ESTATES AND TRUSTS

THE RULE OF CONSISTENCY

By Max Wasser, CPA, Wasser, Brettler, Klar & Lipstein, LLP

In a recent Tax Court case, the IRS prevailed by basing its position on "consistency." The facts of the case, Estate of Letts, 109 TC No. 15 (11/24/97), are as follows:

James Letts, Jr., died in 1985, leaving a will with the standard two-trust arrangement. Trust I was the nonmarital trust equal to the unified credit. Trust II was the marital trust with all the income payable to his wife, Mildred, at least quarter annually for the rest of her life and the remainder to two children. The will authorized the executors to elect to treat Trust II as "qualified terminal interest property" (QTIP) for which an estate tax marital deduction is allowed even though the spouse's interest is terminable.

Whether by mistake or design, the preparer of Estate Tax Form 706 for the estate, checked "no" in the box on page 2, which asked whether the estate was electing a marital deduction for QTIP property. In addition, Schedule M did not list any property as QTIP. It did, however, claim a marital deduction for the Trust II property.

As is fairly common, where no tax is shown as being due, the IRS did not examine the return.

Mildred, the surviving spouse died a year after the statute of limitations had expired on her husband's return. At the time of her death, Trust II had not as yet been funded.

In filing Form 706 for Mildred's estate, it was noted that a QTIP election was not made for Trust II on her husband's return and accordingly the value of Trust II was not included. In examining Mildred's return, the IRS contended that the value of Trust II was includable, notwithstanding the fact that IRC section 2044 requires the inclusion of QTIP property in the estate of the surviving spouse only where an election had been made in the return of the spouse who had previously died. It based its contention on a taxpayer's "duty of consistency." The roots of the taxpayer's "duty of consistency" are found in a Supreme Court case, R.H. Stearns vs. U.S., 291US 54 (1934) in which the court applied the duty, based on the principle that no one may base a claim on an inequity of his or her own making. In effect, the court is saying that it is no more right to allow a party to blow hot and cold as suits his interest in tax matters than in other relationships.

The elements of the "duty of consistency" are as follows:

1.The taxpayer (or a related taxpayer) made a representation of fact or reported an item for tax purposes in one tax year.

2.The commissioner acquiesced or relied on the fact for that year.

3.The taxpayer desires to change the representation previously made in a later tax year after the earlier year has been closed by the Statute of Limitations.

The Tax Court concluded that all three of the above mentioned elements were met, for the following reasons:

Element #1--By taking a marital deduction on the estate tax return for the husband, where an election was made not to elect QTIP treatment for Trust II (the marital trust), the estate was in effect saying that the property in Trust II was not terminable interest property.

Element #2--The commissioner is deemed to have acquiesced or relied on a fact if a taxpayer files a return that contains an inadequately disclosed item of which the commissioner was not otherwise aware, and the commissioner accepts that return and the time to assess tax expires without an audit of that return [Herrington v. Commissioner, 854 F2nd 755 (CA5)]. No facts were provided to the commissioner that would show that Trust II (marital trust) was terminable interest property. A copy of the will was not included. The commissioner may rely on a presumption of correctness of a return that is given under penalty of perjury and where the time to assess tax has expired.

Element #3--The estate tax return for the wife represented that the Trust II (marital trust) reported on her husband's return was terminable interest property. That representation is inconsistent with the representation made on her husband's return.

The estate of the wife also advanced the argument that the duty of consistency does not apply between its estate and the estate of the husband, as they are two different entities. The court held that there was sufficient identity of interest between the two estates to trigger the duty of consistency. The parties were married and their estates were, in effect, a single economic unit. The husband left his estate to his wife and children and the wife left her estate to the children.

There are a number of similar cases where the estate of the first spouse to die claimed QTIP treatment and the estate of the surviving spouse sought to avoid inclusion of the QTIP property on the grounds that QTIP treatment should not have been allowed to the first estate for technical reasons after it was too late for the IRS to go after the first estate because of the statute of limitations. The IRS prevailed in all such cases based on the duty of consistency.

REAPPLYING THE ESTATE OF LUCILLE P. SHELFER V. COMMISSIONER

By Lawrence M. Lipoff, CEBS, CPA, Rogoff & Company, P.C.

A common choice as a designated beneficiary of a pension is a QTIP trust. The QTIP must meet the proposed regulations section 1.401(a) (9)-l, Q&A D-5 requirements for a "qualified trust," i.e., 1) the trust must be valid under state law or it would have been valid under state law if it had been funded, 2) must be irrevocable at the earliest of the participant's required beginning date [usually April 1 of the calendar year following the calendar year that the participant attains 70wQ years of age] or the date of death of the participant, 3) must be identifiable from the trust instrument, and 4) a copy of the trust agreement must be provided to the administrator of the plan.

A person with a "shaky marriage," or a person with children from a previous marriage, can consider naming a qualified terminal interest property (QTIP) trust as his or her pension account's designated beneficiary. First, the participant's spouse's age would be used in calculating the section 401(a)(9) minimum required distributions from the retirement plan. Secondly, regarding the QTIP, income earned by the QTIP must be payable for the current spouse's lifetime and the remainder would be payable to whomever the participant determines via beneficiary designation. Besides achieving income tax deferral by allowing distributions over the participant's and spouse's lifetimes, estate taxes could be deferred by obtaining an estate tax marital deduction for the participant's estate.

Proposed regulations section 1.401(a) (9)-1, Q&A D-5 establishes a "qualified trust" that can be a designated beneficiary if it meets certain requirements by the later of the date it is named as a beneficiary or the date that minimum required distributions under section 401(a)(9) are to begin. Also, for plans subject to joint and survivor annuities, Regulations section 1.401(a)-20 provides requirements for a valid waiver.

Assuming that a QTIP is chosen as a designated beneficiary, consideration must be given as to whether the "greater than" or the "double distribution" option for the QTIP will be used. The double distribution method reduces the income tax deferral possibilities when the trust accounting income exceeds the section 401(a)(9) minimum distribution requirement. This will happen until the ratio of one divided by the lesser of 1) the applicable life expectancy or 2) the applicable divisor under proposed regulation 1.401(a)(9)-1, Q&A F-4A fails to exceed the rate of return the IRA's investments will earn.

The "greater than" method of distribution from a QTIP provides that the amount to be distributed would be the greater of 1) the section 401(a)(9) minimum required distribution or 2) the net accounting income of the trust for the year. When the applicable life expectancy or applicable divisor becomes smaller and causes the minimum required distributions to exceed the return on plan investments, then the section 401(a)(9) amount is solely used.

The "double distribution" method, approved in Revenue Ruling 89-89 requires that 1) equal annual installments of the account balance over the spouse's life expectancy plus 2) the annual income earned on the undistributed portion of the account balance to be paid to a testamentary QTIP trust.

Many commentators have pondered whether the net accounting income requirement must be distributed or must be available to the participant's surviving spouse. This issue would be of particular interest if the spouse had more than adequate income available from his or her other assets. The Eleventh Circuit's decision (regarding a totally separate matter) in Estate of Lucille P. Shelfer v.
Commissioner, No. 94-5211 (11th Cir. July 1, 1996) may lend some authority for the concept of only requiring the accounting income, to the extent it exceeds the section 401(a)(9) minimum required distribution, be available to the spouse.

The facts of the case were that the taxpayer's husband's estate elected QTIP treatment on certain property. Under normal rules, the taxpayer's estate would report the trust as an asset in her estate. However, since the taxpayer did not have a power of appointment over the QTIP accounting income between the time of the last distribution and her death, the executor did not include the property in her estate, i.e., opining that the "stub income" not paid disqualified the QTIP.

The Eleventh Circuit agreed with the IRS (reversing the Tax Court) by citing section 2056(b)(7)(B)(ii)(I) that a "surviving spouse has a qualifying income interest for life if the surviving spouse is entitled to all the income from the property, payable annually or at more frequent intervals, or has a usufruct interest for life in the property ..." The court went on to say that the language does not clearly state that Congress required receipt of income.

Based upon the above, it appears plausible that since the basis for the accounting income portion of the "greater than" distribution formula for a QTIP as a pension designated beneficiary is this same IRC section, if accounting income is available to the spouse but in their sole discretion declined to receive the income, then the standard may be met.

If this analysis is correct, then an issue to deal with would be the compressed marginal tax rates for fiduciary income tax returns. To the extent that income exceeds $7,650, the Federal tax rate is 39.6%. Furthermore, since a QTIP, other than in its final year when proceeds are distributed to the trust's remaindermen, is a simple trust (beware the Eleventh Circuit's opinion to now classify as a complex trust), accounting income will be treated as distributed to the surviving spouse. Except for unusual situations which are beyond the scope of this article, the trust will only pay tax on capital gains at a maximum Federal rate of 28%. The question would be, "Have we accomplished anything?"

However, some practitioners have established IRAs for their clients with the IRS's approved form (Form 5305) and added a paragraph (Article VIII) making the IRA into a QTIP trust. In such a scenario, if the accounting income is not drawn paid to the surviving spouse, then the amount of accounting income that exceeds the section 401(a)(9) minimum distribution could continue to grow as a tax-deferred vehicle.

Application of a QTIP-IRA must be proceeded with a clear warning that section 401(a)(9) minimum distribution rules will still apply. Failure to make a distribution that meets these rules would be subject to a 50% excise tax under section 4974(a).

A QTIP-IRA could be established two ways. The first would be for a situation where the participant would be passed the required beginning date at time of death and would have elected the term-certain method. In such a case, the surviving spouse would receive the amount of the section 401(a)(9) minimum distribution and would have a right to be distributed accounting income to the extent that it exceeded the section 401(a)(9) amount. Accounting income (and earnings on the accounting income) not distributed would continue to be available to the surviving spouse in future years. Practical considerations would suggest that the QTIP-IRA have a separate investment account to track this amount. Furthermore, section 401(a)(9) minimum distribution calculations must include the accumulated accounting income not distributed.

A second scenario suggested is that a prenuptial agreement specify that when the participant dies, a distribution be made to the surviving spouse who is contractually bound to make a nontaxable rollover of the distribution into a QTIP-IRA. The consideration for compliance with such an agreement is the couple's marriage. Since death of a participant is a "triggering event" under section 402(d)(4)(A)(i), and under section 402(c)(9) a spouse of a decedent plan participant is allowed to make a rollover to an IRA as if a participant, there should not be any income tax recognition. Thereafter, the new QTIP-IRA will be subject to section 401(a)(9) as the spouse's IRA. The original participant's heirs, or a trust for them, could be the section 401(a)(9) designated beneficiary.

For this scenario to work, it is important that qualified joint and survivor annuity rules be considered. While a prenuptial agreement for an ERISA retirement plan will not be binding, clearly a prenuptial agreement will be effective if the original participant had an IRA. Additionally, consideration can be given where the participant has a profit-sharing or section 401(k) plan, for the original participant while alive to roll over the account balance to an IRA without spousal waiver requirements.

In summary, while the Eleventh Circuit's opinion in Estate of Lucille P. Shelfer v. Commissioner went against the taxpayer, support for theorized, interesting planning concepts regarding a completely different issue (pension distribution planning) may have arisen.

Editors:
Laurence I. Foster, CPA
KPMG Peat Marwick LLP

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

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

Frank G. Colella, LLM, CPA
Own Account

Jerome Landau, JD, CPA

Nathan H. Szerlip, CPA
Edward Isaacs &
Company CPAs LLP

Lenore J. Jones, CPA
Jacobs Evall & Blumenfeld LLP

James B. McEvoy, CPA
Chase Manhattan Bank