NEW YORK STATE ESTATE TAX DEDUCTION FOR PRINCIPAL RESIDENCES

By Jerome Landau, JD, CPA

Effective June 8, 1995, the New York State Tax Law (Sec. 955) was amended to provide for a deduction for New York estate tax purposes of an amount, not to exceed $250,000, from the value of the decedent's principal residence reported on the New York Estate Tax Return (Form ET-90). The above amendment was passed by the New York State Legislature on June 2, 1995, as Sec. 91 of the New York State Budget Bill approved by Gov. Pataki.

The amendment allows a deduction for the value of the real property (up to a maximum of $250,000) which constitutes the decedent's principal residence on the date of death to the extent includable in the decedent's New York estate, not otherwise deductible as a marital deduction or as a charitable deduction. Further, in determining the amount of the deduction, the value of the principal residence must be reduced by the amount of mortgages or other indebtedness and expenses that are specifically attributable to the principal residence. Thus, the deduction for a $300,000 principal residence with a $200,000 mortgage could be $100,000, and the deduction for a $500,000 principal residence with a $200,000 mortgage would be limited to $250,000. For purposes of this deduction, the term "principal residence" has the same meaning as used in IRC Sec. 1034 (relating to the rollover of any gain on the sale of a principal residence). If only part of the property was used as a principal residence, only that part of the value of the property is to be considered in determining the amount of the deduction. Thus, the portion attributable to a home office or the portion used as rental property is not to be considered in determining the deduction.

The N.Y. State Department of Taxation and Finance has issued a technical services bulletin dated July 20, 1995 [TSB-M-95(9)M] covering this new deduction. The bulletin states that the estate tax deduction for the principal residence will be provided for in a revised N.Y. Estate Tax Return (Form ET-90), which should now be available.

The Bulletin further advises that if the N.Y. Estate Tax Return is being filed before the revised forms are available, New York Schedule L ("Expenses Incurred in Administering Property Not Subject to Claims") on Form ET-90.3 is to be used in claiming the deduction.

Since the rates of tax on New York taxable estates (above the current exemption of $115,000) are taxed at rates beginning at 2% and rising progressively to rates as high as 21%, this new deduction can, under the proper circumstances, save a considerable amount of tax. However, where a principal residence is owned jointly by husband and wife with rights of survivorship, the tax savings are not realized until the death of the surviving spouse. Oral conversations with a member of the technical staff at the N.Y. State Tax Department indicate that this deduction should not affect the date of death tax basis of the property. Lastly, the estate of the decedent is allowed the deduction regardless of the decedent's domicile at the time of death, or the location of the principal residence (in or outside New York State). *

COURT OF APPEALS REVERSES TAX COURT ON MARITAL DEDUCTION FOR CONTINGENT QTIP

By Frank G. Colella, LLM, CPA

In Estate of Spencer v. Commissioner, 43 F.3d 226 (6th Cir. 1995) (Spencer II), the U.S. Court of Appeals, Sixth Circuit, reversed the Tax Court, T.C. Memo 1992-579 (1992) (Spencer I) and held the estate was entitled to a marital deduction for the surviving spouse's interest in the marital trust because the executor's qualified terminable interest property (QTIP) election satisfied the requirements of IRC Sec. 2056(b)(7). Spencer I had held that the possibility property that could fund a nonmarital trust (because of the executor's discretion to forgo a QTIP election) was tantamount to a power to appoint that property. As a result, the requirements for a qualified income interest for life (QIIL) and, therefore, QTIP treatment and the marital deduction were not met.

Spencer II is the third consecutive Court of Appeals decision to reverse the Tax Court and the position of the IRS Commissioner on this important estate planning issue‹contingent QTIP elections. In Estate of Robertson v. Commissioner, 15 F.3d 779 (8th Cir. 1994) (Robertson II) rvsg, 98 T.C. 678 (1992) and Estate of Clayton v. Commissioner, 976 F.2d 1486 (5th Cir. 1992) (Clayton II) rvsg, 97 T.C. 327 (1991), the Eighth and Fifth Circuits, respectively, reversed Tax Court decisions on facts that were indistinguishable from Spencer II.

Spencer II is, perhaps, even more significant than Clayton II and Robertson II because it is the first judicial decision rendered after the commissioner finalized regulations on the marital deduction that specifically rejected the analysis of Clayton II and Robertson II. The commissioner may now reconsider the treatment of contingent QTIP elections.

Factual Background

On March 6, 1982, John D. Spencer died, leaving a gross estate valued in excess of $1,875,000. Ernestine Spencer, his wife, was the executrix for the estate. Most of the estate was divided and funded two separate trusts, Trust A and Trust B. Trust A, provided that Mrs. Spencer would receive all trust income for life, payable at quarterly or more frequent intervals. Trust B, was to be administered for the benefit of Mr. Spencer's wife, children, and grandchildren of any of his deceased children.

Before Trust A could be funded and the income interest vested unconditionally in Mrs. Spencer, however, the executor had to affirmatively elect to treat the interests funding that trust as qualified terminable interest property. The executor was not legally bound to make the QTIP election. In the event the executor declined to make the QTIP election, those interests would, instead, fund Trust B.

The estate claimed a marital deduction in the amount of $1.175 million. This amount represented the value of the property transferred to Trust A. The balance of the estate was transferred to Trust B. In November 1990, the IRS issued a notice of deficiency which disallowed the marital deduction to the extent the deduction was attributable to property transferred to Trust A because the interests did not satisfy the requirements for QTIP treatment.

Applicable Authority

IRC Sec. 2056(a) provides a marital deduction from a decedent's gross estate for the value of all property passing directly from the decedent to the surviving spouse. The property must pass unconditionally to the surviving spouse. The deduction will be denied if the interest passing to the surviving spouse will terminate or fall upon a) the lapse of time, b) the occurrence of an event or contingency, or c) the failure of an event or contingency to occur [IRC Sec. 2056(b)(1)].

IRC Sec.2056(b)(7) permits an estate tax marital deduction for interests passing to a surviving spouse that would otherwise fail to satisfy the conditions set forth in IRC Sec. 2056(a). These otherwise nondeductible "terminable interests" will qualify for the marital deduction if a) they pass from decedent to surviving spouse, b) the surviving spouse has a qualifying income interest for life, and c) an election to treat such interests as qualified terminable interest property is made on Form 706 [IRC Sec. 2056(b)(7)(B)(I)]. A QIIL requires that a) all income from the property must be payable to the spouse annually (or at more frequent intervals), and b) no person has the power to appoint such property to any person other than the surviving spouse [IRC Sec. 2056 (b)(7)(B)(ii)]. In short, IRC Sec. 2056(b)(7) permits a decedent to provide the surviving spouse with a life estate in property while retaining control over the ultimate disposition of that property following the death of the surviving spouse.

Marital deduction regulations finalized in February 1994 restated the commissioner's position that a marital deduction would be denied when the QTIP election was contingent upon the executor's discretion and the failure of the executor to make the election would transfer the property into a nonmarital trust. In fact, the preamble to the final regulations specifically stated that the IRS would not follow the holding of Clayton II and Robertson II. The final regulations were not, however, addressed in Spencer II.

Tax Court Decision

Spencer I adopted the commissioner's position that contingent QTIP elections prevented the bequest from satisfying the statutory requirements of IRC Sec. 2056(b)(7). Spencer I held that the surviving spouse, because of the executor's discretion to forgo the election, did not receive a QIIL. Accordingly, the interest could not satisfy the requirements for QTIP treatment. The Tax Court, in holding the QIIL requirements had not been met, found it unnecessary to consider whether a contingent QTIP election would satisfy the "passing" requirement.

The decedent's will provided Mrs. Spencer an uncontestable legal interest in the Trust A income. However, specific testamentary instructions required the executor to transfer the property into the nonmarital trust, Trust B, if the QTIP election was not made. That specific testamentary directive, according to the Tax Court, created the possibility, however remote, that assets might not fund Trust A but rather, at the discretion of the executor, fund Trust B.

The Tax Court held that such a contingency could not satisfy the statutory requirement that "no person has a power to appoint any part of the property to any person other than the surviving spouse" [IRC Sec. 2056(b)(7)(B)(ii)(II)]. While the testamentary language is not drafted as a traditional power of appointment, the court nevertheless concluded that it had the practical effect of a power of appointment.

Following its holding that the surviving spouse did not receive a QIIL, the Tax Court found it unnecessary to consider whether or not the "passing" requirement was satisfied.

Court of Appeals Decision

The Sixth Circuit Court of Appeals, in Spencer II, rejected the "power of appointment" analysis of the Tax Court and, in addition, also rejected the commissioner's argument that the contingent QTIP election prevented the bequest from satisfying the "passing" requirement. While Spencer II reached the same result as Robertson II and Clayton II, however, the Sixth Circuit did not adopt the analysis provided by the Eighth and Fifth Circuits.

Power of Appointment. The commissioner argued that between the date of decedent's death and the making of QTIP election, the executor held an impermissible power of appointment because, by not making the election, property would pass into a nonmarital trust. Conversely, Mrs. Spencer argued that, under the terms of the marital trust, no one could appoint the property until after her death. Once funded and the QTIP election made, Mrs. Spencer argued, all the QTIP requirements were satisfied.

The decisive question as framed by the Court of Appeals was, "Does the surviving spouse's interest in the qualifying terminable interest property have to be determinable on the date of the decedent's death, or may the estate adopt a wait-and-see attitude and determine the QTIP property later on the date of the QTIP election?" (Spencer II at 230). The court held that no property could satisfy the QTIP requirements until the QTIP election was made on Form 706.

"The words of the statute are plain: No property meets the definition of QTIP until the proper election can be made, and no QTIP election can be made until the estate tax form is filed.... Since no property can be QTIP until the election is made, the proper date to determine if the property satisfies the requirement of IRC Sec. 2056(b)(7) is on the date of election" (Id. at 231). As a result, the notion of a "power of appointment" in the executor from the date of decedent's death until the date the QTIP election is made becomes a moot point.

Passes to the Surviving Spouse. The Court of Appeals also resolved the apparent conflict between two statutory provisions that concerned the issue of "passing" to the surviving spouse. IRC Sec. 2056(b)(7)(A) specifically provides that if property satisfies the QTIP requirements, that property will be treated as passing to the surviving spouse.

IRC Sec. 2056(c), however, provides that if, at the time of the decedent's death, "it is not possible to ascertain the particular person or persons to whom an interest in property may pass from the decedent, such interest shall...be considered as passing from the decedent to a person other than the surviving spouse." The commissioner argued that, because it was impossible to determine which trust would be funded at the date of the decedent's death, IRC Sec. 2056(c) prevented the property from "passing" to the surviving spouse. Thus, the QTIP requirements would not be satisfied.

The Court of Appeals strongly rejected that interpretation: "We hold that in the case of qualified terminable interest property, the self-excepting language of IRC Sec. 2056(b)(7)(A) removes it from the operation of Sec. 2056(c) regarding when property passes from a decedent to another" (Spencer II at 232). "[H]ad Congress intended Sec. 2056(b)(7) to be subject to the requirement of Sec. 2056(c), it would not have included the self-excepting language of Sec. 2056(b)(7)(A) because it would have automatically been subject to section 2056(c) because it was not granted a specific exception" (Id. at 233).

Robertson II and Clayton II. While reaching the same result as the Eighth and Fifth Circuit decisions, the Sixth Circuit found it unnecessary to treat the QTIP election as operating retroactively to the date of the decedent's death. "[T]he Clayton court, however, unnecessarily created a legal fiction that the QTIP election is somehow considered "retroactive" to the date of decedent's death...The Eighth Circuit followed suit...The election provision is plain on its face and need not be read retroactively" (Id. at 233-34). In other words, by holding that the critical measurement point is the date the QTIP election is made on Form 706, what tax consequence, if any, the period between the date of death and date of election has for the executor charged with making the QTIP election, is irrelevant.

What to Do

Given the three consecutive reversals, the last of which followed the final marital deduction regulations, the commissioner should acquiesce to the decisions and, ultimately, rewrite the regulations on contingent QTIP elections.

Until that time, however, Spencer II, Robertson II, and Clayton II are binding precedent for the Tax Court and commissioner only in the jurisdictions of the Sixth (Kentucky, Michigan, Ohio, and Tennessee), Eighth (Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, and South Dakota), and Fifth (Alabama, Florida, Georgia, Louisiana, Mississippi, and Texas) Circuits. Taxpayers in the remaining jurisdictions can only rely on the decisions as persuasive authority. *

Editors:
Marco Svagna, CPA
Lopez Edwards Frank & Co., LLP

Edward A. Slott, CPA
E. Slott & Company

Contributing Editors:
Richard H. Sonet, CPA
Zeitlin Sonet Hoff & Company

Lawrence M. Lipoff, CEBS, CPA
Lipoff and Company, CPA, PC

Frank G. Colella, LLM, CPA

James B. McEvoy, CPA
Chemical Banking Corporation

Jerome Landau, JD, CPA

Eric Kramer, JD, CPA
Farrell, Fritz, Caemmerer, Cleary, Barnosky & Armentano, P.C.

NOVEMBER 1995 / THE CPA JOURNAL