ESTATE TAX MARITAL DEDUCTION AND THE CONTINGENT QTIP ELECTION

By Jerome Landau

There has been a conflict over the past five years between various circuits of the U.S. Court of Appeals and the Tax Court of the U.S. with regard to the deductibility as a marital deduction for Federal estate tax purposes of amounts passing to a surviving spouse pursuant to a contingent QTIP (Qualified Terminable Interest Property) election. The QTIP election is usually made in carrying out the decedent's wishes as provided for in the taxpayer's last will and testament, and is provided for in IRC section 2056(b)(7).

The contingent QTIP election can be effected under a provision in the decedent's will that gives his or her executor the option to elect to qualify a testamentary trust, or a portion thereof, for the benefit of the surviving spouse as a marital deduction on the estate tax return, or to forego such deduction. The conflict among the courts has received wide coverage, recently in the Estates and Trusts column of The CPA Journal (November 1995). That article discussed various cases decided up to that publication date.

Since the November 1995 article, there have been additional court decisions and other developments that impact on the subject.

The Marital Deduction

Under IRC section 2056(a), a marital deduction is available for estate tax purposes in an unlimited amount equal to the value of any interest in property which passes by will, or by operation of law, or by other means at death, from the decedent to the surviving spouse, but only to the extent such interest is included in determining the value of the gross estate. IRC section 2056(b) provides that a marital deduction is not available where the interest passing to the surviving spouse is a terminable interest. A terminable interest is defined in IRC section 2056(b)(1) as an interest that terminates or fails "on the lapse of time, on the occurrence of an event or contingency, or upon the failure of an event or contingency to occur." Thus, a testamentary trust (except for a QTIP Trust) with life income to the surviving spouse and the remainder to others will not qualify. However, a trust with life income to the surviving spouse, with the surviving spouse having a general power to appoint the remainder to others, or to him or herself, or to his (her) estate will qualify for the marital deduction. Accordingly, if a taxpayer leaves a sufficient amount of qualifying marital bequest assets to a surviving spouse, there will be no Federal estate tax in the estate of the first to die. It should be noted, however, effective for estates of decedents dying after November 10, 1988, property passing to a surviving spouse who is not a U.S. citizen is not eligible for the estate tax marital deduction unless the property passes through a qualified domestic trust (QDT).

The Marital Deduction and the
QTIP Trust

IRC section 2056(b)(7) provides an important exception to the terminable interest rule whereby an interest for a surviving spouse which is otherwise a terminable interest will qualify for the marital deduction if--

1. it is property which passes from the decedent,

2. in which the surviving spouse is entitled to all of the income for life from the property (trust) payable annually or at more frequent intervals,

3. no person, other than the surviving spouse has a power to appoint any part of the property during the surviving spouse's lifetime to any person or persons other than the surviving spouse,

4. the term "property" includes an interest in property, including a specific portion of any property, and

5. an election to be treated as a QTIP trust, for the property, or any portion thereof, is made on the decedent's estate tax return (Form 706).

Recent versions of Form 706 provide for a QTIP election by completing the information required on Schedule M (Bequests to Surviving Spouse) and providing a description and value of the property to be covered by the QTIP
election.

It should be noted effective September 1, 1992, the New York Estates, Powers and Trusts Law Sec.5-1.1A was changed to provide that the value of a "terminable interest" would not be counted as passing to the surviving spouse in determining his, or her elective share. Thus, the principal of a QTIP trust may have to be invaded if the surviving spouse elects against the will of the decedent and if some portion of the principal of the trust is needed to satisfy the spouse's "elective share." There are some attorneys that believe that if a spouses' right of election causes an invasion of a terminable interest trust, such election may cause an acceleration of the trust, which may not be desirable. Attorneys drafting wills should consider the effects of these provisions on any trust which is considered a terminable interest trust.

The "Contingent QTIP Election"

As noted above, the contingent QTIP election occurs where the decedent's will gives the executor, in his or her sole discretion, the right to designate which part, or all, of a testamentary trust will qualify for the marital deduction and to make the necessary election on the Federal estate tax return. A typical "contingent QTIP" election may provide that to the extent the executor does not make the necessary election, the property for which the election is not made will pass under the will to a nonmarital trust, such as a unified credit trust, a family trust, or a nonmarital residue. The purpose in giving the executor the discretion as to what portion is to qualify for QTIP treatment is to give the executor the ability to decide how much of a marital deduction the estate wants or needs. Some estate plans call for a zero tax in the estate of the first spouse to die. In some situations, the surviving spouse has considerably more assets, and so it is desirable to balance the tax due with the first to die, as against the tax to be due on the second death, particularly because the value of the property for which a QTIP election is made, is added to the taxable estate of the second to die (IRC section 2044), possibly at increased fair market values as of the date of the second death.

In that event, the estate tax in this second estate attributable to the value of the QTIP trust from the first estate is recoverable from the QTIP trust (IRC section 2207A), unless the will of the second spouse to die provides otherwise. If the value of the QTIP trust is large enough, and if grandchildren or other skip generations are beneficiaries or potential beneficiaries of such trust in large enough amounts, then planning for a potential "generation skipping tax" may be required.

IRS Position on Contingent
QTIP Elections

In recent years, the IRS has taken the position that property covered by such a discretionary contingent QTIP election is equivalent to a power of appointment given to the executor, or trustee, so as to permit the executor to appoint the property to someone other than the surviving spouse, thereby in the IRS's view not constituting as qualifying income for life.

The Tax Court

In three decisions in the last five years, the U.S. Tax Court has agreed with the IRS, basically on the same reasoning:

Estate of Clayton vs. Commissioner,

97 TC 327 (1990)

Estate of Robertson vs. Commissioner,

98 TC 678 (1992)

Estate of Spencer vs. Commissioner,

TC MEMO 1992-579

In the above cases, the Tax Court essentially held that the discretionary power given to the executor to elect QTIP treatment, even if the executor did in fact make the election, prevented the surviving spouse from receiving a qualifying interest for life. Accordingly, in the view of the Tax Court, this form of the right to elect did not satisfy the statutory requirements of IRC section 2056(b)(7), and was not allowed as a marital deduction. All three above cases were appealed to different courts of appeals by the taxpayers, and in all three cases, the courts of appeals reversed the decisions, holding for the taxpayer that there was no language in the statute, as passed by Congress, that would deny the marital deduction in these cases. These courts of appeal cases are cited as follows:

Estate of Clayton vs. Commissioner,

976 F.2nd 1486 (5th Cir. 1992) (92-2

USTC 60,121)

Estate of Robertson vs. Commissioner,

15 F.3rd 779, (8th Cir. 1994) (94-1

USTC 60, 153)

Estate of Spencer vs. Commissioner,

43 F.3rd 226, (6th Cir. 1995) 95-1 USTC

60, 188

IRS New Regulation

Prior to March 1, 1994, IRS regulations did not specifically cover the issue of a contingent QTIP election. However, effective March 1, 1994, and prior to the 1995 decision in the Spencer case (noted above), the IRS amended its regulations at regulations section 20.2056(b)-7(d)(3) to provide as follows:

"(3) Contingent Income Interests...in addition, an income interest (or Life Estate) that is contingent upon the Executor's election under Section 2056(b)(7)(B)(v) is not a qualifying income interest for life, regardless of whether the election is actually made."

This regulation, if it is valid, apparently starkly states the Commissioner's point of view regarding contingent QTIP elections. Also, to be noted is that the Spencer case was decided after the above regulation was promulgated. However, the Spencer case, the Clayton case, and the Robertson case all dealt with pre-March 1, 1994 estates.

The Courts of Appeals Cases

All three courts of appeals cases dealt with typical contingent QTIP election issues in which the executor had the discretion to elect QTIP treatment. The 6th Circuit Court of Appeals in the Spencer case rejected the Tax Court's power of appointment argument, in effect saying that since the QTIP election is to be made at the time of filing of Form 706, which can be nine months (or more under an extension of time to file) after the date of death, the time for determining if the property satisfies the section 2056(b)(7) provisions is at the time of the election. Therefore there can be no power of appointment issue from the date of death until the QTIP election is made on Form 706. The courts of appeals in Clayton (CA-5) and Robertson (CA-8) both took the point of view that though the QTIP election is made on the Federal estate tax return filed after the date of death, the election is, in effect, retroactively made as at the date of death. Hence, there is no power of appointment in the executor at the time of death. These three cases therefore allowed the marital deduction in full for the QTIP trust. It has appeared since then that the IRS has been looking for a suitable case to be appealed to another circuit with the possibility of a decision in its favor, with such a potential conflict to be reviewed by the U.S. Supreme Court. Also, more recently a district court in the 7th Circuit in the case of P. Mathis, D.C. Ind. (96-1 USTC 60,224), in allowing a marital deduction for the contingent QTIP trust held that the 7th Circuit would probably look to the decisions in Clayton, Robertson, and Spencer for guidance on a case appealed to its court. Subsequent to the above cases, the Tax Court has recently reversed its above stated position in the case of the Estate of Clack, 106 TC No.6 (2/29/96).

Estate of Willis Edward Clack in the Tax Court

In the Estate of Willis Edward Clack, deceased July 1, 1987, 106 TC No.6, decided on February 26, 1996, the Tax Court finally reversed itself on the issue of the deductibility of a contingent QTIP Trust as a marital deduction in a very long case and opinion of approximately 40 pages which was reviewed by the full court, with 10 judges joining the majority opinion, three concurring opinions and several judges in dissent. The majority of the Tax Court, in effect, held that it was time to change its mind on the issue of the contingent QTIP election in view of the weight of authority prevailing in the three circuit court cases referred to above, and allowed the marital deduction claimed. The will in the Clack case gave to the trustee the "minimum pecuniary amount which would qualify for the Federal estate tax marital deduction and which would result in the smallest Federal estate tax" and gave the trustee the discretion to elect any part or all of this trust to qualify as qualified terminable interest property. Any part not so elected was to be distributed pursuant to the terms of a family trust (nonmarital trust). In holding for the taxpayer, the Tax Court said it was unnecessary to reconcile the divergent view of the 6th Circuit, as opposed to the 5th and the 8th Circuit.

The Tax Court majority in the Clack case made reference to the new IRS Regulation Section 20.2056(b)-7(d)(3) saying, "because the regulation is effective for estates of decedents dying after March 1, 1994.... it is not applicable to the instant case. Consequently, we leave for another day the issue of the validity of the regulation. Obviously, if the regulation were held to be valid there might be a different result for estates of decedents dying after March 1, 1994." Does this statement give any clue to the court's opinion as to the validity of the regulation? Also of interest is the dissenting opinion in which the dissenting judges chide the majority for "not sticking to their guns" on the issue, but agree that for cases in the 5th, 6th, and 8th circuits the Tax Court would have to go along with the court of appeals decisions under the "Golsen Rule." However, since an appeal in the Clack case would probably go the 7th Circuit, the dissenting judges do not feel bound by the Clayton, Robertson, and Spencer decisions. In Golsen vs. Commissioner (54 TC 742) the Tax Court established a procedural rule whereby the Tax Court will follow a U.S. court of appeals decision that is squarely in point with the case it is presently considering, where the only appeal from its decision is to that Circuit's Court of Appeals. For example, a Tax Court case being tried in New York will follow a decision of the Second Circuit (CA 2) Court of Appeals on the particular issue.

IRS Acquiescence in the
Clack Decision

On July 15, 1996, the IRS, through its chief counsel, issued an Action on Decision (AOD CC-1996-011) in which it acquiesced "in result only" in the Clack decision. The AOD, in its concluding paragraphs, referring to the Tax Court opinion in the Clack case and in the three above cited appellate decisions says as follows:

The Tax Court, in this reviewed opinion, determined that it will "accede to the result" in those appellate decisions and under facts similar to those in Estate of Clack, it will no longer disallow the marital deduction for interests that are contingent upon the executor's election under section 2056(b)(7)(v), where the election is actually made.

Defense of the service's position following rejection by the courts of appeals in three different circuits and by the Tax Court in Estate of Clack would be problematic and would also raise problems in the consistent administration of the QTIP provisions. Accordingly, in cases involving estates of decedents dying prior to the effective date of Treas. Reg. §20.2056(b)-7(d)(3), we will no longer take the position that an income interest for life that is solely contingent upon the executor's election is not a qualifying income interest for life, so long as the election is properly made.

Recommendation: Acquiescence in
result only.

The above language is very clear. It seems to be saying that in cases of decedents dying before March 1, 1994, where the facts are similar to those in Clack, if not "on all fours," the marital deduction will be allowed. However, in situations not similar to Clack, it still may take issue with the contingent QTIP election in pre-March 2, 1994 date of death cases, and certainly will disallow the marital deduction at the IRS level in post-March 1, 1994 cases. It will therefore put the burden on estates in such cases to contest the issue through appellate forums in order to test the validity of the 20.2056(b)-7(d)(3) regulation.

Suggestions

It therefore behooves advisors in pre-March 2, 1994 estates to review those wills with a view to determining what the result might be to an IRS inquiry or challenge, and plan accordingly. With regard to post-March 1, 1994 estates, advisors can expect, and be ready for, a challenge at the IRS level if the estate tax return is selected for audit. Most probably, more returns may be selected for audit if there is a QTIP election. With regard to estates not yet in being, advisors should consider tightening up the QTIP election so that the executor does not have complete discretion in making the election. If the language can be more in the form of a direction to the executor to "elect" QTIP in order to conform to certain estate and/or tax results that the testator is looking to accomplish, this may go a long way in overcoming IRS objections. For example, a testator might provide that his executor should make a QTIP election in such a manner as to result in a zero Federal estate tax, after giving effect to bequests covered by the unified credit, and a valid QTIP election, or the testator may direct the executor to elect in such a way as to balance the tax in the first estate with the estimated potential taxable estate at a later time of the surviving spouse. Other choices
may be apparent to other attorneys
and planners.

The QTIP election is an important estate planning tool and should be considered by all attorneys drafting wills for married couples, and for CPAs involved in the estate planning process. The drafting of the clauses concerning the QTIP election should be carefully done, considering the position of the IRS on this issue as described in this article and the decisions of the various court cases. The making of the election on the Form 706 is technical, and the rules for making the election should be followed in the prescribed manner lest the marital deduction be challenged or even disallowed. In an informal discussion, with an attorney in the Office of the Chief Counsel of the IRS, indication was given that the IRS may attempt to clarify this issue in the near future with a pronouncement explaining its position going forward. *

Jerome Landau, JD, CPA, practices in the estate planning area.

Editors:
Marco Svagna, CPA
Lopez Edwards Frank & Company LLP

Lawrence Foster, CPA
KPMG Peat Marwick LLP

Contributing Editors:
Richard H. Sonet, CPA
Marks Shron & Company LLP

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

Frank G. Colella, LLM, CPA
Own Account

Jerome Landau, JD, CPA

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

James B. McEvoy, CPA
Chase Manhattan Bank