Tax Court Rejects QTIP Trust Deduction of Undistributed Income

Tax Court Rejects QTIP Trust Deduction of Undistributed Income

One of the most common types of trusts is a QTIP trust (Qualified Terminable Interest Property Trust). The purpose of the QTIP trust is generally to protect the children of the first spouse while providing an income stream for the surviving spouse. Generally, when the first spouse is the wealthier spouse and has children from a prior marriage, she may want to both provide the corpus (property) or the assets to transfer to the children while providing a stream of income to the current spouse. By creating a QTIP trust, both objectives can be met with the same trust. The issue becomes what happens if the QTIP does not distribute income that should have been distributed — does that impact the value of the estate with respect to potential estate taxes? This was the question posed in the recent US Tax Court case of Kalikow.

26 USC 2044

• • (a) General rule

    • • The value of the gross estate shall include the value of any property to which this section applies in which the decedent had a qualifying income interest for life.

1. • (b) Property to which this section applies

     • • This section applies to any property if—

         • a deduction was allowed with respect to the transfer of such property to the decedent—

           • (A)under section 2056 by reason of subsection (b)(7) thereof, or

           • (B) under section 2523 by reason of subsection (f) thereof, and (2)section 2519 (relating to dispositions of certain life estates) did not apply with respect to a disposition by the decedent of part or all of such property. (c)Property treated as having passed from decedent For purposes of this chapter and chapter 13, property includible in the gross estate of the decedent under subsection (a) shall be treated as property passing from the decedent.

26 USC 2056 (7)

(7) Election with respect to life estate for surviving spouse

• • • In general:

      • In the case of qualified terminable interest property—

        • (i) for purposes of subsection (a), such property shall be treated as passing to the surviving spouse, and

        • (ii) for purposes of paragraph (1)(A), no part of such property shall be treated as passing to any person other than the surviving spouse.

Kalikow Court Ruling

Here are key excerpts from the Tax Court’s ruling:

Purpose of the QTIP

• • • Section 2044(a) generally includes in the gross estate the value of QTIP trust property, i.e., property in which the decedent had a qualified income interest for life and for which a marital deduction was allowed to the estate of a predeceased spouse under section 2056(b)(7). “[T]he QTIP regime employs a fiction that treats QTIP as passing entirely from the first spouse to die to the surviving spouse.” Estate of Morgens v. Commissioner, 133 T.C. 402, 412 (2009), aff’d, 678 F.3d 769 (9th Cir. 2012). The QTIP regime generally allows a transfer of QTIP to qualify for a marital deduction for the first spouse to die and thereby to escape inclusion in that spouse’s estate, even though only a life interest passes to the surviving spouse. “[A]t the death of the second spouse, QTIP property is taxed as part of the surviving spouse’s estate.” Estate of Mellinger v. Commissioner, 112 T.C. 26, 32 (1999); see also Estate of Morgens, 133 T.C. at 412 (“Inclusion in the transfer tax base of the surviving spouse is the quid pro quo for allowing a marital deduction to the estate of the first spouse to die.”).

What does this Mean?

It means that in order to determine the gross estate value, the value of the QTIP trust property is included in the value of the estate. While it avoids inclusion in the surviving spouse’s estate for estate tax purposes while the surviving spouse is still alive. it is included in the value of the estate of the surviving spouse.

What is Included in the Estate

• • •  [*10] Under section 2044 the amount included in the gross estate is generally “the value of the entire interest in which the decedent had a qualifying income interest for life, determined as of the date of the decedent’s death.” Treas. Reg. § 20.2044-1(d)(1). Consequently, where, as here, the decedent is the beneficiary of a QTIP trust, the decedent’s gross estate must generally include the fair market value of the trust assets as of the date of the decedent’s death. See Treas. Reg. § 20.2044-1(e) (example 1).

What does this Mean?

The gross estate includes the value of the interest at the time of the decedent’s death, based on the Fair market value of the QTIP assets at the time of the decedent’s death. The case refers to the following example as well for reference:

• • • “Example 1. Inclusion of trust subject to election.

      • Under D’s will, assets valued at $800,000 in D’s gross estate (net of debts, expenses and other charges, including death taxes, payable from the property) passed in trust with income payable to S for life. Upon S’s death, the trust principal is to be distributed to D’s children. D’s executor elected under section 2056(b)(7) to treat the entire trust property as qualified terminable interest property and claimed a marital deduction of $800,000. S made no disposition of the income interest during S’s lifetime under section 2519. On the date of S’s death, the fair market value of the trust property was $740,000. S’s executor did not elect the alternate valuation date. The amount included in S’s gross estate pursuant to section 2044 is $740,000.”

Be Careful What You Stipulate to

• • • “We are unpersuaded. Having stipulated that the relevant value of the SK Trust’s KFLP partnership interest was $54,492,712, the limited administrators cannot successfully argue for some lesser value [*11] of this asset on account of the undistributed income payment liability.”

May Not Have Been Included Anyway

• • • Respondent represents, and the limited administrators have not disputed, that the $6,572,310 undistributed income amount was not included in the stipulated value of the KFLP partnership interest

What about Deductions for the Taxable Estate?

The estate wanted to try to claim certain deductions in relation to the QTIP trust as part of the administration of the estate.

26 U.S. Code § 2053 – Expenses, indebtedness, and taxes

• • • (a) General rule

      • For purposes of the tax imposed by section 2001, the value of the taxable estate shall be determined by deducting from the value of the gross estate such amounts—

        • (1) for funeral expenses,

        • (2) for administration expenses,

        • (3) for claims against the estate, and

        • (4) for unpaid mortgages on, or any indebtedness in respect of, property where the value of the decedent’s interest therein, undiminished by such mortgage or indebtedness, is included in the value of the gross estate, as are allowable by the laws of the jurisdiction, whether within or without the United States, under which the estate is being administered.

    • (b) Other administration expenses

      • Subject to the limitations in paragraph (1) of subsection (c), there shall be deducted in determining the taxable estate amounts representing expenses incurred in administering property not subject to claims which is included in the gross estate to the same extent such amounts would be allowable as a deduction under subsection (a) if such property were subject to claims, and such amounts are paid before the expiration of the period of limitation for assessment provided in section 6501.

Court Rejects Deducting the Settlement/Payout 

• • • The parties devote much of their arguments to the question of whether the various components of the agreed-upon settlement payment meet the limitations on deductibility as set forth in Treasury Regulation § 20.2053-8(b). These arguments are misdirected. The limitations on deductibility set forth in these regulations do not apply with respect to claims in favor of the estate that are includible in the decedent’s gross estate under section 2031. See Estate of Saunders, 136 T.C. at 418. The obligation of the SK Trust to make the agreed-upon settlement payment to the estate does not give rise to any deduction by the estate. Rather, the estate’s claim against the SK Trust is itself property to be included in the gross estate. Even if we were to assume, for the sake of argument and in the absence of any evidence in this regard, that the estate actually incurred the fees and commissions specified as components of the agreed-upon settlement payment, reimbursement of these expenses under the settlement agreement would preclude any deduction by the estate. See Treas. Reg. § 20.2053-4(d)(3).

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.