The overarching policy of the estate tax regime in the United States can largely be summed up as follows: Assets should be taxed once at each generation. In developing the sections of the Internal Revenue Code that govern the estate tax, Congress has also made clear that spouses are considered to be in the same generation, regardless of age. This is grounded in another tenet of U.S. tax policy that treats spouses as one economic unit.
Since 1981, the Internal Revenue Code has permitted unlimited, tax-free transfers between spouses. That same year, Congress also enacted an exception to the terminable interest rule, permitting a decedent to leave assets in trust for the surviving spouse, without requiring the decedent to give the surviving spouse a right to dispose of the property during the survivor’s life or at the survivor’s death. This type of trust, a qualified terminable interest property (QTIP) trust, permits the surviving spouse to receive all income from the QTIP trust for the survivor’s life and delays the payment of tax until the death of the surviving spouse. By using a QTIP trust, the donor-spouse may choose to whom the assets pass after the death of the survivor spouse. Further, the donor-spouse’s estate may receive a deduction for the assets transferred to a QTIP trust if the appropriate election is made.
But, inevitably, things happen between the death of one spouse and that of the survivor. The needs of the surviving spouse may wane, and those of the descendants or other beneficiaries may grow. It may also become necessary to react to changes in the IRC or to the growth (or depletion) of trust assets. While the terms of the QTIP might be black and white, it doesn’t follow that trustees and beneficiaries are bound to their eventual, potentially unintended, results without recourse.
Division and Modification of a QTIP Trust
Private Letter Ruling 202116001 (released April 23, 2021) involved a QTIP trust established by a decedent spouse. As required by the IRC, all income was to be paid to the surviving spouse for the survivor’s lifetime. The residual beneficiaries were the decedent’s two daughters, who would only become income beneficiaries after the death of the surviving spouse.
It was represented that the terms of the QTIP trust didn’t restrict the trustee from dividing the trust. The applicable state statutes authorized a trustee to divide a trust into two or more trusts, provided that such division didn’t impair the rights of any beneficiary or adversely affect the accomplishment of the purposes of the trust. Additionally, such statutes authorize courts within the state to order the termination or modification of a trust, in whole or in part, if the continuance of the trust unchanged would defeat or substantially impair the purposes of the trust.
During the life of the surviving spouse, the trustee of the QTIP trust divided the trust into two separate trusts, named “Qualified Trust-A” and “Continuing Qualified Trust.” Both new trusts contained the exact same terms as the original QTIP trust. Following the division, the trustee and beneficiaries petitioned a court to enter an order modifying the terms of Qualified Trust-A.
The order issued by the court modified the Qualified Trust-A by permitting termination of all or any portion of the trust in favor of the principal beneficiaries, including—critically—before the death of the surviving spouse. Additionally, the surviving spouse was removed as an income beneficiary of Qualified Trust-A, and the two daughters became income beneficiaries in proportion to their interests in the principal. The modification explicitly treated the surviving spouse as having died on the date the order was entered. The order also was effective on “Date 3,” but was expressly conditioned on a subsequent receipt of a favorable ruling by the Internal Revenue Service prior to “Date 4.”
Where’s The Tax?
In evaluating the facts, the IRS first confirmed that the division of the QTIP into two separate trusts didn’t subject the transaction to the gift tax regime. The simple division of the QTIP trust into two separate trusts with terms mirroring the original trust didn’t change the beneficial interests of the surviving spouse or the daughters.
Unlike the simple division of the QTIP trust, however, the IRS determined that the modification of Qualified Trust-A by court order did change the beneficial interests of the surviving spouse and the two daughters, thereby triggering gift tax consequences.
The Gift Needn’t Be Directly Made
IRC Section 2511 provides that the provisions imposing a gift tax apply “whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. . . .” Additionally, IRC Section 2519(a) provides that “any disposition of all or part of a qualifying income interest for life in any property . . . shall be treated as a transfer of all interests in such property other than the qualifying income interest.” According to Section 2519(b), this includes, specifically, QTIP property for which the donor’s estate received a deduction.
The surviving spouse also needn’t directly grant the gift to be subject to gift tax. Treasury Regulations Section 25.2511-1(c)(1) provides that the gift tax applies to gifts indirectly made. Thus, any transaction in which an interest in property is gratuitously passed or conferred on another, regardless of the means or device employed, constitutes a gift subject to tax. Therefore, the court’s modification order disposing of the income interest is sufficient to subject the transaction to gift tax.
Valuing the Resulting Gift
Treasury Regs Section 25.2519-1(c)(1) provides that for gift tax purposes, the amount treated as transferred under Section 2519 on a disposition of all or part of a qualifying income interest for life in QTIP property is equal to the fair market value of the entire property subject to the qualifying income interest, determined on the date of disposition (including any accumulated income and not reduced by any amount excluded from total gifts under IRC Section 2503(b) with respect to the transfer creating the interest), less the value of the qualifying income interest in the property on the date of the disposition. The gift tax consequences of the disposition of the qualifying income interest are determined separately under Treas. Regs. Section 25.2511-2.
Accordingly, the IRS ruled:
- The surviving spouse is deemed to have made a transfer of all the property in Qualified Trust-A under Section 2519, other than the value of her qualifying income interest; and
- The surviving spouse is deemed to have made a transfer of her qualifying income interest in Qualified Trust-A under Section 2511.
Both taxable gifts were deemed to have been made as “Date 3,” or the date the court entered its order approving the modifications to Qualified Trust-A.
While the reason for the division of the QTIP trust and modification of the terms of Qualified Trust-A isn’t expressed in the present case, one could imagine how a transaction such as this might be useful to families in their estate planning:
- Use available exemption before it’s lost. A lot of recent talk in the estate tax world has surrounded the eventual, perhaps inevitable, lowering of the estate tax exemption. The Tax Cuts and Jobs Act of 2017 doubled the available exemption, but such doubling is set to sunset at the end of 2025. We may even see a lowering sooner than expected, with the White House and both houses of Congress currently controlled by Democrats. If a surviving spouse is determined to use exemption before it disappears, such spouse may opt to gift all or a portion of assets held in a QTIP trust to quickly use up exemption.
- Tax-exclusive vs. tax-inclusive asset transfers. Gift tax is thought of as the lesser of two evils because it allows a donor to transfer wealth and further reduce the taxable estate by the current payment of gift tax (that is, tax-exclusive). By contrast, the estate tax is the greater evil because tax is levied not only on assets passing to beneficiaries, but also on assets used to pay the estate tax (that is, tax-inclusive). A surviving spouse who subscribes to this idea may choose to gift assets before death and may look to QTIP property to make that gift.
- QTIP trust no longer needed. Perhaps it’s become a hassle to administer, or the exemption available to the surviving spouse is so great that no tax results from terminating the trust now. Either way, a surviving spouse may choose to terminate the QTIP trust early by adjusting the beneficial interests of the trust.
- Spin-off assets that have greatest appreciation potential. Are there assets currently held by the QTIP trust that are expected to appreciate dramatically? If so, there may be tax advantages to dividing the QTIP trust into two trusts: one holding the assets due to appreciate; and the second holding the balance of the QTIP property. From there, the trustee, either directly or with a court order, could modify the provisions of the trust holding the assets due to appreciate by changing the beneficial interests of the trust. By this division, only the assets due to appreciate are subject to the gift tax regime at their current, lower value.
- Change in family dynamics. Finally, one could put aside the tax consequences and decide that the ultimate beneficiaries need access to assets now. Instead of waiting for a surviving spouse to die, beneficiaries may receive access to some or all of the assets immediately.
There are many reasons to shift the beneficial interest of a QTIP trust and its underlying assets during a surviving spouse’s lifetime. Motives will vary from one family to another. Regardless, the PLR discussed above provides practitioners with a road map to navigate the tax consequences of the QTIP trust modification.
Andrew M. Nerney is a senior associate and Stephanie Rapp is an associate, both at Day Pitney LLP.