate Planning* Richard S. Franklin McArthur Franklin PLLC Washington, DC Testamentary Qualified Terminable Interest Property ( QTIP ) trusts are used extensively in estate planning. 1 Lifetime QTIP trusts (aka inter vivos QTIP trusts) are not used as often. However, tremendous benefits are available when using lifetime QTIPs. Recent changes to the income and transfer tax laws contribute to the utility of lifetime QTIPs. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Pub. L. No , enacted December 17, 2010) (hereinafter, the 2010 Act ) and the American Taxpayer Relief Act of 2012 (Pub. L. No , enacted January 2, 2013) (hereinafter, ATRA 2012 ) significantly increased the lifetime exclusion amount (now $5.45 million), introduced portability, and generally increased the income tax rates relative to the estate tax rates. Lifetime QTIPs can ensure that the higher exclusions of both spouses are used notwithstanding the order of the spouses deaths and achieve better income tax results; but many more opportunities are available for lifetime QTIPs. The possible uses of a lifetime QTIP are so extensive that they should be ubiquitous in estate planning. This outline provides background on lifetime QTIPs, ideas for specific uses of lifetime QTIPs, and practical implementation information. I. Background on Lifetime QTIPs For gift tax purposes, qualified terminable interest property is property in which the donee spouse has a qualifying income interest for life and to which a gift tax QTIP election has been made. 2 Both testamentary and lifetime QTIPs must provide the surviving spouse or donee spouse with a qualifying income interest for life the requirements are identical and both require a QTIP election to obtain the marital deduction. 3 1 For an overview of QTIP trusts, see M. Read Moore, et al., Estate Planning for QTIP Trust Assets, 44 th Heckerling Inst., 12 (2010); Sebastian V. Grassi, Jr., Estate Planning with QTIP Trusts after the 2001 Tax Act, 30 ACTEC J. 111 (2004). 2 IRC 2523(f)(2). 3 Compare IRC 2523(f)(2) and IRC 2056(b)(7)(B). 1 * 2016 University of Miami School of Law. This outline was prepared for the 50 th Annual Heckerling Institute on Estate Planning sponsored by the University of Miami School of Law, and published by LexisNexis. It is reprinted with the permission of the Heckerling Institute and the University of Miami.

7 A. Qualifying Income Interest for Life Section 2523(f)(3) 4 defines a qualifying income interest for life for a lifetime QTIP by referencing section 2056(b)(7)(B)(ii), which sets forth the definition in the context of a testamentary QTIP trust. The donee spouse has a qualifying income interest for life if (i) the donee spouse is entitled to all the income from the property and (ii) no person has a power to appoint any part of the property to any person other than the donee spouse. The donee spouse s right to income must begin immediately upon establishing the lifetime QTIP and must continue for the donee spouse s life. 5 A term of years or a life estate subject to termination upon the occurrence of a specified event (e.g., divorce) will not satisfy the qualifying income interest for life requirement Income Requirement In a lifetime QTIP, all of the trust income 7 must be paid to the donee spouse at least annually. Regs (f)-1(c)(1)(i) applies the rules under Regs (e)-1(f) (i.e., applicable to general power of appointment marital trusts) to define the all income requirement for QTIP trusts. The all income requirement is not satisfied if the income is required to be accumulated in whole or in part or may be accumulated in the discretion of any person other than the donee spouse. 8 Neither permitting non-income producing assets to be retained 9 nor investing in non-income producing assets automatically results in disqualification. For example, a power to retain a residence for the spouse or other property for the personal use of the spouse will not disqualify the interest transferred in trust. To be cautious, however, the donee spouse should have the power to require the trust to produce a reasonable amount of income. An extensive discussion of the all income requirement is beyond the scope of this paper, but it is critical to understand these principles. The core standard is in Regs (e)-1(f)(1), which provides: If an interest is transferred in trust, the donee spouse is entitled for life to all of the income from the entire interest or a specific portion of the entire interest, for the purpose of the condition set forth in paragraph (a)(1) of this section, if the effect of the trust is to give her substantially that degree of beneficial enjoyment of the trust property during her life which the principles of the law of trust accord to a person 4 References to a section are to a section of the Internal Revenue Code of 1986, as amended (the IRC ), unless otherwise indicated, and references to Regs. or Regulations are to the Treasury Regulations promulgated thereunder. 5 Regs (f)-1(c)(2). 6 Regs (f)-1(c)(1)(i), (e)-1(f). 7 The term all income means all trust accounting income as set forth in IRC Reg (e)-1(f)(7). 9 See Regs (f)-1(f), Ex. 2 ( D transfers assets having a fair market value of $500,000 to a trust pursuant to which S is given the right exercisable annually to require distribution of all the trust income to S. No trust property may be distributed during S's lifetime to any person other than S. The assets used to fund the trust include both income producing assets and nonproductive assets. Applicable local law permits S to require that the trustee either make the trust property productive or sell the property and reinvest the proceeds in productive property within a reasonable time after the transfer. If D elects to treat the entire trust as qualified terminable interest property, the deductible interest is $500,000. If D elects to treat only 20 percent of the trust as qualified terminable interest property, the deductible interest is $100,000; i.e., 20 percent of $500,000. (emphasis added)). 2

8 who is unqualifiedly designated as the life beneficiary of a trust. Such degree of enjoyment is given only if it was the donor's intention, as manifested by the terms of the trust instrument and the surrounding circumstances, that the trust should produce for the donee spouse during her life such an income, or that the spouse should have such use of the trust property as is consistent with the value of the trust corpus and with its preservation. The designation of the spouse as sole income beneficiary for life of the entire interest or a specific portion of the entire interest will be sufficient to qualify the trust unless the terms of the trust and the surrounding circumstances considered as a whole evidence an intention to deprive the spouse of the requisite degree of enjoyment. In determining whether a trust evidences that intention, the treatment required or permitted with respect to individual items must be considered in relation to the entire system provided for the administration of the trust. In addition, the spouse s interest shall meet the condition set forth in paragraph (a)(1) of this section if the spouse is entitled to income as defined or determined by applicable local law that provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust and that meets the requirements of 1.643(b)-1 of this chapter. Planning Pointer: Consider incorporating parts of the language of the Regulation in your lifetime QTIP provision requiring the payment of income to the donee spouse. For example, the following sample provision is designed to ensure that the all income requirement is satisfied: The Trustee shall distribute to my husband all of the net income of the trust at least quarter-annually. I intend that my husband shall have substantially that degree of beneficial enjoyment of the trust property during his life which the principles of the law of trusts accord to a person who is unqualifiedly designated as the life beneficiary of a trust as contemplated by Treasury Regulations (e)-1(f). I intend that the trust should produce for my husband an income consistent with the value of the trust corpus and with its preservation. If the trust consists of nonproductive or underproductive property, the Trustee shall take such steps as are necessary to provide my husband with the requisite degree of beneficial enjoyment in the trust, which steps could include, but are not limited to, converting such property to property which is productive of a reasonable amount of income, providing payments to my 3

9 husband out of other assets of the trust or, if permitted, borrowing against such property for the purpose of providing payments to my husband. My husband may require the Trustee to provide the required beneficial enjoyment. 2. No Power to Appoint To qualify as QTIP property, no person may have a power to appoint any part of the property to any person other than the donee spouse. 10 This means, for example, that neither the trustee nor the donee spouse may possess a power to appoint assets from the QTIP trust during the spouse s lifetime to the children Optional Provisions Optional provisions that may be included in a lifetime QTIP include: distributions of principal, special testamentary powers of appointment, assignment of the life interest, spendthrift provisions, and varying dispositive options after the donee spouse s lifetime. a. Principal Distributions The QTIP trust could provide for principal distributions to be made to the donee spouse, 12 which provision could be subject to an ascertainable standard 13 or, if an independent trustee is used, a best interests or other non-ascertainable standard. b. Special Testamentary Power of Appointment The QTIP trust could grant the donee spouse a special testamentary power of appointment. 14 An inter vivos special power of appointment is not permitted. 15 c. Assignment The QTIP trust could, by not imposing spendthrift trust protection on the donee spouse, essentially permit the donee spouse to assign his or her interest in the trust. Consider whether doing so will expose the trust assets to possible claims by the donee spouse s creditors. 16 For a discussion regarding the merits of the donee spouse being able to release the life interest, as distinct from assignment, see section III.D below. 10 IRC 2056(b)(7)(B)(ii)(II) made applicable to lifetime QTIPs by IRC 2523(f)(3). 11 Regs (f)-1(f), Ex. 4 (illustrating that trustee s power to distribute $5,000 per year to child disqualifies QTIP). 12 Regs (f)-1(c)(1)(iv). 13 IRC 2041(b)(1)(A). 14 See Section II.F.4b. 15 IRC 2056(b)(7)(B)(ii)(II) made applicable to lifetime QTIPs by IRC 2523(f)(3). See also Henry J. Lischer, Jr., Gifts, 845-3rd Tax Mgmt. (BNA) Estates, Gifts, and Trusts, at X.A.5.c.(2)(a)(iv), (not even the donee spouse may have a power to appoint to someone else during the donee spouse s lifetime). 16 See, e.g., VA. CODE ANN ( To the extent a beneficiary's interest is not subject to a spendthrift provision, the court may authorize a creditor or assignee of the beneficiary to reach the beneficiary's interest by attachment of present or future distributions to or for the benefit of the beneficiary or other means. The court may limit the award to such relief as is appropriate under the circumstances. ). 4

10 d. Spendthrift Trust Protection Alternatively, the QTIP trust could provide spendthrift trust protection to the donee spouse s interests. Creditors are, however, likely able to reach the income of the lifetime QTIP once distributed to the donee spouse. e. Remainder Structure Assuming the gift tax QTIP election is made, the balance of the lifetime QTIP will be included in the donee spouse s estate for estate tax purposes. 17 There are many options for the lifetime QTIP following the donee spouse s death. If the donor spouse is then living, the lifetime QTIP could continue for the donor spouse in a format that again qualifies for QTIP treatment. 18 Another option is to use a formula dividing the balance in the QTIP at the donee spouse s death between a by-pass trust and a continuing QTIP trust for the donor spouse. 4. Divorce Suppose the donor spouse desires to plan for the possibility of divorce. Is it possible to use a generic definition of spouse so that if a divorce occurs with spouse #1, the lifetime QTIP could continue for spouse #2? No, it is not possible. The donee spouse s right to income must continue for the donee spouse s life. The possibility of spouse #1 s interest ending on the couple s divorce would not satisfy the qualifying income interest for life requirement. 19 A lifetime QTIP is necessarily established with the knowledge that even if divorce subsequently occurs, the income payments must continue to the former spouse for life. The lifetime QTIP could provide that any authority to make discretionary principal distributions terminates upon divorce, as well as eliminating or curtailing other rights given to the donee spouse, but the income interest must continue uninterrupted. See the discussion below in Section III.F.2 regarding marital rights. B. Gift Tax 1. QTIP Election The gift tax QTIP election must be made by the time for filing a gift tax return, plus extensions. 20 Section 6075(b) provides that gift tax returns must be filed by April 15 th after the calendar year of the gift. If the donor spouse timely extends the time for filing the 17 IRC See Section III.A. 19 Regs (f)-1(c)(1)(i), (e)-1(f). See also Regs (f)-1(f), Ex. 5 (QTIP not qualified because donee spouse s interest passes to child upon divorce); TAM (Mar. 22, 1991) (QTIP not qualified because Tenn. law terminated donee spouse s interest upon divorce). 20 Section 2523(f)(4)(A) provides that the gift tax QTIP election must be made on or before the date prescribed by section 6075(b) for filing a gift tax return with respect to the transfer (determined without regard to section 6019(2)) and shall be made in such manner as the Secretary shall by regulations prescribe. Regs (f)-1(b)(4) repeats this requirement. 5

11 gift tax return, the election must be made by the extended due date of October 15 th (after the calendar year of the gift). 21 If the donor spouse dies during the calendar year of the gift, the gift tax return must be filed by the time for filing the estate tax return, if sooner. 22 a. No Late Filed Gift Tax QTIP Elections A great deal of caution is warranted in ensuring that a gift tax return is timely filed and the QTIP election is made because the IRS has privately ruled that it does not have discretion to grant a request for an extension of time to make the QTIP election beyond the 6-month period allowed automatically by Regs The IRS reasoned that the time for filing an inter vivos QTIP election is expressly prescribed by the statute in section 2523(f)(4), and the IRS's authority to grant discretionary extensions applies only to requests for extensions of time fixed by Regulations or other published guidance (and not statutory rules). 23 In PLR , the IRS mistakenly granted a 60-day extension of time to make a Federal gift tax QTIP election pursuant to section 2523(f)(2)(C) on a supplemental Form 709 pursuant to Regs The IRS revoked that ruling because the Service does not have the discretion to grant an extension of time under Regs to make the QTIP election. 25 There is, however, no logical reason for 9100 relief to be available for estate tax QTIP elections and not available for gift tax QTIP elections. 26 Gift tax QTIP elections are scary because the failure to make the election means that there will be no marital deduction. In the best case, the use of the donor spouse s lifetime exclusion amount would occur, and in the worst case, gift tax liability, perhaps accompanied by penalties and interest, would occur. This situation is illustrated in Estate of Nielsen, 27 where Ms. Nielsen made a gift of $550,000 to a lifetime QTIP but the gift tax QTIP election was not made. The estate paid the resulting gift tax and sought a refund by claiming that there was an absence of donative intent by Ms. Nielsen pursuant to state law. The Tenth Circuit, however, found that the applicable standard for determining the imposition of the Federal gift tax is not donative intent, but rather whether the donor parted with dominion and control as to leave her no power to change its disposition. 28 In this case, the court found that Ms. Nielsen clearly parted with dominion and control, amusingly noting the architect of the trust employed virtually every word in a legal scrivner s [sic] 21 An extension of the donor spouse s income tax return also extends the time for filing the gift tax return. See IRC 6075(b)(2). 22 IRC 6075(b)(3). 23 PLRs (Dec. 17, 2002) and (July 10, 1996). 24 PLR (Feb. 19, 2010). 25 PLR (Nov. 15, 2010). 26 For the reasons why the IRS should adopt PLR as being the correct result, see the letter from Beth Shapiro Kaufman, Douglas Siegler, Howard Zaritsky, and Richard Franklin to the IRS (July 23, 2010), published by 2010 Tax Notes, (July 27, 2010). See also the letter from the ABA RPTE Section to Congress dated April 25, 2013 asking for the statute to be changed to specifically allow relief for late gift tax QTIP elections similar to IRC 2642(g)(1)(B) enacted to allow relief for failed allocations of GST exemption, and the comments from ACTEC to Congress dated April 3, 2013, suggesting the enactment of legislation permitting Regs relief for certain late lifetime QTIP elections F.3d 1222 (10 th Cir. 2003) F.3d at 1225 (citing Regs (b)). 6

12 lexicon to denote the complete abandonment by Ms. Nielsen of any interest in the transferred property. 29 Because this lifetime QTIP election is so critical, and must be timely made, the planning attorney should consider insisting that he or she take responsibility for preparing and filing the gift tax return just to be sure that the QTIP election is made. Alternatively, write to the client and accountant and confirm that they are responsible for the return and election, being sure to explain the critical nature of the election. Even in this case, because the client may have to pay large sums of gift tax, interest and penalties if the election is not actually made, do not rest easy until you obtain a copy of the signed and filed return. A client who must unexpectedly pay hundreds of thousands or millions of dollars in gift taxes (and/or penalties and/or interest) will be dissatisfied even if you have a letter in your files confirming that the accountant is responsible for the filing. Failing to make the gift tax QTIP election is especially punishing because, in effect, the value of the donee spouse s life interest remains part of the aggregate taxable estate of the marital unit. Without the QTIP election, the donor spouse has made a transfer to the donee spouse (i.e., the life interest) that fails to qualify under any of the marital deduction rules. Typically, of course, we as planners eschew making transfers between spouses that are not qualified for the marital deduction. With the missed gift tax QTIP election, if the donee spouse later transfers his or her life interest, the donee spouse has made a gift for gift tax purposes. 30 This means that some of same value (i.e., the life interest) is being taxed twice before leaving the marital unit (presumably the value of the remainder interest is only taxed upon the donor spouse s transfer to the QTIP trust). If the donee spouse keeps the life interest until his or her death, estate taxation in the donee spouse s estate should be avoided (i.e., section 2044 would not apply because of the missed QTIP election), but any accumulations from the mandatory income payments to the donee spouse during his or her lifetime will be subject to estate taxation in the donee spouse s estate. Therefore, strategizing to mitigate the impacts of a missed gift tax QTIP election should focus on minimizing the income distributions to the donee spouse, not on minimizing the principal value. b. Rev. Proc and Rev. Proc Do Not Apply to Gift Tax QTIP Elections The Service issued Revenue Procedure in response to numerous requests for relief in situations in which an executor made an unnecessary QTIP election. For example, the procedure is designed to provide relief if a QTIP election is made for an estate having a value less than the applicable exclusion amount under section In such a case, the election is unnecessary because no estate tax would be imposed without the election. The F.3d at See Estate of Regester v. Comm r, 83 T.C. 1 (1984) (decedent made a gift equal to the present value of the life income interest in the trust when she exercised the special power of appointment during her lifetime). 31 Rev. Proc , C.B

13 procedure notes that in some cases QTIP elections were mistakenly made for by-pass trusts. 32 Importantly, this original procedure only applied to estate tax QTIP elections. Gift tax QTIP elections are beyond its scope. Rev. Proc , effective on September 27, 2016, modified and supersedes Rev. Proc Under the new procedure it is also clear that the ability to void QTIP elections does not apply to gift tax QTIP elections. Prior to the new procedure some planners were concerned that a QTIP election could be voided in a situation in which a portability election was desired to transfer the deceased spouse s applicable exclusion to the surviving spouse. The new procedure clarifies that a QTIP election cannot be voided if a portability election was made. Prior to the procedure a lifetime QTIP trust could have been used immediately before a donor spouse s death to own such spouse s assets, rather than a testamentary QTIP trust upon such spouse s death, to enable the estate tax portability election, without any concerns with Rev. Proc Section 2519 Dispositions Section 2519 creates a complicated system to impose gift tax upon a lifetime transfer by the donee spouse of his or her interest in the lifetime QTIP. The theory is explained as follows: The transfer that created the QTIP interest was exempt from the transfer taxes (the gift and estate taxes) on the theory that interspousal transfers should not be subject to tax, but that an eventual transfer of the property to another person would be subject to either the gift tax (if the donee spouse makes a subsequent inter vivos gift of the property) or the estate tax (if the donee spouse dies owning the property). A QTIP transfer requires special rules to accomplish this tax on the donee spouse's subsequent disposition or death because the donee spouse's interest is only an income interest. Even though the donee spouse had only an income interest, the donee spouse's disposition of the property should and will generate a tax on the entire value of the property to maintain the integrity of the interspousal transfer tax theory of deferral of tax, not forgiveness of tax. 34 Essentially, if the donee spouse makes a lifetime transfer of all or any portion of his or her qualifying income interest, that will result in a taxable gift pursuant to sections 2511 and The amount of the section 2519 taxable gift will be 100% of the fair market value of the entire trust property minus the value of the qualifying income interest for life. 35 In other words, the section 2519 gift will be the value of the entire remainder interest, even if only a portion of the income interest is transferred. The gift of the remainder interest will 32 See PLR (Nov. 29, 2010) (erroneous QTIP election for by-pass trust ruled void). 33 See also ABA RPTE Section, Est. & Gift Committee s Comments on Rev. Proc (June 11, 2013). 34 Lischer, supra note 15, at X.A.5.c.(2)(b). 35 IRC 2519(a); Regs (a). 8

14 not be eligible for the annual gift tax exclusion. 36 Pursuant to section 2207A, the spouse is entitled to recover any gift taxes imposed as a result of section 2519 from the person receiving the property, in effect resulting in a net gift structure. 37 The gift tax consequences of the disposition of a portion or all of the life income interest are determined separately under the ordinary gift tax rules of section 2511 and will be eligible for the annual gift tax exclusion. 38 A transfer by the donee spouse of a portion or all of the life interest results in the donee spouse being treated pursuant to section 2519 as the transferor of the trust property, other than the qualifying income interest for life, for purposes of chapters 11 and 12 of the IRC. The donee spouse is deemed as making a transfer for purposes of section 2036 of the entire trust corpus, including the portion from which the retained income interest is payable. 39 See Section III.C below for section 2519 concerns and planning possibilities. C. Estate Tax 1. Section 2044 Inclusion Upon the donee spouse s death, section 2044 requires the inclusion in the donee spouse s estate for estate tax purposes of the value of any property in which the donee spouse had a qualifying income interest for life. 40 Inclusion is applicable to any property for which a deduction was allowed under section 2523(f) and for which a section 2519 transfer did not occur. 41 a. Passing From Donee Spouse Section 2044 inclusion also means that for estate and generation-skipping transfer ( GST ) tax purposes, the QTIP property is treated as property passing from the donee spouse. 42 For example, this means that the property is treated as passing from the donee spouse for purposes of determining the availability of the charitable deduction, the marital deduction, special use valuation, and qualification for installment payment of estate tax under section Even if the donor spouse through the creation of a lifetime QTIP is the one who specifies that an amount shall pass to charity upon the donee spouse s death, the donee 36 Regs (c). 37 IRC 2207A(b), 2519(c); Regs (c)(4) ( The amount treated as a transfer under paragraph (c)(1) of this section is further reduced by the amount the donee spouse is entitled to recover under section 2207A(b) (relating to the right to recover gift tax attributable to the remainder interest). If the donee spouse is entitled to recover gift tax under section 2207A(b), the amount of gift tax recoverable and the value of the remainder interest treated as transferred under section 2519 are determined by using the same interrelated computation applicable for other transfers in which the transferee assumes the gift tax liability. The gift tax consequences of failing to exercise the right of recovery are determined separately under A-1(b). ). 38 Regs (c). 39 Regs (a). See Section III.C below for section 2519 concerns and planning possibilities. 40 IRC 2044(a). 41 IRC 2044(b). 42 IRC 2044(c). The exception to this rule for GST tax purposes is if the donor spouse made the reverse QTIP election. See Section I.D.1 below. 43 Regs (b). 9

15 spouse s estate is entitled to the charitable deduction. Example 6 of Regs (e) provides: D transferred $800,000 to a trust providing that trust income is to be paid annually to S, for S's life. The trust provides that upon S's death, $100,000 of principal is to be paid to X charity and the remaining principal distributed to D's children. D elected to treat all of the property transferred to the trust as qualified terminable interest property under section 2523(f). At the time of S's death, the fair market value of the trust is $1,000,000. S's executor does not elect the alternate valuation date. The amount included in S's gross estate is $1,000,000; i.e., the fair market value at S's death of the entire trust property. The $100,000 that passes to X charity on S's death is treated as a transfer by S to X charity for purposes of section Therefore, S's estate is allowed a charitable deduction for the $100,000 transferred from the trust to the charity to the same extent that a deduction would be allowed by section 2055 for a bequest by S to X charity. b. Who is Responsible for Valuing the QTIP property? Section 6018(a)(1) provides that the executor is responsible for the estate tax filing, including reporting the value of assets held by a QTIP trust. Hopefully, the executor and trustee of the QTIP trust will cooperate to resolve issues of responsibility and cost. It behooves them to do so, given that the executor is responsible for the estate tax filings, but the QTIP trustee, in most cases, is responsible for estate tax payments relating to the QTIP inclusion (see next Section). The executor would typically pay for whatever appraisals the executor obtains, and the QTIP trustee would typically pay for whatever appraisals the trustee obtains. In some cases, the estate and QTIP trust might own interests in the same investment and might agree to share the costs. 2. Section 2207A Right of Recovery Section 2207A(a) creates a right of recovery for the estate of the donee spouse against the person receiving the QTIP trust property to obtain the additional amount of federal estate tax that is caused by having the QTIP trust included in the donee spouse s estate under section Importantly, section 2207A is not a right of recovery for a ratable amount or pro rata share of the total estate tax; 44 rather, it is a recovery of the marginal federal estate tax that is imposed by adding the value of the QTIP trust (under section 2044) to the donee spouse s gross estate. 45 Section 2207A does not provide a right of recovery for state death taxes caused by the section 2044 inclusion. 44 Cf. IRC 2207 (ratable sharing right of recovery for section 2041 general power of appointment property). 45 IRC 2207A(a)(1). 10

16 Failure to enforce the right of recovery is a transfer subject to gift tax from the persons who would benefit from the recovery to the persons from whom the recovery could have been obtained. 46 However, the donee spouse may waive the section 2207A right of recovery by specifically indicating such intent in his Will or revocable trust. 47 If the right of recovery is waived by the donee spouse, no gift tax transfer occurs. 48 If there is more than one person receiving the QTIP property, the right of recovery is against each person. 49 The liability for penalties and interest follow the tax liability. 50 As mentioned above in Section I.B.2, section 2207A(b) creates a similar right of recovery for gift taxes paid with respect to a transfer occurring pursuant to section D. GST Tax 1. Allocation of GST Exemption by Donor Spouse and Reverse QTIP Election Pursuant to section 2652(a)(3), the donor spouse may elect the so called reverse QTIP election. In the case of QTIP property under section 2523(f), the election under section 2652(a)(3) has the effect of treating the gift tax QTIP election as having not been made, thereby making the donor spouse the transferor of the QTIP property for GST tax purposes. 51 In the case of a lifetime QTIP, the reverse QTIP election is made on the gift tax return making the gift tax QTIP election, and it is irrevocable. 52 The donor spouse can then allocate his or her GST exemption to the lifetime QTIP trust. 2. Allocation of GST Exemption by Donee Spouse If the reverse QTIP election is not made, the donee spouse will be the transferor of the QTIP property for GST tax purposes as a result of inclusion of the QTIP property in the donee spouse s estate pursuant to section 2044 upon the donee spouse s death 53 or as a result of a transfer pursuant to section 2519 during the donee spouse s lifetime. In either case, the donee spouse s GST exemption may be allocated to the QTIP trust. 3. Waiver of 2207A Right of Reimbursement Pursuant to Regs (a)(3), the waiver of the section 2207A right of reimbursement for estate taxes on a GST exempt QTIP trust is not treated as a constructive addition. This is the case whether (i) the spouse in whose estate the QTIP property is included waives the right of reimbursement 54 or (ii) the beneficiaries of such spouse s 46 Regs A-1(a)(2). 47 IRC 2207A(a)(2). 48 Regs A-1(a)(3). 49 IRC 2207A(c). 50 IRC 2207A(d). 51 The same reverse QTIP election is available for a QTIP election made pursuant to section 2056(b)(7). 52 Regs (a), (b). 53 Regs (d), Ex Regs (a)(5), Ex

17 residuary estate (i.e., those persons who would benefit from the recovery) refuse to enforce the right of reimbursement Application of Move-up Rule to Lifetime QTIP How does the predeceased ancestor or move-up rule of section 2651(e)(1) apply in the context of a lifetime QTIP trust? Section 2651(e)(1) provides that if (A) an individual is a descendant of a parent of the transferor (or the transferor s spouse or former spouse), and (B) such individual s parent who is a lineal descendant of the parent of the transferor (or the transferor s spouse or former spouse) is dead at the time of the transfer (from which an interest of such individual is established or derived) is subject to a tax imposed by chapter 11 or 12 upon the transferor (and if there shall be more than 1 such time, then at the earliest such time), then such individual moves up to the generation which is 1 generation below the transferor. In the case of a QTIP trust, Regs (a)(3) provides: For purposes of section 2651(e) and paragraph (a)(1) of this section, the interest of a remainder beneficiary of a trust for which an election under section 2523(f) or section 2056(b)(7) (QTIP election) has been made will be deemed to have been established or derived, to the extent of the QTIP election, on the date as of which the value of the trust corpus is first subject to tax under section 2519 or section The preceding sentence does not apply to a trust, however, to the extent that an election under section 2652(a)(3) (reverse QTIP election) has been made for the trust because, to the extent of a reverse QTIP election, the spouse who established the trust will remain the transferor of the trust for generation-skipping transfer tax purposes. Example #1: W establishes a lifetime QTIP for H and makes the gift tax QTIP election on a timely filed gift tax return. W does not make the reverse QTIP election for GST tax purposes. Upon H s death, the QTIP distributes to W s descendants, per stirpes. W has one son and two daughters, each of whom has children. W s son is alive when the lifetime QTIP is established, but predeceases H. The son s children will move-up in the generation assignment upon H s death as a result of the section 2044 inclusion in H s estate Regs (a)(5), Ex. 7. Note that the failure to enforce the right of reimbursement may still be a gift subject to gift taxes from those persons who would benefit from the recovery to those persons from whom the recovery could have been obtained. See Section I.C.2 above. 56 Regs (c), Ex

18 The move-up rule would not apply had W made the reverse QTIP election. 57 It also does not matter that son is not a child of H, as the move-up rule applies because he is the son of H s spouse. E. Income Tax 1. Grantor Trust During Donor Spouse s Lifetime During the donor spouse s lifetime, the lifetime QTIP would typically be a wholly grantor trust for income tax purposes under section As a grantor trust, the donor spouse is considered the owner of the assets held in the lifetime QTIP, and all of the income and deductions of the trust would be reported on the donor spouse s income tax return. Pursuant to section 677(a), the grantor is treated as the owner of any portion of a trust whose income is or may be distributed to the grantor or grantor s spouse, or is accumulated for the benefit of the grantor or the grantor's spouse. If the QTIP trust limits the donee spouse to income, then, depending on its other terms, the trust may not be a grantor trust as to principal items. 59 In most cases, for wealth transfer tax planning purposes, it will be desirable for the QTIP trust to be a wholly grantor trust and, if necessary, grantor trust triggers should be included. 60 For example, to ensure that the trust is a grantor trust as to the corpus, the lifetime QTIP could grant the trustee authority to make discretionary principal distributions to the donee spouse. Additionally, as a grantor trust, the lifetime QTIP automatically qualifies to own S corporation stock. 61 If the lifetime QTIP is not a wholly grantor trust during the donor s lifetime, it could not qualify as a qualified subchapter S trust (QSST), 62 but may qualify as an electing small business trust (ESBT) After Divorce After divorce what is the result? After divorce, it appears that section 682 requires that income paid to the former spouse (i.e., the donee spouse, now divorced) be taxed to the former spouse, and that capital gains would remain taxable to the donor spouse, if the QTIP trust remains a grantor trust as to principal. These issues are discussed in greater detail in Section III.F.1 below. Among other potential traps in this situation, the lifetime QTIP will 57 Regs (c), Ex See generally, Robert T. Danforth and Howard M. Zaritsky, Grantor Trusts: Income Taxation Under Subpart E, st Tax Mgmt. (BNA) Estates, Gifts, and Trusts, at IX. 59 Regs (a)-1(g), Ex See Danforth and Zaritsky, supra note 58, at XII. 61 IRC 1361(c)(2)(A)(i). 62 Howard M. Zaritsky, Tax Planning for Family Wealth Transfers During Life, 6.03[2][b] (5 th ed. 2013) (discussing the inability to qualify as a QSST as the fifth disadvantage). 63 Regs (j)(4) provides a specific rule on lifetime QTIPs: [I]f property is transferred to a QTIP trust under section 2523(f), the income beneficiary may not make a QSST election even if the trust meets the requirements set forth in paragraph (j)(1)(ii) of this section because the grantor would be treated as the owner of the income portion of the trust under section 677. In addition, if property is transferred to a QTIP trust under section 2523(f), the trust does not qualify as a permitted shareholder under section 1361(c)(2)(A)(i) and paragraph (h)(1)(i) of this section (a qualified subpart E trust), unless under the terms of the QTIP trust, the grantor is treated as the owner of the entire trust under sections 671 to 677 [i.e., a wholly grantor trust]. 13

19 no longer be a wholly grantor trust and the S election would be blown unless, within 2 ½ months following the termination of wholly grantor trust status, the trust qualifies as a QSST and makes a QSST election or, if it does not so qualify, it makes an ESBT election. A QSST election would not be possible, if the QTIP trust remains a grantor trust as to principal. 3. Section 1014 Basis Adjustment a. Automatic Basis Adjustment under Section 1014(a) Section 1014 s general rule is that the income tax basis of property acquired from a decedent is the fair market value of such property at the date of the decedent's death, or, if the decedent's executor so elects, at the alternate valuation date (the general basis adjustment rule ). 64 Other than section 1014(e) applicable to transfers to the decedent within one year of death (discussed below), the main exception to this rule relates to items of income in respect of a decedent. 65 The general basis adjustment rule applies whether or not an estate tax return is filed. 66 If QTIP property is included in a spouse s estate pursuant to section 2044, then pursuant to section 1014(b)(10) the QTIP property is considered to have been acquired from or to have passed from that spouse, and thereby the general basis adjustment rule will apply to the QTIP property. b. Exception of 1014(e) If the donee spouse dies within one year after the donor spouse establishes the lifetime QTIP, will the general basis adjustment rule be applicable to the assets of the trust upon the donee spouse s death? Section 1014(e) prohibits the general basis adjustment rule from applying when appreciated property was acquired by the decedent by gift during the 1-year period ending on the date of the decedent's death, and such property is acquired from the decedent by (or passes from the decedent to) the donor of such property (or the spouse of such donor). Therefore, consider whether this rule prevents a basis adjustment for QTIP trust property that passes back to the donor spouse after the donee spouse s death within one year of the donor spouse funding the QTIP trust. Some commentators believe that section 1014(e) should not apply if the property passes to a trust for the donor spouse s benefit as distinct from passing outright to the donor spouse or, if applicable, only to the proportionate part of the trust representing the donor spouse s interest in the trust. 67 F. The Deeming Rules of QTIP Trusts The QTIP trust is a construct designed to help achieve marital unit transfer taxation of a married couple s wealth, yet allow the donor spouse to have ultimate control over the trust s disposition (e.g., to address the second marriage situation, in which the donor spouse 64 IRC 1014(a); Regs (a). 65 Regs (c)(1). Also excepted from the general basis adjustment rule are unexercised incentive stock options and options to purchase pursuant to an employee stock purchase plan. Regs (c)(2). 66 Regs (b)(2). 67 For more on this section 1014(e) issue, see Lester B. Law and Howard M. Zaritsky, Basis, Banal? Basic? Benign? Bewildering?, 49 U. Miami, Philip E. Heckerling Inst. on Est. Plan., IV.E.3(d) (2015); Steve Akers, Current Developments and Hot Topics, pp (June 2014) (available at 14

20 wishes to benefit a second spouse, but ensure the remainder passes to the children of the first marriage). Consider that when a QTIP trust is created, two economic interests are created: the life interest in the donee spouse (or surviving spouse in the case of a testamentary QTIP trust) and the remainder interest in the beneficiaries that become possessory following the termination of the donee spouse s interest. Under the deeming rules, however, the entire bundle of economic interests is deemed to have been transferred to the donee spouse. Upon the donee spouse s lifetime transfer of his or her interest or upon the donee spouse s death, the donee spouse is deemed to be the transferor of all economic interests to the remainder beneficiaries. Understanding the deeming rules allows you to better appreciate the symmetry of the QTIP construct, and ways to use the rules to your client s advantage. The deeming rules for QTIP property use language such as shall be treated or shall be considered and includes the following (emphasis added to deeming language): 1. Deeming Rules Applicable to the Donor Spouse a. All Transferred Section 2523(f)(1)(A) provides that, for purposes of obtaining the marital deduction, QTIP property shall be treated as transferred to the donee spouse 68 b. Nothing Retained and Nothing Passing to Non-Spouse Section 2523(f)(1)(B) provides that, for purposes of abrogating the rule that prohibits the marital deduction if any interest in the property is retained by the donor spouse or passes to a person other than the donee spouse, no part of [the QTIP] shall be considered as retained in the donor or transferred to any person other than the donee spouse." 69 c. All Transferred Section 2056(b)(7)(A)(i) provides that, for purposes of obtaining a marital deduction, QTIP property shall be treated as passing to the surviving spouse d. Nothing Passing to Non-Spouse 2056(b)(7)(A)(ii) provides that, for purposes of abrogating the rule that prohibits the marital deduction if any interest in the property passes to a person other than the surviving spouse, no part of [the QTIP] property shall be treated as passing to any person other than the surviving spouse. 68 Similarly, Regs (f)-1(a)(2) provides that QTIP property is treated as passing to the donee spouse 69 Similarly, Regs (f)-1(a)(2) provides that no part of the property is treated as retained by the donor or as passing to any person other than the donee spouse 15

21 e. No Estate or Gift Tax Consequence for Donor s Retained Interests Section 2523(f)(5)(A) provides that (i) [QTIP] property shall not be includible in the gross estate of the donor spouse, and (ii) any subsequent transfer by the donor spouse of an interest in such property shall not be treated as a transfer for purposes of this chapter. 70 Furthermore, pursuant to Regs (f)-1(d)(1), the retention of the interest until the donor spouse's death does not cause the property subject to the retained interest to be includible in the gross estate of the donor spouse Deeming Rules Applicable to the Donee Spouse a. Donee Spouse is Transferor [I]f the donee spouse makes a disposition of part of a qualifying income interest for life in trust corpus, the spouse is treated under section 2519 as making a transfer subject to chapters 11 and 12 of the entire trust other than the qualifying income interest for life. Therefore, the donee spouse is treated as making a gift under section 2519 of the entire trust less the qualifying income interest, and is treated for purposes of section 2036 as having transferred the entire trust corpus, including that portion of the trust corpus from which the retained income interest is payable. 72 b. Deceased Donee Spouse is Transferor Pursuant to section 2044(c), QTIP property included in the donee spouse s estate (or surviving spouse s estate) under section 2044(a) shall be treated as properly passing from the donee spouse for estate and GST tax purposes. Regs (b) provides that [f]or purposes of section 1014 and chapters 11 and 13, property included in the decedent s gross estate under section 2044 is considered to have been acquired from or to have passed from the decedent to the person receiving the property upon the decedent s death. 3. Deeming Rules in Action For a discussion of deeming rule implications, see Sections II.B and G (deeming rules and step-transaction doctrine), Section III.A.1 (deeming rules and sections 2036 and 2038), and Section III.A.2 (deeming rules and section 2044). 70 Similarly, Regs (f)-1(d)(1) provides that if a donor spouse retains an interest in qualified terminable interest property, any subsequent transfer by the donor spouse of the retained interest in the property is not treated as a transfer for gift tax purposes. 71 Pursuant to IRC 2523(f)(5)(B), these rules do not apply to any property after the donee spouse is treated as having transferred such property under section 2519, or such property is includible in the donee spouse s gross estate under section See also Regs (f)-1(d)(2). However, the deeming rules applicable to the donee spouse may alter the otherwise expected rule to be applicable to any such retained interest by the donor spouse. 72 Regs (a). 16

22 II. Specific Uses of Lifetime QTIPs A. Funding Testamentary use of Donee Spouse s Applicable Exclusion Amount A lifetime QTIP could be used to enable the full funding of the donee spouse s federal applicable exclusion amount ( AEA ), if the donee spouse is the first spouse to die. Because the lifetime QTIP will be included in the donee spouse s estate under section 2044, the donee spouse s AEA can be used upon the donee spouse s death. The QTIP format allows the donor spouse to control the disposition of the remainder interest after the donee spouse s death. Particularly in second (and third and fourth ) marriages, the lifetime QTIP may be more palatable than outright gifts to the donee spouse for this purpose. This plan is illustrated as follows: Example #2: W s first husband, H1, died in W has two children by H1. W has $25 million. W then marries H2, who has no children and $500,000 in assets. W would like to ensure that H2 s AEA is used if H2 predeceases her (i.e., for the benefit of W s children by H1). They could rely on portability to transfer H2 s remaining AEA to W. Alternatively, W could create a lifetime QTIP for H2, fund the trust with approximately $5 million of assets, and make the gift tax QTIP election. Advantages of this approach include: (i) the donor spouse s design of the lifetime QTIP controls the management and disposition of the assets at all times, (ii) the donee spouse s estate tax AEA and GST tax exemption can be used notwithstanding the order of the 17

23 spouses deaths, and (iii) the assets can be protected from the donee spouse s creditors by being a spendthrift trust. The assets funding the lifetime QTIP should also be protected from the donor spouse s creditors if the transfer to the trust is not a fraudulent transfer. B. Funding Lifetime use of Donee Spouse s Applicable Exclusion Amount A lifetime QTIP could be used to establish a controlled plan to use the donee spouse s AEA during his or her lifetime (i.e., as a gift). Suppose the donor spouse has used her entire AEA and wishes to currently use the AEA of the donee spouse, but does not wish to give assets directly to the donee spouse (i.e., subjecting the assets to the donee spouse s control). The donor spouse could fund a lifetime QTIP with an amount equal to the donee spouse s AEA and elect QTIP treatment to qualify the lifetime QTIP for the federal gift tax marital deduction on a gift tax return reporting the gift. If the election is made, the gift to the lifetime QTIP would not cause any federal gift tax liability and the value of the trust would be included in donee spouse s estate for federal estate tax purposes at the time of his or her death. However, if the donee spouse entirely released his interests in the lifetime QTIP, the donee spouse would be treated as having made a gift of 100% of the QTIP property. 73 Example #3: Same facts as Example #2, except that W has already made gifts using her own gift exclusion and GST exemption to an irrevocable GST grantor trust for her descendants, and now would like to use H2 s applicable exclusion amount and GST exemption as soon as possible, while W and H2 are living, to also fund similar trusts for W s descendants. W could give funds to H2 with the idea that someday H2 would make gifts to trusts for W s descendants, but W eschews giving H2 control of $5 million. An alternative is for W to create a lifetime QTIP for H2, fund the trust with approximately $5 million of assets, and make the gift tax QTIP election, but not make the reverse QTIP election for GST tax purposes. Without any agreement or obligation to do so being imposed on H2 at the time the QTIP trust is established, H2 could at some point release his interests in the lifetime QTIP, triggering a gift of his income interest under section 2511 and the entire value of the remainder interest under section The gifts triggered by the release would consume H2 s applicable exclusion amount and permit his GST exemption to be allocated to the QTIP trust assets. Advantages of this approach include: (i) the donor spouse s design of the lifetime QTIP controls the management and disposition of the assets at all times, (ii) the donee spouse s AEA and GST exemption are used upon the release of the life interests by the donee spouse, and (iii) the assets can be protected from the donee spouse s creditors by being a spendthrift 73 IRC See Section III.C below for a discussion of section 2519 and Section III.D below regarding spendthrift clauses. 18

24 trust. The assets funding the lifetime QTIP should also be protected from the donor spouse s creditors if the transfer to the trust is not a fraudulent transfer. Besides not giving H2 control over the assets, the other significant advantage of this approach is that the remaining QTIP assets can continue in trust for the benefit of W s descendants in trusts that are grantor trusts as to W. Prior to H2 s release, the QTIP trust would be a grantor trust under section 677. This is discussed in Section I.E.1 above. The trust instrument, however, would also provide other grantor trust triggers, such as the power to reacquire (or substitute) assets pursuant to section 675(4)(c). This would allow the continuing trusts for W s descendants after H2 s release or earlier death to also be grantor trusts. Enabling the assets to be retained in grantor trusts as to W is a significant tax advantage over W simply giving funds to H2 to make gifts in the future to trusts for W s descendants. This plan is illustrated as follows: W remains the grantor of any continuing trust for her children s benefit under the grantor trust rules, even though H2 s release of his interests in the QTIP trust makes him the transferor for gift and GST tax purposes. This result is reliant upon the language of Reg (e)(5), which provides: If a trust makes a gratuitous transfer of property to another trust, the grantor of the transferor trust generally will be treated as the grantor of the transferee trust. However, if a person with a general power of appointment over the transferor trust exercises that power in favor of another trust, then such person will be treated as the grantor of the 19

25 transferee trust, even if the grantor of the transferor trust is treated as the owner of the transferor trust under subpart E of the Internal Revenue Code. (emphasis added.) Pursuant to this Regulation, a change in grantor for income tax purposes occurs only if someone possesses a general power of appointment over the transferor trust and actually exercises it in favor of another trust. In the example above, H2 would not hold a general power of appointment over the lifetime QTIP and therefore W will remain the grantor of the trust for income tax purposes after H2 s release of his interests in the trust. A caveat to this plan is to consider any possible application of the step transaction doctrine (STD). 74 If W sets up the lifetime QTIP trust and H2 immediately releases his interest in it, the IRS might argue that W really made a gift to her descendants, H2 s AEA cannot be used to shelter it from tax, and W rather than H2 is the transferor for GST purposes. That argument may be technically more difficult than it sounds when dealing with a lifetime QTIP because of the deeming rules set forth in Section 1.F above. Section 2523(f)(1)(B) provides that "for purposes of subsection (b)(1), no part of such property shall be considered as retained in the donor or transferred to any person other than the donee spouse." Therefore, how could the STD apply to something that this section says has not been retained? Section 2523(f)(1)(B) does have meaning outside just "subsection (b)(1)." You see this play through in the examples 10 and 11 of Regs (f)-(1)(f). Moreover under the STD, the donor spouse would have necessarily transferred something to someone other than the donee spouse, which Section 2523(f)(1)(B) says shall not be considered to happen. These statutory and regulatory deeming rules provide a basis for argument not present in the typical STD case, such as the Linton case, which involved whether LLC membership interests were given or its underlying assets. While giving due regard to this technical argument, do not hard wire the future release (i.e., plan to fail the end results test), and make sure that there is a reasonable amount of time between the funding of the QTIP trust and the donee spouse s release (i.e., plan to fail the binding commitment test). A few years would be best, perhaps wait for the statute of limitations to run on the gift tax return on which the QTIP election is made. The possible release should be one of several options available to the donee spouse (i.e., plan to fail the interdependence test). C. Funding use of Donee Spouse s GST Exemption Similar to using a lifetime QTIP to enable the use of the donee spouse s AEA, a lifetime QTIP could be used to establish a plan to use the donee spouse s GST exemption during his or her lifetime (i.e., through allocation to gifts) or upon the donee spouse s death. This may be part of a plan to use the donee spouse s AEA or independent of it. When the lifetime QTIP is established, if the donor spouse does not make the reverse QTIP election, the donee spouse would become the transferor of the QTIP property for GST tax purposes and his GST exemption could be allocated to the QTIP assets. The donee spouse becomes the transferor of the QTIP property upon a section 2519 transfer during the donee spouse s 74 See, e.g., Linton v. United States, 630 F.3d 1211, 1224 (9 th Cir. 2011) ( The step transaction doctrine treats multiple transactions as a single integrated transaction for tax purposes if all of the elements of at least one of three tests are satisfied: (1) the end result test, (2) the interdependence test, or (3) the binding commitment test. ) 20

26 lifetime or upon inclusion of the QTIP assets in his or her estate pursuant to section 2044 upon the donee spouse s death. See Section 1.D above. Example #4: W s first husband, H1, died in W has two children by H1. W has $25 million. W then marries H2, who has 1 child and $6 million in assets. H2 plans to leave his entire estate outright to his child. W would like to ensure that H2 s GST exemption is used if H2 predeceases her. Portability cannot transfer H2 s remaining GST exemption to W. W could create a lifetime QTIP for H2, fund the trust with approximately $5.45 million assets, and make the gift tax QTIP election and not make the reverse QTIP election. Upon H2 s death, he becomes the transferor of the QTIP trust for GST tax purposes and his GST exemption can be allocated to the trust. If he predeceases W, the QTIP trust could continue for W in a continuing trust that again qualifies for the QTIP election, and in this case H2 s estate would make both the QTIP election and reverse QTIP election (i.e., allocating his GST exemption to the trust). This defers the estate tax until W s later death. W can waive application of section 2207A and direct that the estate tax on the reverse QTIP property be paid by her other nonexempt assets. D. Funding Lifetime use of Donor Spouse s Applicable Exclusion Amount Rather than use a Petter 75 formula allocation clause ( FAC ), a lifetime QTIP could be used as a means to mitigate gift tax risk associated with a gift of a hard to value asset. 1. Formula QTIP Election Regs (f)-1(b)(3) provides that the taxpayer may make the gift tax QTIP election by means of a formula that relates to a fraction or percentage of the QTIP trust, but the gift tax Regulations provide no examples of such an election. The estate tax QTIP Regulations, however, are helpful in illustrating such formula elections. Examples 7 & 8 of Regs (b)-7(h) provide: Example 7. Formula partial election. D s will established a trust funded with the residue of D's estate. Trust income is to be paid annually to S for life, and the principal is to be distributed to D's children upon S's death. S has the power to require that all the trust property be made productive. There is no power to distribute trust property during S's lifetime to any person other than S. D's executor elects to deduct a fractional share of the residuary estate under section 2056(b)(7). The election specifies that the numerator of the fraction is the amount of deduction 75 Estate of Petter v. Comm r, 653 F.3d 1012 (9th Cir. 2011), aff d. T.C. Memo (Dec. 7, 2009). 21

27 necessary to reduce the Federal estate tax to zero (taking into account final estate tax values) and the denominator of the fraction is the final estate tax value of the residuary estate (taking into account any specific bequests or liabilities of the estate paid out of the residuary estate). The formula election is of a fractional share. The value of the share qualifies for the marital deduction even though the executor's determinations to claim administration expenses as estate or income tax deductions and the final estate tax values will affect the size of the fractional share. Example 8. Formula partial election. The facts are the same as in Example 7 except that, rather than defining a fraction, the executor's formula states: I elect to treat as qualified terminable interest property that portion of the residuary trust, up to 100 percent, necessary to reduce the Federal estate tax to zero, after taking into account the available unified credit, final estate tax values and any liabilities and specific bequests paid from the residuary estate. The formula election is of a fractional share. The share is equivalent to the fractional share determined in Example Simulated FAC Gift A formula QTIP election could be implemented with respect to a lifetime gift designed to use, for example, the balance of the donor spouse s $5.45 million AEA. The donor spouse could make a gift to a lifetime QTIP, wherein descendants would be relegated to being remainder beneficiaries. In many cases this would be acceptable, but perhaps inefficient because the income is required to be distributed to the spouse. A formula QTIP election on the donor s gift tax return could be worded as follows: I elect to treat as qualified terminable interest property that portion of the gift, up to 100%, necessary to reduce the Federal gift tax to zero, after taking into account the available gift tax exclusion amount and final gift tax values. [i.e., tracking the language quoted in Regs (b)- 7(h), Ex. 8.] 76 This approach is illustrated as follows: 76 For a more extensive discussion of using a formula QTIP election in relation to gift planning, see PRACTICAL DRAFTING, The Lifetime QTIP Trust, iii. Formula QTIP Elections (October 2006). It is not clear that the Regulations (Regs (b)-7(d)(3)) issued in response to Estate of Clayton, 976 F.2d 1486 (5 th Cir. 1992), apply for gift tax purposes. See Steve Akers, Planning Flexibilities with Inter Vivos QTIP Trusts, 38 th Heckerling Inst. (workshop materials Jan. 2004). 22

28 3. Formula Disclaimer The second alternative is that the donee spouse would have the ability to disclaim (i.e., refuse to accept) a portion or all of the interests transferred to the lifetime QTIP, 77 thereby allowing the disclaimed assets to pass into another, discretionary trust for the donee spouse and descendants. The donee spouse s disclaimer must occur within nine months of the donor spouse s transfer of assets to the lifetime QTIP. The disclaimer by the donee spouse can be by a formula clause based on final gift tax values. 78 Example 20 of Regs (d) sanctions such a disclaimer: Example (20) A bequeathed his residuary estate to B. B disclaims a fractional share of the residuary estate. Any disclaimed property will pass to A's surviving spouse, W. The numerator of the fraction disclaimed is the smallest amount which will allow A's estate to pass free of Federal estate tax and the denominator is the value of the residuary estate. 79 B's disclaimer is a qualified disclaimer. 77 Regs (b) provides in part: A disclaimer of an undivided portion of a separate interest in property which meets the other requirements of a qualified disclaimer under section 2518(b) and the corresponding regulations is a qualified disclaimer. An undivided portion of a disclaimant's separate interest in property must consist of a fraction or percentage of each and every substantial interest or right owned by the disclaimant in such property and must extend over the entire term of the disclaimant's interest in such property and in other property into which such property is converted. 78 See, e.g., Christopher P. Cline, Disclaimers Federal Estate, Gift and Generation-Skipping Tax Considerations, rd Tax Mgmt. (BNA) Estates, Gifts and Trusts, at IV.D. 79 While this regulatory example does not use the language as finally determined for federal estate tax purposes, many rulings have been issued where such language was used and the disclaimers approved. For example, in PLR

29 Therefore, the donee spouse of a lifetime QTIP trust could implement a fractional formula disclaimer by reference to the largest amount which could pass free of federal gift tax on account of the donor spouse s gift tax exclusion amount and considering final gift tax values. The portion of the lifetime QTIP disclaimed could also be defined by a fraction that simply has a numerator that is a set number and a denominator that is the finally determined gift tax value of the asset transferred to the lifetime QTIP trust. The example below illustrates the latter. Example #5: For years prior to 2015, H s prior taxable gifts are $1.5 million. On January 31, 2015, H funds lifetime QTIP for W with a 35% limited partnership interest (the Transferred Partnership Interest ) in HWC Family Limited Partnership. The appraised value of the 35% interest is $3.5 million on January 31, Pursuant to the trust instrument, any portion of the lifetime QTIP disclaimed by W passes to a discretionary trust for W and descendants. On August 1, 2015, W disclaims a fractional share of lifetime QTIP, as follows: W (Disclaimant) irrevocably disclaims a fractional portion of all of her rights and interests in the QTIP Trust. The numerator of this fraction is (i) Three Million Five Hundred Thousand Dollars ($3,500,000), plus (ii) 5 percent (5%) of the excess, if any, of the fair market value of the Transferred Partnership Interest on January 31, 2015 as finally determined for federal gift tax purposes over Three Million Five Hundred Thousand Dollars ($3,500,000). 80 The denominator of this fraction is the fair market value of the Transferred Partnership Interest on January 31, 2015, as finally determined for federal gift tax purposes. On April 15, 2016, H files a 2015 gift tax return and reports the transfer to the lifetime QTIP, the fractional disclaimer and resulting taxable gift, and makes the gift tax QTIP election for any portion of the lifetime QTIP that is not disclaimed. This approach is illustrated as follows: (Mar. 14, 1986) the facts recited S disclaimed under local law a fractional portion of the assets passing to her under Article Fourth of D's Will. The fraction disclaimed is based on a formula, the numerator of which is the value of D's probate estate that can pass to persons other than D's surviving spouse free of federal and state estate tax by reason of the unified credit under the Internal Revenue Code (section 2010), and the denominator of which is the value of D's gross estate as finally determined for federal estate tax purposes. (emphasis added). 80 The clause (ii) of this language is an attempt to prevent a public policy argument by the Service that such clauses reduce their incentive to audit since any adjustment in value would not result in a taxable gift. With this clause, any valuation adjustment on audit would increase the taxable gift by 5% of the increase in valuation. See Carlyn S. McCaffrey, Formulaic Planning to Reduce Transfer Tax Risks, 45 Heckerling Inst., (Jan. 10, 2011). 24

30 a. Decedent s Surviving Spouse v. Transferor s Spouse Under section 2518 and the Regulations thereunder, the property disclaimed must pass without any direction on the part of the disclaiming spouse to the disclaiming spouse or another person. Regarding this rule, section 2518(b)(4)(A) refers to the spouse of the decedent. The first sentence of Regs (e)(2) uses the words decedent and surviving spouse, as follows: In the case of a disclaimer made by a decedent's surviving spouse with respect to property transferred by the decedent, the disclaimer satisfies the requirements of this paragraph (e)(2) if the interest passes as a result of the disclaimer without direction on the part of the surviving spouse either to the surviving spouse or to another person. [Emphasis added]. What about a disclaimer by the donee spouse in respect to a transfer to a lifetime QTIP when the disclaimed property will pass to a by-pass like trust in which the donee spouse and descendants are beneficiaries? There is no decedent or surviving spouse in this setting. One authority reasons that the references to the decedent s surviving spouse should be read to apply to the spouse of a transferor. 81 An alternative analysis might also be possible. Suppose that the donee spouse validly disclaims (for state law purposes) within nine months of the gift, thereby causing the property to drop down to the by-pass trust arrangement in which the donee spouse is only a discretionary beneficiary. Because a QTIP election cannot be made for the by-pass trust, a taxable gift is triggered. The idea is that the QTIP election would only be made for the 81 Cline, supra note 78, at III.A, note 101 ( presumably 2518(b)(4)(A) will be read to apply to the spouse of the transferor. ). 25

31 fraction of the QTIP that is not disclaimed. Even so, if a fractional formula disclaimer is desired to mitigate the gift tax risks with a hard to value asset, it would be desirable for the disclaimer to be qualified under section 2518 to enable reliance upon the regulatory provision authorizing such a formula disclaimer. E. Grantor By-Pass Trust Typically, if a by-pass trust is funded upon the first spouse s death, that by-pass trust is a non-grantor trust for income tax purposes as to the surviving spouse. Wouldn t it be great if the by-pass trust could be a grantor trust as to the surviving spouse? The lifetime QTIP structure can be used to establish a by-pass trust for the benefit of the donor spouse that is a grantor trust for income tax purposes as to the donor spouse, which enables other estate planning advantages The Plan Described The essence of this lifetime QTIP trust planning is to enable the AEA of the donee spouse to be used on a trust that will be a grantor trust as to the donor spouse. For example, W establishes a lifetime QTIP trust for H s benefit and transfers $5.45 million of assets to the trust. W elects QTIP treatment to qualify the trust for the federal gift tax marital deduction on a timely filed gift tax return reporting her gift. Because the QTIP election is made, W s gift to the lifetime QTIP trust would not cause any federal gift tax liability at the time of the trust funding and the value of the trust would be included in H s estate for federal estate tax purposes at the time of his death pursuant to section W has the option of making a reverse QTIP election under section 2652(a)(3) so that the trust is exempt for GST tax purposes. This approach is illustrated as follows: 82 See Jonathan Blattmachr, Mitchell Gans and Dianna Zeydel, Supercharged Credit Shelter Trust, 21 PROB. & PROP. 52 (July/Aug. 2007) (hereinafter Supercharged ); Jonathan Blattmachr, Mitchell Gans and Dianna Zeydel, Supercharged Credit Shelter Trust versus Portability, 28 PROB. & PROP. 10 (March/April 2014). See also Portability The Game Changer, ABA-RPTE, Income and Transfer Tax Group, Estate and Gift Tax Committee Project (distributed at 47 th Heckerling Inst., Jan 2013 and available on Committee s webpage); Richard S. Franklin and Lester B. Law, Portability's Role in the Evolution Away from Traditional By-Pass Trusts to Grantor Trusts, Vol. 37, No. 2 Bloomberg BNA, Tax Management's Estates, Gifts and Trusts Journal (March-April 2012). 26

32 The primary reason for establishing the lifetime QTIP trust is to set the stage for creating the grantor by-pass trust in the event that W survives H. W must put the plan into effect while H is living think of it as staging before the important and critical second act. During the first act, while H is alive, he would be the sole beneficiary of the lifetime QTIP. Upon H s death, if W is then living, an amount of the lifetime QTIP trust s assets equal to H s AEA could be distributed to the grantor by-pass trust for W s benefit and the balance (if any) could be held in a second QTIP trust for W s benefit. A QTIP election would be made for this second QTIP trust on H s estate tax return. The grantor by-pass trust could provide for W and any of W and H s descendants (i.e., similar to a traditional by-pass trust). The creation of a grantor by-pass trust is the key to this plan. Because the trust was included in H s estate under section 2044, the grantor bypass trust will not be included in W s estate pursuant to sections 2036 or 2038 even though W is a beneficiary of the trust. 83 Careful attention must also be given to avoid inclusion in W s estate pursuant to section 2041 (e.g., based on application of the rule against selfsettled spendthrift trusts thereby enabling W s creditors to reach her interests in the trust). 84 For GST purposes, if W made a reverse QTIP election, W will be deemed to be the transferor, and as such the assets in both the grantor by-pass trust and the second QTIP trust for the donor spouse would be GST exempt. The central idea of this arrangement is that, for income tax purposes, W remains the grantor of any continuing trust for her benefit under the grantor trust rules, even though the QTIP 83 Regs (f)-1(f), Examples 10 and See Section III.A.2 below. 27

33 trust assets have been included in H s estate under section This allows W to have the benefits of grantor trust status as to the grantor by-pass trust and to be a discretionary beneficiary of the trust s income and principal. This result is reliant upon the language of Regs (e)(5), which provides: If a trust makes a gratuitous transfer of property to another trust, the grantor of the transferor trust generally will be treated as the grantor of the transferee trust. However, if a person with a general power of appointment over the transferor trust exercises that power in favor of another trust, then such person will be treated as the grantor of the transferee trust, even if the grantor of the transferor trust is treated as the owner of the transferor trust under subpart E of the Internal Revenue Code. (emphasis added.) Pursuant to this Regulation, a change in grantor for income tax purposes occurs only if someone possesses a general power of appointment over the transferor trust and actually exercises it in favor of another trust. In the example above, H would not hold a general power of appointment over the lifetime QTIP and therefore W will remain the grantor of the trust for income tax purposes. 85 This technique is also discussed in Barry Nelson s outline: Nelson, Seeking and Finding New Silver Patterns in a Changed Estate Planning Environment: Creative Inter Vivos QTIP Planning, ABA RPTE Section Spring Symposia (Chicago May 2014) (hereinafter Nelson, Creative Inter Vivos QTIP Planning ). F. Minority Interest Planning When properly structured, interests owned by a lifetime QTIP trust are not subject to being aggregated to determine voting control with the interests owned by either spouse. 86 Therefore, a lifetime QTIP may be used to avoid a control premium and engender a minority interest discount being applicable to the interests owned by the QTIP trust (and, perhaps, even as to the remaining interests owned by either spouse). In dealing with a large private company, this is a fantastic way to reduce estate taxes without triggering a gift tax upon establishing the plan or transferring the equity interests beyond the benefit of the spouses when either of them is living. 87 NOTE: The analysis in this Section II.F assumes existing law. Much has been made of the Treasury s priority guidance plan issued on July 31, Apparently, the Treasury will issue regulations under section 2704 that will be designed to ignore certain restrictions on the liquidation of an interest in certain corporations. The effect will be to limit valuation discounts. It appears that family control will be the keystone of these regulations, not 85 See Pennell, Myths, Mysteries, & Mistakes, sec. 3. Note that Regs (e)(5), quoted above, was adopted in T.D (August 23, 1999). 86 See Grassi, supra note 1, at It s important to understand that this planning idea will have the effect of reducing the income tax basis of the interest by the minority interest discount. 28

34 whether there is an operating or business activity. These regulations will likely directly impact the effectiveness of the strategies discussed in this Section. Example #6: W owns 100% of Waddles, Inc., an S corporation. Without planning upon W s death, 100% of the stock is taxed for estate tax purposes without any minority interest discount. Alternatively, W creates a lifetime QTIP for H s benefit and transfers 49% of the stock to the trust. W values the transfer to the QTIP trust as a minority interest and makes the gift tax QTIP election on a timely filed gift tax return. Upon W s death, her Will leaves the remaining 51% of stock outright to H. Upon H s subsequent death, the 49% of the stock owned by the QTIP trust is included in his estate under section 2044 and valued as a minority interest and the 51% of the stock owned by him is included in his estate under section 2033 and valued as a controlling interest. The idea of this plan is to save the estate tax on the minority interest discount relating to the 49% of the stock owned by the QTIP trust. Example #7: Same as Example #6, except that W recapitalized the stock to create two classes of equity, voting shares representing 5% of the equity and nonvoting shares representing 95% of the equity. W transfers nonvoting shares representing 80% of the equity to the lifetime QTIP. The idea of this plan is to save the estate tax on the minority interest discount relating to the 80% of the stock owned by the QTIP trust. 1. Estate of Mellinger 88 Mr. and Mrs. Mellinger owned 4,921,160 shares of common stock in Frederick s of Hollywood, Inc. (FOH), which Mr. Mellinger founded, in a joint revocable community property trust. Mr. Mellinger predeceased Mrs. Mellinger and his community property shares passed to a QTIP trust for her benefit. The QTIP election was made on his estate tax return. Independent persons were named as trustees of the QTIP trust. After Mr. Mellinger s death, Mrs. Mellinger transferred the remaining shares (her share of the community property) to a new revocable trust she created. 88 Estate of Mellinger v. Comm r, 112 T.C. 26 (1999), acq., I.R.B. 314, as corrected by Ann , I.R.B. 763 (Dec. 27, 1999). 29

35 At the time of Mrs. Mellinger s death, each of her revocable trust and the QTIP trust owned % of the FOH stock. Together the two trusts owned % of the FOH stock and a controlling position. The executors for Mrs. Mellinger s estate filed her estate tax return on the basis of valuing the stock owned by each trust as a separate block. While FOH was a public company, each separate block was sufficiently large as to justify a blockage discount. The two appraisers for the estate opined, respectively, that a 30% and 31% blockage discount was appropriate. The estate tax return reported a value of $4.79 per share. Upon Mrs. Mellinger s death, the average price of FOH on the NYSE was $ per share. The Service argued that the blocks owned by the trusts should be combined for valuation purposes and issued a notice of deficiency using a value of $8.46 per share. The Service s position was that Mrs. Mellinger s stock was included in her estate under section 2033 and the QTIP trust s stock was included in her estate under section Therefore, Mrs. Mellinger is considered to have owned all of the stock. Furthermore, the Service argued that the combined block of stock was a controlling interest in FOH and should be valued with a premium. 89 The Tax Court found that section 2044 inclusion in the surviving spouse s estate is the quid pro quo for obtaining the marital deduction under section 2056(b)(7) in the estate of the transferor spouse. While the property is treated as passing from the surviving spouse for estate tax purposes under section 2044, the property does not actually pass from the surviving spouse. The court could not find any evidence that Congress intended to have aggregation of interests in the QTIP trust with that of the surviving spouse for valuation purposes. 2. Action on Decision In Action on Decision , the Service indicated that it will no longer litigate the aggregation issue presented in Mellinger. This means that lifetime QTIPs can be used to achieve the result of having a greater portion of the equity interests in a business taxed on a minority interest basis. 3. Same Result for Continuing QTIP for Donor Spouse s Estate after Section 2044 Inclusion in Donee Spouse s Estate The same non-aggregation should apply if the donee spouse dies first and the QTIP property continues in trust for the donor spouse s benefit in the format of a second QTIP. Consider the following example: 89 Prior to Mellinger, the Service had already lost cases on family aggregation. See e.g., Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981). In Propstra v. United States, 680 F.2d 1248 (9th Cir. 1982), the Service lost the argument for aggregating undivided interests in real property owned between spouses. Then, in Estate of Bonner v. United States, 84 F.3d 196 (5th Cir. 1996), the Service lost the argument for aggregating undivided interests in real property owned by the surviving spouse and a QTIP trust for his benefit. 30

36 Example #8: W owns 75% of High-Up, Inc., an S corporation. Son owns 25% of the stock. W creates a lifetime QTIP for H s benefit and transfers 37.5% of the stock to the trust. W values the transfer to the QTIP trust as a minority interest and makes the gift tax QTIP election on a timely filed gift tax return. H predeceases W. Upon H s death, the QTIP trust is included in his estate under section 2044 and valued as a minority interest. The QTIP trust then continues for W s benefit (i.e., the donor spouse has a backend interest in the format of a QTIP trust) and the estate tax QTIP election is made in H s estate. Upon W s subsequent death, the 37.5% of the stock owned by the QTIP trust is included in her estate under section 2044 and the remaining 37.5% of the stock owned by her individually is included in her estate under section Each block of stock is valued separately and as a minority interest. The idea of this plan is to save the estate tax on the minority interest discount relating to 75% of the stock. The plan is arranged to defer all estate taxation until the surviving spouse s death. The plan achieves the same result notwithstanding the order of the spouses deaths. If the donor spouse will have a backend interest in the form of a QTIP trust, it will be important to ensure that inclusion occurs in the donor spouse s estate only under section See below in Section III.A the discussions regarding sections 2036, 2038 and 2041 with respect to a backend interest held by the donor spouse. If the Service could effectively argue that inclusion of the QTIP assets should be under section 2033 or 2041, then aggregation may apply. 90 Because the donor spouse originally transferred the assets to the QTIP trust, this is an especially delicate arrangement to structure. 4. Planning Concerns a. Trustee To be cautious, neither the donor spouse nor the donee spouse should be a trustee of the lifetime QTIP to prevent an argument that they actually controlled both blocks of stock immediately prior to the taxable event. Note that in Mellinger, the trustees of the QTIP trust were independent. It is not clear from the opinion whether this made a difference in 90 Estate of Fontana v. Comm r, 118 T.C. 318 (2002) (stock owned by surviving spouse aggregated with stock owned by general power of appointment marital trust for surviving spouse s benefit, because, at the moment of death, the surviving spouse had control and power of disposition over the property). See also FSA (Feb. 6, 2001) (decedent's 50% interest includible under section 2033 aggregated with the 44% interest subject to decedent's testamentary general power of appointment and includible under section 2041, and valued as a single 94% block). 31

37 the end result. Note that in Nowell 91 the decedent and a grandchild were co-trustees of the QTIP trusts and the court ruled against aggregation. b. Special Powers of Appointment The premise of the foregoing cases is that the donee spouse does not control the QTIP trust property; therefore, for valuation purposes the QTIP property should not be aggregated with non-qtip property included in the donee spouse s estate. If the donee spouse possesses a special power of appointment and, at least to some extent, controls the QTIP trust property, should aggregation apply? In Estate of Bonner 92 the court alluded to that possibility by noting that the donor spouse controlled at every step the assets in the QTIP trust. Had the donee spouse held a special power of appointment over the QTIP trust, the outcome may have been different, as a special power of appointment could be viewed as providing the donee spouse some control over the disposition of the assets. To be cautious, consider limiting the use of special powers of appointment in QTIPs where minority discounts are important or, at least limit the use of such powers to trust property other than that for which a discount is desired. c. Separate QTIPs Suppose two lifetime QTIPs are created and funded with minority interests, one for which the donor spouse s GST exemption is allocated and the reverse QTIP election is made (see Section I.D.1) and one for which the reverse QTIP election is not made. Alternatively, suppose two lifetime QTIPs are created at different points in time, each funded with a minority interest in the same company. For valuation purposes, are the minority interests in each of the multiple QTIP trusts aggregated or are each valued as separate blocks? Suppose that together the blocks amount to a majority interest and separately they are each a minority block. Perhaps the answer depends on whether the separate QTIP trusts are separate shares for state law and tax purposes. 93 Other than to achieve a minority interest discount, are there reasons having independent significance for there being separate QTIP trusts? By analogy to interests transferred to separate children, interests transferred to separate QTIP trusts should be analyzed as separate blocks. In Revenue Ruling 93-12, the IRS held that simultaneous gifts of 20% of the corporate stock to the donor's five children should be valued separately. In planning mode, consider using different trustees for the separate QTIPs to prevent an argument that one person controls both blocks. 91 See infra note 93 and accompanying text F.3d 196 (5th Cir. 1996). 93 In Estate of Nowell Est. v. Comm r., T.C. Memo (1999), two QTIP trusts were involved, a GST exempt QTIP trust and non-gst exempt QTIP trust. If the two QTIPs had been aggregated as one block, it still would have been a minority interest. Thus, in Nowell, the valuation of the two QTIPs as one block may not have resulted in much of a valuation difference. Nowell does not directly reach the issue of whether two separate QTIPs should be aggregated as one. 32

38 d. LLCs and LPs While Mellinger involved corporate stock, the planning strategy of using lifetime QTIPs to achieve minority interest valuation on a portion of the equity interests also applies to interests in LLCs and limited partnerships. 94 e. Fractional Interests in Real Property The idea is likewise applicable to fractional interests in real property. 95 f. Important Difference Between Estate and Gift Taxes There are differences between estate and gift taxation that should be carefully considered when deciding on a lifetime versus testamentary disposition. 96 If in Example #6 above W kept 100% of the stock until death, simply giving 49% of the stock to a testamentary QTIP trust would not achieve the same result as using the lifetime QTIP to receive the same interest as a gift. Having 100% of the stock in W s estate would cause it to be valued as a controlling block. However, the Service would likely take the position that the estate tax marital deduction available for a 49% interest passing to the testamentary QTIP should be reduced because it is a minority interest. 97 Hence, there is a mismatch i.e., the disappearing value would be a taxable disposition. On the other hand, in Example #6, when W funds the lifetime QTIP, the interest being transferred is just 49% of the stock. It is valued for gift tax purposes on the basis of being a minority interest and the gift tax marital deduction matches that amount. 98 W s remaining 51% would still be valued on a 94 The Tax Court in Nowell refused to aggregate for valuation purposes interests owned in limited partnerships by the decedent s revocable trust and QTIP trusts: These [Mellinger] principles are equally applicable to the case before us. Analysis of section 2044 and the accompanying regulations thereunder does not indicate that Congress intended that property interests includable under section 2044 should be merged or aggregated with interests in the same property included in the estate pursuant to section 2038 for purposes of determining Federal estate tax value. Section 2044 provides only that the value of property in the gross estate shall include property in which the decedent had a qualifying income interest for life and that the inclusion of such property shall be at its fair market value. Sec (d), Estate Tax Regs. Section 2044(c) treats QTIP property as passing from the decedent but does not indicate that the decedent should be treated as the owner of such property for purposes of aggregation. Thus, the partnership interests included pursuant to section 2038 and section 2044 should be valued separately. Id. at See Estate of Bonner v. United States, 84 F.3d 196 (5th Cir. 1996). 96 Ahmanson Foundation v. United States, 674 F.2d 761, 768 (9th Cir. 1981) (discussing differences in estate and gift taxation: There is nothing in the statutes or in the case law that suggests that valuation of the gross estate should take into account that the assets will come to rest in several hands rather than one. ). 97 Estate of Chenoweth v. Comm r., 88 T.C (1987) (51% of stock passing to surviving spouse included control premium); TAM (Oct. 14, 1993) (Service ruled that the decedent s entire stock holdings must be valued with a control premium in decedent s estate, and because the stock was divided between a by-pass trust and marital trust, the marital deduction may be taken only with respect to the net value of any deductible interest which passed from the decedent to the surviving spouse. Because the value of the interest that passed to the surviving spouse is a minority interest in Company, the value deductible for purposes of section 2056 must reflect this fact. Accordingly, we conclude that, for purposes of the estate tax marital deduction, a minority discount is appropriate in valuing the portion of the decedent's stockholding in Company that passes to the surviving spouse. ). 98 In TAM (Mar. 11, 1994), the Service determined: Unlike the estate tax where the tax is imposed on an aggregation of all the decedent's assets, the gift tax is imposed on the property passing from the donor to each donee and it is the value of that property passing from the donor to the donee that is the basis for measuring the tax. Thus, where a donor makes simultaneous gifts of property to multiple donees, the gift tax is imposed on the value of each separate gift. Accordingly, the value of property that is the subject of multiple simultaneous gifts may be different from the value of that same property if that property were included in the donor's gross estate at his death. See also Rev. Rul , C.B. 202 ( If a donor transfers shares in a corporation to each of the donor's children, the factor of corporate 33

39 controlling basis upon her death (and upon H s death if she gives the stock to him). There is no mismatch in this paradigm. In Example #8 above, when W transfers 37.5% of her 75% to the lifetime QTIP, while she is left with a minority interest, the fact that her remaining interest becomes less valuable is not a transfer for gift tax purposes. However, the Service might attempt a swing vote argument to offset any minority interest discount on the gift to the QTIP or the value of the separate blocks upon death. 99 g. Fractional Interest Discounts in Artwork The Fifth Circuit, in Estate of Elkins v. Comm r, 767 F.3d 443 (5th Cir. 2014), allowed valuation discounts for an undivided fractional interest in artwork. 100 Example #9: H owns four paintings that in the aggregate are valued at $10 million. H desires for these four paintings to remain in the family and to reduce estate taxes applicable to their transfer. H would prefer that the paintings continue to be displayed in his and W s home. H has already used approximately $4 million of his AEA. Based on the Mellinger analysis, consider a plan wherein H gives an undivided 25% interest in each of the four paintings to a spousal limited access trust ( SLAT )(i.e., a DGT in which the spouse is a discretionary beneficiary along with the descendants) and gives the remaining 75% undivided interest in each of the four paintings to a lifetime QTIP for the initial benefit of W. This plan is illustrated as follows: control in the family is not considered in valuing each transferred interest for purposes of section 2512 of the Code. This would be the case whether the donor held 100 percent or some lesser percentage of the stock immediately before the gift. ). 99 Estate of Winkler v. Comm r., T.C. Memo ; TAM (May 26, 1994) ( As the court concluded in Estate of Winkler, swing block potential is one such factor. In this case, each 30 percent block of stock has swing vote characteristics. The extent to which the swing vote potential enhances the value of each block transferred is a factual determination. However, all relevant factors including the minority nature of each block, any marketability concerns, and swing vote potential, should be taken into account in valuing each block. ). 100 See generally, Jeff Baskies, Discounts Permitted For Fractional Interests in Artworks The Fascinating 5 th Circuit Opinion in Estate of James A. Elkins, Jr. v. Comm r, Leimberg Est. Plan. Newsletter #2247 (Sept. 25, 2014); Steve Akers, Estate of Elkins, 140 T.C. No. 5 (Mar. 11, 2013) (available at 34

40 This plan should enable fractional interest discounts on 100% of the value of the four paintings. Moreover, because W is the income beneficiary of the QTIP trust and discretionary beneficiary of the SLAT, she could have the rent free use of the paintings. Therefore the paintings could be displayed in her home for the balance of her lifetime. The trustees and W should document the rent free use arrangement and agree on such matters as security and insurance against loss or damage. G. Donee of Excess Value under Formula Allocation Gift or Sale (a la Petter) When the IRS questions the valuations applicable to intra-family transfers of interests in closely held entities, the disputed issue is usually the level of valuation discounts used by the taxpayer for lack of control as to a minority interest and lack of marketability for a closely held interest with no ready market. If the IRS can sustain a higher value for the sold interests, it will likely argue that the taxpayer has made a deemed gift of the additional value. In Estate of Petter, 101 the mother used a FAC to make both gifts and sales of interests in LLCs to her children. 102 The documents referred to specific blocks of LLC interests and provided that dollar amounts of those blocks of LLC interests would be given and sold F.3d 1012 (9th Cir. 2011), aff d T.C. Memo (2009). 102 For new sales to defective grantor trusts, see Steve Akers, Sale to Grantor Trust Transaction (Including Note With Defined Value Feature) Under Attack, Estate of Donald Woelbing v. Commissioner (Docket No ) and Estate of Marion Woelbing v. Commissioner (Docket No ) (February 4, 2014) (available at 35

41 based on the final gift tax value of the LLC interests. Any LLC interests not given and sold under the formula were given to a donor advised fund ( DAF ) and thereby qualified for the charitable gift tax deduction. The key to the Petter decision is that valuation is an accounting or legal function that may be determined in hindsight, and therefore, the parties know precisely the amounts transferred and to whom under a FAC on the date of the transaction. This analysis leads to the conclusion that a non-charity as the donee under a FAC, such as a lifetime QTIP, ought to be effective in mitigating gift tax risk. 103 In Petter, the Tax Court reasoned that charities, as recipients of the excess value, will be regarded as third parties dealing at arm s length. The charities are obligated to ensure the proper valuation of the interests being transferred. Similarly, it could be argued that lifetime QTIP trustees would be obligated to ensure the proper valuation of the interests being transferred. Like the trustees of a charitable trust, the trustees of the marital trust have an obligation to protect the interests of the trust No Procter Reversion Using a lifetime QTIP should not be construed as an invalid Procter 105 reversion to the donor. The gift to the lifetime QTIP is real, is irrevocable, and is for the life of the spouse, notwithstanding the possibility of a subsequent divorce. Moreover, a gift to a lifetime QTIP would be subject to gift tax but for the QTIP election a Congressionally authorized period of tax deferral. While the donor may be a remainder beneficiary of the lifetime QTIP following the donee spouse s death, this beneficial interest is necessarily contingent on survival and subject to the very real possibility of not occurring. Lastly, section 2523(f)(1)(B) provides that "for purposes of subsection (b)(1), no part of such property shall be considered as retained in the donor or transferred to any person other than the donee spouse." Therefore, how could the donor spouse have an invalid reversion when this section says nothing has been retained? For these reasons, using a lifetime QTIP should not be viewed as being akin to a reversion in the donor. 2. Analogy to Estate Tax Credit Shelter/Marital Trust Formula Using a lifetime QTIP as the donee under a FAC is similar to a credit shelter/marital trust formula. Assume a preresiduary credit shelter trust formula bequest, residuary bequest to a QTIP marital trust, and that the value of the estate is $5.45 million (with a $5.45 million AEA), at the time the estate tax return is filed. The funding of the credit shelter/marital 103 Notwithstanding that lifetime QTIPs are discussed herein as possible donees under a FAC, the reader is cautioned to consider the limits of the cases. 104 See Dan Holbrook, Where There's a Will: Value Definition Clauses, Part 4: Tax Court in Christiansen Unanimously Rejects IRS Public Policy Arguments, TENN. BAR J., pp. 36, 37 (Apr. 2008)( IRS s public policy argument is clearly weakest with charity as the remainder donee, but even the trustee of a marital trust or other trust as donee has fiduciary responsibilities that cannot be ignored. ). 105 Comm r v. Procter, 142 F.2d 824 (4th Cir. 1944) (operative clause essentially provided that if certain transferred property were found to be subject to the gift tax, it would automatically be removed from the conveyance and remain the property of the transferor). 36

42 trusts is based on final estate tax values. If the IRS can sustain a higher value for the estate assets, the excess over $5.45 million would spill over into the marital trust as to which a QTIP election is made. Similarly, if the final gift tax values increase under a FAC, the excess spills over into the lifetime QTIP. In Petter, the IRS argued that for policy reasons a formula clause like that which the taxpayer used should not be allowed. The taxpayer countered that various types of formula clauses are specifically allowed in the Regulations, such as the gift tax Regulations that allow a formula disclaimer of a fractional amount with a numerator that is the smallest amount which will allow A s estate to pass free of Federal estate tax and the denominator is the value of the residuary estate. 106 The IRS argued that all of these instances of allowing formula clauses involve situations where money passing under the formula will not escape taxation (i.e., money passing by the marital deduction will be taxed when the spouse dies). When using a lifetime QTIP as the donee under a FAC, any amount passing to the lifetime QTIP would necessarily be subject to taxation when the donee spouse dies. Therefore, the IRS should be less concerned with using a lifetime QTIP as the donee under a FAC than using a DAF, where, as in Petter, the IRS argued that the property escapes taxation by passing to a charity. 3. Gift Tax The idea of using a lifetime QTIP as the donee under a FAC is that the gift tax QTIP election can be made on the gift tax return for the calendar year of the sale for the interest passing to the lifetime QTIP trust. The gift tax return would be filed reporting the sale transaction with the irrevocable defective grantor trust (DGT) as a non-gift and reporting the gift to the lifetime QTIP trust. 107 a. Not a Contingent or Protective QTIP Election Some commentators are concerned that the amount passing to the QTIP under a FAC is contingent, thereby making the QTIP election unavailable, or that the QTIP election is contingent. The estate tax QTIP Regulations specifically allow for a protective QTIP election. 108 There is no similar provision permitting a protective gift tax QTIP election in the gift tax Regulations. Arguably, if the type of FAC in Petter did not work neither a charitable deduction nor a marital deduction would be available for the donee interest under these clauses, notwithstanding in the case of the marital deduction whether the donee is a spouse outright, lifetime general power of appointment marital trust or lifetime QTIP. That is, if FACs fail, it will be because the donee interest itself is contingent. Therefore, in the case of the charitable deduction, the argument would be that the interest is subject to a precedent event or, in the case of the marital deduction, the amount passing under the FAC is a 106 Regs (d), Ex See Richard S. Franklin, Molly B.F. Walls, David M. Bradt, Donee Selection and Practical Considerations Under Formula Allocation Clauses, Vol. 36 Bloomberg BNA, Tax Management's Estates, Gifts and Trusts Journal, 271 (Nov. 10, 2011) (sample disclosures for non-gift transactions provided). 108 Regs (b)-7(c). 37

43 nondeductible terminable interest and/or not passing from the donor spouse or considered passing to the donee spouse and another person (i.e., in violation of Regs (b)- 1(b)). If FACs fail with lifetime QTIP trusts it would most likely be because the interest passing is contingent, not because the QTIP election is contingent. This is visible in the context of what the government argued in the Petter appeal. The government argued that the excess value passing under the FAC was dependent upon a precedent event, within the meaning of Regs (c)-3(b)(1). Pursuant to the gifts and sales in Petter, if the irrevocable grantor trusts received an initial allocation of units in excess of their rightful share, the trusts were obligated to transfer the excess to the charities. The government s position was that the charitable gifts kick in only if the IRS audits the taxpayer s gift tax return and there is an adjustment to the valuation. According to the government, the audit itself constitutes a precedent event in violation of the cited Regulation. The government reasoned that no change would occur but for the audit and therefore a gift that occurs to the charity as a result of the audit is by definition contingent. If the government s theory of the FAC was correct, then no marital deduction (or charitable deduction) would be available for the excess value again notwithstanding the format of the marital conveyance. The taxpayer argued and the courts accepted that the gifts under the FAC were not conditioned on any post-transfer event. The values were determinable as of the date of transfer. A disagreement over valuation between the taxpayer and the IRS does not equate to a post-transfer contingency. In Petter, the charitable contributions were not conditioned on any subsequent event. At the time of transfer the legal rights were vested, enforceable and determinable. If valuation is the only element in play under a FAC, a QTIP election should be available for the donee interest passing under a FAC to a lifetime QTIP. The transfer agreement would give a defined legal entitlement. It is that legal entitlement for which the QTIP election would be made. There is not a contingency involved with the election. What s in play is determining the value of the legal entitlement. The estate tax protective QTIP election provision, Regs (b)-7(c), deals with different situations. It primarily addresses when it is unclear that a particular asset is includible or the extent to which it is includible. Examples of situations for which a protective election would be appropriate include: According to one authority: There is an ongoing will contest action that makes the marital bequest uncertain. TAM (May 24, 1989) protective election proper when the calculated amount under formula marital language was in question (the issue was not valuation). An executor may make an irrevocable, protective QTIP election only if, at the time of filing the estate tax return, the 38

44 executor reasonably believes that there is a bona fide issue that concerns: (1) whether an asset is included in the decedent's gross estate; or (2) whether property that is included in the gross estate is eligible for the QTIP election. The protective election must identify either the specific asset, group of assets or trust to which the election applies and the specific basis for the protective election. Note: The only situation where a protective election will be used is when the executor contends that an asset is not included in the gross estate. In this situation, the executor may wish to make a protective QTIP election if the particular asset is determined ultimately to be included in the gross estate. If an asset is included in the gross estate but may not be eligible for the QTIP election, the executor could make the QTIP election directly for such asset. If it is later determined that such asset was not so eligible, then the QTIP election was never valid and, as a result, never applied to the disputed asset. [citations omitted] 109 It seems that a protective election is not appropriate when just dealing with a difficult to value asset. Suppose that the estate has $3.6 million of assets, $100,000 of cash and $3.5 million of XYZ private company stock. Assume the remaining AEA is $3.5 million. Expenses are $100,000. The family trust is funded by a formula with the maximum amount that can pass free of estate taxes, $3.5 million. The QTIP trust is to receive the balance, $0. Because the stock is subject to valuation discounts, one cannot be sure where the final estate tax values will come to rest. On the estate tax return one would explain the formula on Schedule M and indicate that, based on returned values, the QTIP has a zero value but the election is being made for the legal entitlement the trust has under the formula and that final estate tax values control. If the value of the stock is increased, the election is therefore made for the value spilling over to the QTIP. This is also a situation where valuation is the only element in play. This is not a protective election situation. There is no dispute that XYZ stock is included in the estate. 110 This is the same as the Petter situation when using a lifetime QTIP as the beneficiary of the excess value. b. QTIP Election on Form Alan S. Acker, Estate and Trust Administration Tax Planning, rd (BNA) Estates, Gifts, and Trusts, at VI.A Id. at VI.A.3. In the prior version of Mr. Acker s Portfolio he seems to reach this conclusion by implying that its posited situation does not fit the true protective election scenario: The question remains unanswered as to whether a protective formula election can be made if the filing level is close and the estate contains assets that are difficult to value. (The formula would be set to solve to zero estate tax due.) Increasing asset values slightly in order to reach the 706 filing threshold allows the QTIP election but subjects the QTIP property to tax in the surviving spouse's estate. The regulations are clear that a true protective election can only be made in certain circumstances: if there is a question as to the includibility of property in the taxable estate or the eligibility of the property for the QTIP election. Once made, the protective election becomes effective and irrevocable if the property is determined to be includible or eligible, as the case may be. 39

45 A disclosure of the FAC gift that indicates substantially as follows should suffice for making the gift tax QTIP election when a lifetime QTIP is the donee under a FAC: The Taxpayer, JANE SMITH, elects QTIP treatment for the Doe QTIP Marital Trust under Section 2523(f)(4). [GST alternative: However, the Taxpayer makes a reverse QTIP election under Section 2652(a)(3) so that upon the death of the Taxpayer s spouse, [the donee spouse], the decedent shall be deemed the transferor of the Doe QTIP Marital Trust.] The property passing to the Doe QTIP Marital Trust is described below. The Taxpayer owned a 99% Class B membership interest (the Transferred Interest ) in the NEWCO, LLC (EIN ). Pursuant to the Transfer Agreement made on, 2015, by the Taxpayer, the Doe Family Trust ( Purchaser ), and the Doe QTIP Marital Trust, the Taxpayer sold a portion of the Transferred Interest (the Purchased Interest ) to the Purchaser. Pursuant to the Transfer Agreement, the Purchased Interest was the lesser of the Transferred Interest and a fraction of the Transferred Interest, the numerator of which was the Purchase Price and the denominator of which was the fair market value as of the date of the Transfer Agreement of the Transferred Interest as finally determined for Federal gift tax purposes. The Purchase Price is $XXX. The sale of the Purchased Interest to the Purchaser is disclosed as a non-gift transfer at Item of this return. The Taxpayer gave to the Doe QTIP Marital Trust all of the Taxpayer s right, title and interest in and to the portion of the Transferred Interest that is the difference between the Transferred Interest and the Purchased Interest (the Gift Interest ). The value of the Transferred Interest was determined by an independent appraisal, prepared by. The Taxpayer hereto attaches a copy of the appraisal used for determining the value of the Transferred Interest consistent with Regs (c)-1(f)(2)(iv) and (c)-1(f)(3). Pursuant to this appraisal, the Transferred Interest is valued on a noncontrolling, nonmarketable interest basis at $XXX. Based on values as returned, the Purchased Interest equals 100% of the Transferred Interest pursuant to the formula set forth in the Transfer Agreement and the Gift Interest is zero One could consider having the QTIP s economic rights valued under the Transfer Agreement. Even though based on the appraisal the Gift Interest has a zero value, a valuation of the economic rights may have a positive value. Consider 40

46 The values represented for the Transferred Interest, the Purchased Interest and the Gift Interest for purposes of this QTIP election are being made on the basis of the values reported on the return as filed. For purposes of the final amounts to be used, the values and the components of the formula shall be those finally determined for Federal gift tax purposes. Thus, if the values or amount of a component as so finally determined shall be different from the values or amount as reported on this return, the values and amount are changed accordingly. 4. Comparison to Using a Charity under FAC An advantage to using a lifetime QTIP is that the excess value remains with the family unit rather than passing to charity. This advantage, however, may also be its weakness because it would not allow for reliance on the public policy of encouraging charitable gifts that helped the taxpayer prevail in Petter. If an interest in a given or sold asset passes to the lifetime QTIP under a FAC sale, the lifetime QTIP could retain the interest. Unlike most charities, the lifetime QTIP will be under no compulsion to liquidate the investment, subject to the donee spouse s right to force the trustee of the trust to make the property productive of a reasonable amount of income. 112 However, the donor spouse s goal was likely to move all of the interest to the purchasing DGT, thereby removing future appreciation from the taxable estates of the donor and spouse. The donor or the DGT could reacquire the interest that passes under the FAC to the lifetime QTIP by purchase. Because the lifetime QTIP trust is a grantor trust, such a sale would be ignored for income tax purposes. The DGT could provide a promissory note as consideration for the purchase. Being able to structure the reacquisition at the time of the family s choosing and perhaps with favorable terms is an advantage of using the lifetime QTIP as the donee under a FAC rather than a DAF. The income tax reporting as to an interest in an operating company will also be easier to address in the context of a lifetime QTIP that is a wholly grantor trust as to the donor spouse. 5. Comparison to using a GRAT under FAC Using a grantor retained annuity trust (GRAT) as the donee in a FAC gift or sale offers the following advantages as to any excess value passing under the FAC: (i) it removes any appreciation in excess of the section 7520 rate from the transferor s estate if he or she survives the GRAT term, (ii) it allows the excess value to pass to family members, rather whether this could be the reported value for the QTIP election. In addition to the legal entitlement under the FAC, a small gift of cash could be made to the lifetime QTIP upon creation for which the QTIP election would apply. 112 See Regs (e)-1(f)(4), made applicable to lifetime QTIP by Regs (f)-1(c). 41

47 than charity, and (iii) income tax reporting clean-up after the FAC ownership comes to rest is made simpler because the GRAT is a grantor trust. The GRAT and the lifetime QTIP share many of these advantages, as potential donees. One advantage that the GRAT has, as compared to the QTIP, is that future appreciation in any excess value passing under the FAC transaction is removed from the grantor s taxable estate. On the other hand, the lifetime QTIP offers other estate planning opportunities, such as enabling the funding of a donee spouse s AEA while also allowing the donor spouse to control the disposition of the remainder interest after the donee spouse s death. The lifetime QTIP could be used as the donee under multiple FACs relating to multiple sales and gifts over time, whereas a GRAT would be a single use device as a GRAT can be funded only once. The same lifetime QTIP could also be used for other estate planning purposes. As a practical matter, section 2702 places certain administrative demands on the GRAT trustee the annuity must be paid annually out of the assets in the GRAT (i.e., the trustee cannot distribute a note or other debt instrument and no additional contributions can be made to the GRAT). In a FAC sale situation, if the asset sold is retained by the purchasing DGT, then the annuity payments relating to any excess value passing to the GRAT would presumably be satisfied by interests in the same asset, subject to similar valuation discounts. Remember, it may be several years after the formula transaction is implemented before any adjustment occurs and the parties would need to go back and make adjustments to the annuity payments after the fact. If the value used in the FAC sale is eventually adjusted upward, then the GRAT trustee would need to prepare a valuation for each annuity payment date that has passed, in order to determine precisely what the GRAT owns and what the grantor owns following the annuity payments. This assumes that the GRAT is prepared to essentially deem the payments to occur automatically. Note that the GRAT rules under section 2702 do not provide protection for valuation risks with respect to payment of the annuity amount, so that paying the annuity amount with discounted assets, prior to final determination of value, may result in technical violation of the rules under section With a lifetime QTIP, revaluations would generally be unnecessary. If the government could successfully argue that the FAC gift to a GRAT does not qualify for GRAT treatment, so that the grantor s retained interest is valued at zero under section 2702, then a taxable gift occurs as to 100% of the GRAT. In addition, annuity payments still must be made to the grantor. 113 With a lifetime QTIP, on the other hand, if the gift to the trust fails to qualify for QTIP treatment, a taxable gift occurs, but none of the property returns to the grantor, and none would be included in either spouse s estates. H. Sales to Defective Grantor Trusts A lifetime QTIP could serve a complementary role in the structure of an asset sale to a DGT The mitigation provisions under Regs might provide some relief. 114 For a general discussion of sales to DGTs, see e.g., Michael D. Mulligan, The Reinvigorated GRAT: Is a Sale to a 42

48 Example #10: W owns a $3 million limited partnership interest and desires to sell it to a SLAT for a promissory note, thereby obtaining a valuation discount on the sale and removing any future appreciation over the interest rate used on the promissory note from her taxable estate. Will the promissory note be respected as consideration, or treated as having no value under section 2702, and if W retains the promissory note until death, does this arrangement expose W s estate to an argument under section 2036 that the promissory note is a de facto retained income interest in the asset sold? The IRS has, for example, recently made such arguments in the Woelbing cases. 115 Consider restructuring the transaction with a lifetime QTIP. Under the alternative plan depicted below, W makes a $3 million gift of cash to the lifetime QTIP and makes the gift tax QTIP election on a timely filed gift tax return. The QTIP trust loans the cash to the DGT. The DGT purchases the limited partnership interest from W for cash (i.e., W is without the cash for a period of time). The value of the promissory note is still part of the married couple s aggregate estate (now owned by the lifetime QTIP rather than W), but this restructured arrangement should avoid triggering section 2702 or attracting section This plan is illustrated as follows: Defective Trust Still Superior?, 29 EST. PLAN. 379 (August 2002); Michael D. Mulligan, Sale to an Intentionally Defective Irrevocable Trust for a Balloon Note--An End Run Around Chapter 14? 32 U. Miami, Philip E. Heckerling Inst. on Est. Plan (1998); Michael D. Mulligan, Sale to a Defective Grantor Trust: An alternative to a GRAT, 23 EST. PLAN., No 1, 3 (Jan. 1996); Hesch, Installment Sale, SCIN and Private Annuity Sales to a Grantor Trust: Income Tax and Transfer Tax Elements, 23 Tax Mgt. Est., Gifts, & Trusts Journal, 114 (May June 1998). 115 Estate of Donald Woelbing v. Comm r (Tax Court Docket No ); Estate of Marion Woelbing v. Comm r (Tax Court Docket No ). See generally, Steve Akers, Heckerling Musings 2015 and Current Developments #14 (April 2015) (available at 43

49 What about the STD (step transaction doctrine) being applicable to the gift of cash to the QTIP trust (and eventual loan and purchase)? That argument, as discussed above in Section II.B, may be technically more difficult to support because of the deeming rules set forth in Section I.F above. Pursuant to section 2523(f)(1)(B), no part of the QTIP property is considered as retained in the donor or transferred to any person other than the donee spouse. Therefore, how could the STD apply to something that this section says has not been retained? Moreover under the STD the donor spouse would have necessarily transferred something to someone other than the donee spouse, which section 2523(f)(1)(B) says shall not be considered to happen. Careful planning would perhaps involve the passage of time, over funding the lifetime QTIP with additional assets so that it has an independent purpose, and using different trustees for the two trusts. Another combination plan would be to give the actual asset to the lifetime QTIP and enable it to sell the asset to the DGT. Example #11: W owns a 90% limited partnership interest in Waddles Limited Partnership. W desires to sell a 30% limited partnership interest to a SLAT. With a direct sale and retention of the SLAT s promissory note, W has potential gift tax issues under section 2702 and estate tax issues with section Alternatively, W creates a lifetime QTIP for H s benefit and transfers a 60% limited partnership to the trust. W values the transfer to the QTIP trust as a minority interest and makes the gift tax QTIP election on a timely filed gift tax return. After a reasonable period of time, the QTIP Trust sells a 30% limited partnership interest to the SLAT for a promissory note (see the discussion below in Section III.C.1 regarding the risks of sales by QTIPs). This arrangement is illustrated as follows: 44

50 This structure should avoid gift and estate issues under sections 2702 and In the future, W could trigger gifts or sales with the LP interest remaining in her ownership, or H could trigger gifts by making a partial or full release of his interests in the QTIP trust or the QTIP trust could implement further sales of LP interests. I. Income Tax Basis Adjustment The donor spouse could transfer appreciated assets to a lifetime QTIP trust with the expectation that the assets will obtain a basis adjustment pursuant to section 1014 (as described above in Section I.E.3(a)). This might be useful if the donee spouse is expected to die quickly. For example, in Estate of Kite, 116 Mrs. Kite transferred certain stock into a lifetime QTIP trust for Mr. Kite seven days before his death on February 23, Upon Mr. Kite s death, the QTIP property was included in his estate under section 2044, but a QTIP election was made in his estate for the continuing QTIP trust benefiting Mrs. Kite (i.e., she had a back-end QTIP interest). The 1014(e) question was not analyzed in the court s opinion. 117 Footnote 9, however, states: All of the underlying trust assets, including the OG&E stock transferred to Mr. Kite in 1995 [the lifetime QTIP trust], 118 received a step-up in basis under sec T.C. Memo (2013). For an analysis of the court s order and Rule 155 computations issued in an unpublished opinion on October 25, 2013, see Steve Akers on Estate of Kite v. Commissioner, Leimberg Est. Plan. Newsletter (Jan. 21, 2014). 117 See Kerry A. Ryan, Kite: IRS Wins QTIP Battle but Loses Annuity War, Tax Notes, 2013 TNT (Dec. 12, 2013). 118 The court loosely refers to the stock transferred to Mr. Kite in the quoted sentence from footnote 9. However, when read together with footnote 5 and the accompanying text in the body of the Kite opinion, it is clear that the court is 45