An Examination of the Marital Deduction Final Regulations

By Mark A. Segal

The marital deduction is a tantalizing benefit. It enables the estate of the first spouse to pass to the surviving spouse free of estate tax. But what about the tax consequences of the second death? A major aspect of estate planning for high-net-worth individuals is the proper use of the marital deduction, including use of bypass trusts and QTIPs, to keep the total estate taxes for both spouses to a minimum. New final regulations on the mechanics of the marital deduction must now become part of the planning for most high-net-worth individuals. Also presented is a sidebar that gives practical guidance on the use of the bypass trust.

Final regulations were issued recently pertaining to the marital deduction. These regulations are generally effective for transfers made or property passing by reason of death to a spouse that occur after March 1, 1994.

As a general rule, there is an unlimited deduction from gift and estate taxes for assets transferred to a spouse. Qualification for this deduction is based on satisfaction of the following criteria:

* Property must be transferred to a spouse or pass from a decedent to the decedent's spouse by reason of death.

* The deduction is limited to the value of the asset deemed transferred or included in the transferor's estate.

* The decedent and recipient spouse must each be a citizen or resident of the U.S.

For sizable estates, utilization of the marital deduction often involves the use if a bypass trust or having assets in an amount equal to the unified credit passed to persons other than the surviving spouse, with the balance of the estate passing to the surviving spouse. Under present law, maximization of the unified credit in this manner enables a married couple to transfer at least $1,200,000 out of their combined estates without being subject to Federal estate taxes. The amount removed from estates without incurring a transfer tax can be substantially enhanced through utilization of a prudent gift-giving program that takes advantage of the annual gift tax exclusion. In some instances, a decedent may intentionally allow a portion of an estate to be subject to estates taxes to avoid bunching of assets in the surviving spouse's estate and thereby minimize overall estate taxes. Guidance on the use of a bypass trust for such purposes is included in the accompanying sidebar

In many instances, a taxpayer seeks qualification for the marital deduction while restricting the recipient spouse's rights with regard to the assets. This is done to prevent mismanagement of assets or protect the assets or value for others, e.g., children. Caution must be exercised in restricting a surviving spouse's interest in property for which the marital deduction is sought to avoid IRS disallowance of the marital deduction.

Under the terminal interest rule of IRC Sec. 2056(b), no deduction will be allowed if an interest passing to a surviving spouse will terminate or fail upon "the lapse of time...the occurrence of an event or contingency or the failure of an event or contingency to occur" whereÑ

* an interest in the property passes or has passed to someone else for less than adequate and full consideration in money or money's worth.

* if by reason of such passing, the person, or his heirs or assigns, may possess or enjoy any part of the interest.

A deduction will be denied if the executor, pursuant to the direction of the decedent, acquires an interest meeting the above standard.

A number of exceptions to the terminal interest rule exist. The most popular exceptions for estate tax purposes are these prescribed by IRC Sec. 2056(b)(7) for qualified terminal interest property (QTIP) and IRC Sec. 2056(b)(5) for transfer of a life estate with general power of appointment.

QTIP

Utilization of a QTIP enables use of the marital deduction while controlling to whom assets will pass upon the death of the recipient spouse. Three requirements must be met to successfully make a QTIP transfer.

* The surviving spouse must be entitled to all income from the property at least annually for life or have an unconditional right to use the property for life. Where the right to income exists, but the asset transferred is not income producing property, the recipient spouse must have the right to demand the property be converted to income producing property within a reasonable period of time.

* No one, including the surviving spouse, can have the power to appoint any part of the property to one other than the surviving spouse during the surviving spouse's lifetime.

* The legal representative of the decedent's estate must elect to have the interest, or a specific portion thereof, be treated as a QTIP.

Transfer of Life Estate with General Power of Appointment

IRC Sec. 2056(b)(5) constitutes another useful exception to the terminal interest rule. This relates to a life estate with a power of appointment in the surviving spouse. In recent years, its application has waned in comparison to that of the QTIP. This is largely due to the reduced control it permits over transferred assets while still qualifying for the marital deduction. The following criteria must be met to qualify as a martial deduction under IRC Sec. 2056(b)(5):

* The surviving spouse must be entitled for life to all of the income from the entire interest, or to a specific portion of all of the income from the entire interest. Controversy has long surrounded the definition of "specific portion." According to the 1967 Supreme Court decision in Northeastern Pennsylvania National Bank and Trust Co., a broad construction was given the term, including a flat payment from a fixed sum.

* The income payment must be made at least annually.

* The surviving spouse must have the power to appoint the property to either his-or herself or his or her estate. Determination of whether the requisite power exists is to be made based upon local law.

* The power held by the surviving spouse must be exercisable by the surviving spouse alone and (whether exercisable by will or during life) must be exercisable in all events.

* The entire interest or specific portion must not be subject to a power in any other person to appoint any part to any person other than the surviving spouse.

Drawbacks to QTIP

While the use of a QTIP holds appeal, drawbacks do exist. For estate-tax purposes, IRC Sec. 2044 generally requires the interest for which a marital deduction was taken for a QTIP be included in the estate of the surviving spouse. IRC Sec. 2523 provides analogous treatment to the recipient spouse with respect to gifts qualifying for the marital deduction as a QTIP. The purpose of these requirements is to ensure QTIP property will be includable in the gross estate of at least one of the spouses. To deter possible disposition of property for which a martial deduction was claimed as a QTIP, the tax law treats any lifetime disposition of this type property as a gift of all interest other than the income interest in property.

Final RegulationsÑMajor Changes

The final regulations made major changes relating toÑ

* the redefinition of specific portion

* QTIP election

* certain contingent interests

* executor discretion

Specific Portion. Both IRC Secs. 2056(b)(5) and 2056(b)(7) allow a marital deduction with respect to a specific portion of corpus or principal appropriately transferred to a surviving spouse. Despite longstanding IRS opposition, courts deciding litigation have found a specific portion can exist where the recipient spouse is to receive distribution of a designated pecuniary amount out of the amount transferred. According to the Supreme Court, the amount of the marital deduction is computed by determining the amount of the corpus required to produce the income amount and is not computed by determining the present value of the right to secure payments over an actuarially computed life expectancy. In contrast to the dispute surrounding distribution of flat pecuniary amounts, general agreement exists that the phrase specific portion encompasses an interest in the income of or receipt of a fraction or percentage of the share of property.

The final regulations reflect the IRS's position concerning that distribution of a designated pecuniary amount. An exception to this treatment is extended to decedents and transfers meeting transition rules.

The final regulations provide that where a surviving spouse has the right to receive the income from a specific portion of the trust property, but has a power of appointment over a different specific portion, the marital deduction is limited to the lesser of the specific portions.

Example: Decedent dies in June 1994, leaving property under a will executed in February 1992. Pursuant to the will, $500,000 is to be placed in trust, from which decedent's surviving spouse will receive an annual distribution for life of $20,000. The surviving spouse is also provided with a testamentary general power of appointment over the property in trust. Pursuant to the transition rule, this bequest should qualify for the marital deduction. In determining the amount of the deduction, the applicable interest rate for valuing annuities on the date of decedent's death is used. Assuming the rate was 10%, the value of the specific portion received by the surviving spouse is $200,000 ($20,000/.10). Thus a marital deduction of $200,000 may be claimed, as this is the lesser of the interest of the specific portion for which payment is to be received and the $500,000 amount to which the testamentary general power of appointment exists.

Under the language of the final regulations, should the transfer not qualify for treatment under the transition rules, a marital deduction will be denied due to the recipient spouse not being considered to have received an interest in a specific portion of property.

Regarding IRC Sec. 2056(b)(5), the final regulations provide that where a surviving spouse has the right to receive the income from a specific portion of trust property, but has a power of appointment over a different specific portion, the marital deduction is limited to the lesser of the two specific portions.

Example: X dies leaving $200,000 in trust with income on $150,000 to surviving spouse. The surviving spouse is also provided with a testamentary power of appointment. A marital deduction of $150,000 may be taken with regard to this interest.

QTIP Election. An appropriate election is critical in obtaining a marital deduction as a QTIP. According to the final regulations, this election is to be made by the executor of the estate, if the executor is within the U.S., regardless of whether the executor has actual or constructive possession of the property. Should there be no qualified executor within the U.S., the election may be made by one who has actual or constructive possession of the property. Once made, the election is irrevocable. Where uncertainty exists over whether a particular asset or interest qualifies for the martial deduction as a QTIP, a protective election can be made.

Contingent Interests. The regulations indicate an income interest for life will not fail to constitute a qualifying income interest for life solely because the trustee has the power to distribute principal to or for the benefit of the surviving spouse. Neither will the fact a surviving spouse has the potential of transferring distributed property to another cause failure. An interest will be ineligible for the marital deduction as a QTIP if the recipient spouse is legally obligated to transfer distributed property to another person for less than full and adequate consideration in money or money's worth.

Executor Discretion. A requisite for an interest in property to qualify for the marital deduction as a QTIP is that the interest in property be viewed as having passed from the transferor (or decedent) to the recipient (surviving spouse). Controversy has surfaced in recent years over whether allowing the executor to have discretion over the amount with respect to which an election is made will prevent qualification for the marital deduction. In the IRS's eyes, such discretion operates to cause the transfer to a surviving spouse to be characterized as a result of the executor's actions, rather than those of the decedent. Therefore, the IRS has argued that a marital deduction should be denied where the interest received by the surviving spouse is dependent upon an election left to the executor's discretion.

In recent years, the IRS's position has been rejected by the Eighth and Fifth Circuits. According to these courts, the language of the section makes clear that QTIP is simply that property with regard to which the executor makes the election. Nevertheless the final regulations deny a marital deduction for an otherwise qualifying income interest for life if the income interest is contingent upon the executor making a QTIP election.

Example: Decedent's will provides for surviving spouse to receive income for life on whatever property the executor elects to treat as QTIP. The executor elects QTIP treatment on the entire estate. According to the regulations, the property will not qualify for the marital deduction because the surviving spouse's interest is contingent upon the executor's election.

Example: Decedent's will provides the executor shall elect the marital deduction for all property (as a QTIP), in excess of the amount necessary to fund the unified credit, to bring the estate tax to zero. The executor makes such election. The amount for which the election is made will qualify for the marital deduction. The executor is not considered to have sufficient discretion as his potential action is sufficiently limited.

Other Changes

While the changes previously mentioned have a significant impact on marital deduction qualification, other provisions of the final regulations worthy of note include the following:

* An annuity interest will not be treated as QTIP if any person other than the surviving spouse may receive a distribution of property or income from the annuity contract during the surviving spouse's lifetime.

* An interest will not be a qualified interest if terminable upon the occurrence of a specified event other than the surviving spouse's death.

* Property includable in a surviving spouse's estate under IRC Sec. 2044 is to be used in determining if installment payments under IRC Sec. 6166 may be made.

* In making a partial election, a trust may be divided into separate trusts if local law permits.

* An interest will not fail to be considered a qualifying interest solely because the income arising between the last distribution date and the date of death of the surviving spouse need not be distributed to the surviving spouse or the surviving spouse's estate.

* A right of recovery from heirs exists with respect to estate taxes attributable to property includable in a surviving spouse's estate under IRC Sec. 2044. A similar provision exists with regard to property transferred from one spouse to another as a gift.

In general, the gift tax rules concerning the marital deduction parallel the estate tax rules.

A transition rule extends previously established tax treatment to situations involving the following:

* Inter vivos transfers made on or before October 24, 1992, and

* Decedent's dying on or before October 24, 1992, or amounts passing to a surviving spouse from decedent dying after October 24, 1992 from wills or revocable trusts executed on or before October 24, 1992, where eitherÑ

A. the decedent's death occurred before October 24, 1992, or

B. on October 24, 1992, the decedent was under a mental disability preventing a change in the disposition and did not regain capacity before death.

The regulations make clear the transition rule will not extend to a will or revocable trust amended after October 24, 1992.

Work to Be Done

In light of these final regulations, wills should be reviewed to determine how they will be impacted. In some cases, utilization of transition rules will be beneficial, while in certain instances the amendment of a will should be undertaken. For most estates, the definition of separate portion, and the continued rejection of executor discretion in the case of QTIP qualification, will be the most significant and controversial aspects of the regulations. While case law holds promise for challenging these aspects of the regulations, it is likely planning objectives can be achieved without confrontation through careful use of language in wills. For example, the marital deduction may be preserved by carefully delineating the amount an executor should elect QTIP treatment for in different situations. *

Mark A. Segal, LLM, CPA, is professor of accounting at the University of South Alabama.

SEPTEMBER 1995 / THE CPA JOURNAL

Using A Bypass Trust

By Curtis C. Howell

Typical Bypass Trust

The typical bypass trust is created as a testamentary trust at the direction of the deceased spouse's will. This trust could be funded by a prescribed amount ($600,000) of assets from the deceased spouse's estate, or the will may contain a formula to be used to fund the trust. The remaining assets in the deceased's gross estate can then be passed, by will, to the surviving spouse. Under the terms of the trust, the surviving spouse would receive part or all of the income from the trust's assets for life, and upon the surviving spouse's death, the remainder would be paid to the next generation of heirs. In later paragraphs, ways to tailor the control granted over trust assets to the surviving spouse and ways to allow the surviving spouse the benefit of trust corpus will be discussed.

Division of Marital Assets

An important point is that the bypass trust must be funded out of the estate assets of the first spouse to die. Because no one can predict the future with complete accuracy, each spouse's estate must have enough assets from which to fund the bypass trust. In a situation where one spouse holds sole title to the bulk of the marital assets (a more common problem in common law states than in community property states), the holder must transfer to the other spouse sufficient assets to fund the bypass trust. This asset transfer should pose no problem from a gift tax perspective because of the unlimited lifetime gift exemption for transfers between husband and wife. Also, sufficient assets, especially real estate, held as tenants in common will automatically cause a favorable asset division, because for married couples only half of the value of property held as tenants in common is included in the estate of the first to die. Property held as joint tenants will not work, as the interest of the deceased spouse passes directly to the survivor.

Adapting a Bypass Trust to a Taxpayer's Needs

Bypass trusts should be tailored to fit the needs of the parties involved. In the simplest bypass trust arrangement, the deceased spouse's will establishes a trust funded with a prescribed amount of estate assets and names a trustee other than the surviving spouse to administer the trust. If, under the terms of the trust, the surviving spouse is given no special or general powers of appointment except the right to receive trust income for life with the remainder to be paid to the couple's heirs, none of the trust's assets can be drawn into the surviving spouse's estate.

Special Power of Appointment

Certain advantages exist to having someone other than the surviving spouse act as a trustee with special powers to appoint trust property. A special power of appointment allows the holder to affect only the beneficial interest of other parties to the trust. A nonspouse trustee could be directed by the trust agreement to appoint additional funds to the surviving spouse whenever the trustee, in his or her sole discretion, deems it appropriate for happiness or comfortÑwithout causing any remaining trust assets to be included in the surviving spouse's estate.

In another situation where the surviving spouse may have little need to invade the corpus of the trust, the surviving spouse could be named trustee with certain special powers to appoint the trust remainder and the ability to manage trust assets in a legitimate fiduciary capacity. Care must be taken to ensure that the power of appointment is a special, and not a general, power of appointment. The special powers a surviving spouse trustee can possess include the power to affect the timing and relative proportion, but not the ultimate total amount, of the remainder or that part of income to be received by the other beneficiaries of the trust. Also, a surviving spouse trustee can hold the power to manage trust assets in a legitimate fiduciary capacity because the power to manage trust assets is not considered either a special or general power of appointment.

General Power of Appointment

A general power of appointment allows the holder of the power to direct trust assets for the holder's own benefit, the benefit of the holder's creditors, or the benefit of the holder's estate. There are three limited exceptions that allow a surviving spouse trustee to possess a general power of appointment and invade the corpus without having the trust assets drawn into the surviving spouse's estate.

Limited by an Ascertainable Standard. A surviving spouse trustee can possess a general power of appointment if that power is limited by an ascertainable standard. An ascertainable standard describes terms written into the trust agreement that limit the holder's general power to provide for certain needs that can be reasonably measured such as health, education, or support. A general power limited by a standard such as comfort, welfare, or happiness, however, is not considered an ascertainable standard and would subject the holder to inclusion of the trust asset into the holder's estate.

Jointly with Another Party. A surviving spouse trustee can also hold a general power of appointment if the trust agreement provides for that power to be held jointly with another party who has a substantial adverse interest in the power being exercised. A party with adverse interest is a beneficiary who would be negatively affected by the exercise of the general power of appointment by the surviving spouse trustee. In other words, any beneficiary who would be affected by the surviving spouse trustee's exercise of a general power would have to approve of the power's exercise before the surviving spouse trustee could appoint the property.

Five-by-Five Power. The third situation where a limited general power of appointment can be used by the surviving spouse to have limited access to corpus is found in IRC Sec. 2042(b)(2) and is known as the five-by-five power. The trust agreement may provide that the surviving spouse be given all the trust income along with the right to withdraw from the trust, on an annual noncumulative basis, the greater of $5,000 or five percent of the value of the property constituting the trust, to be valued for these purposes, as of the last calendar day of the year.

The five-by-five language is very important and must be correctly used to avoid gift tax consequence from a lapse of the five-by-five power. IRC Sec. 2041(b)(2) treats the lapse of a general power of appointment as if the lapse were an exercise of the power by the power holder with the holder then giving the property to the other beneficiaries. However, the five-by-five power allows a surviving spouse who lets the power lapse in some years to not be treated as making a taxable gift to the other beneficiaries of the trust. Of course, any possible gift tax due because of a lapsed power would be tempered somewhat by the present $10,000 per donee annual gift exemption.

Disclaimer

The final alternative to increase trust flexibility involves the use of a disclaimer. If allowable under local law, the IRC will allow a gift or bequest to be disclaimed, which treats the property as though it had never been transferred to the person making the disclaimer. IRC Sec. 2518 places several requirements on a disclaimer for it to be recognized for gift and estate tax purposes. The disclaimer must be in writing, unconditional, and irrevocable, and presented to the transferor within nine months of the asset transfer. Also, the person disclaiming the property cannot accept any benefit from the disclaimed property, and the disclaimed property must pass to another party without any direction by the person making the disclaimer.

To make use of the disclaimer, the deceased spouse's will would establish a bypass trust funded with only a modest bequest and the remainder of the estate being bequest to the surviving spouse. The will would direct any property disclaimed by the surviving spouse to be used to fund the bypass trust. This gives the surviving spouse up to nine months to decide on the optimum division of estate assets and to assess family circumstances.

Some care must be taken in the design of a bypass trust that allows for disclaimed property to be added to the bypass trust. The surviving spouse may not have any special or general power not limited by an ascertainable standard or a five-by-five power. If the surviving spouse should hold such prohibited power, the surviving spouse will be considered by Reg. Sec. 25.2518-2(e) to have directed the disposition of the disclaimed property and thus nullify the disclaimer. This will cause any disclaimed property to be included in the surviving spouse's estate. *

Curtis Howell, CMA, CPA, is a doctoral student at Northern Illinois University and an adjunct accounting instructor at Rock Valley College, Rockford, IL.

SEPTEMBER 1995 / THE CPA JOURNAL