There are a variety of reasons why a taxpayer may want to consider creating a QTIP trust if his spouse survives him.
- Taxpayer may be in a second marriage. He wants to provide for his spouse if she survives him. However, taxpayer also wants to ensure that the trust assets will be available for taxpayer’s children from his first marriage when the surviving spouse dies.
- Taxpayer is the person responsible during the marriage for handling the family finances. Taxpayer is concerned that his spouse does not know how to handle investments or create a budget.
- Taxpayer totally trusts his spouse and is not concerned about leaving assets outright to her. However, he is concerned about preserving his generation skipping tax exemption. One possible solution is to create a reverse QTIP.
Although the QTIP trust can be beneficial, it can come at a significant tax cost. This is because the assets remaining in the QTIP trust are includible in the surviving spouse’s taxable estate when the surviving spouse dies. The surviving spouse does not have the same flexibility to minimize the estate tax impact that would otherwise be available if the assets held in the trust were owned outright by the surviving spouse.
The surviving spouse cannot merely dispose of her income interest in the trust without incurring a significant tax cost. This is because code Sections 2519 and 2511 cause the disposition of the surviving spouse’s income interest to be treated as if it were a transfer of all interests in the trust property.
McDougal v. Commissioner, 163 T.C. No.5 (2024) discusses a taxpayer’s unsuccessful attempt to minimize the estate tax consequences of using a QTIP Trust. When Ms. McDougal died in 2011, a QTIP trust was created for the benefit of her surviving husband with assets valued at almost $60 million. The surviving husband was entitled to receive all of the trust income. In addition, the trustee was authorized to make distributions of principal to the surviving spouse for “health, maintenance and support in his accustomed manner of living.” The couple’s children were the remainder beneficiaries of the trust.
In 2016, just five years after the decedent died, the value of the trust had more than doubled. Taxpayers were looking for a way not to have the full amount of trust assets held in the trust be includible in the husband’s estate when he dies.
The two children entered into a nonjudicial agreement with their father whereby they commuted their remainder interest in the trust. On the same day, the father transferred all of the trust assets to trusts established for his children in exchange for promissory notes. The payments received under the notes were intended to serve as a substitute for the surviving spouse’s income interest in the QTIP trust.
The taxpayers took the position that the transfer of the remainder interest to the father was offset by the “deemed gift” of the transfer of the trust assets to the children in exchange for promissory notes payable over their father’s lifetime. The children filed gift tax returns stating that there was a “reciprocal gift transfer” which did not give rise to any taxable gifts.
The tax court looked at the gift tax consequences of the commutation of the remainder interest to both the father and to the children. In the case of the father who was the beneficiary of the QTIP trust, the question was whether commutation of the remainder interest was taxable under code Section 2519(a) which provides that “any disposition of all or part of a qualifying income interest for life in any QTIP shall be treated as a transfer of all interests in such QTIP other than the qualifying income interest.” For gift and estate tax purposes, Section 2519 treats any disposition of the surviving spouse's income interest in a QTIP trust as if the surviving spouse transferred 100% of the remainder interests in the trust. In this case, the remainder interest was transferred to the surviving spouse.
To determine whether the surviving spouse made a gift in connection with the deemed transfer, the court compared what he had before and after the transaction. The surviving spouse's deemed transfer of the remainder interest in the trust assets (other than his qualifying income interest) resulted in his actual outright receipt of all the trust property. At the end of the day, he gave away nothing of value as a result of the deemed transfer. Since nothing was given away, there could not have been a gratuitous transfer, and hence there was no taxable gift. Even though the commutation of the trust remainder interest triggered Section 2519, it did not result in any taxable gift. The court’s decision in McDougal followed the holding in Anenberg v. Commissioner, 162 T.C. No. 9 (2024) which was decided only a few months earlier.
Although the court found no gift made by the surviving spouse, it did hold that the commutation of the QTIP remainder interest resulted in a taxable gift made by the children. In concluding that the surviving spouse did not make any taxable gift under Section 2519, there were no deemed gifts from the father to his children to offset the very real gifts the children made to their father. The children never actually obtained anything of value from their father a result of the nonjudicial agreement. Under state law, they already were the beneficiaries of the remainder interest in the QTIP trust. A deemed transfer under section 2519(a) added nothing to what they already owned. Nothing of value passed to the children that offset the value they gave up by relinquishing their remainder rights.
The trust as drafted did not give the surviving spouse any right to receive trust principal other than distributions by the trustee for the surviving spouse’s health, maintenance and support. But what if instead, the trust also had contained a provision authorizing the trustee to make distributions to the surviving spouse in such amounts as the trustee determined in its discretion? The court in Anenberg found that the termination of the QTIP trust was similar to an appointment of the assets to the surviving spouse. The exercise of the power of appointment was not treated as a taxable transfer as to the surviving spouse who was deemed to already be the owner of the remainder interest for purposes of Section 2519. See Treas. Reg. Sec. 25.2519-1(e) ("The exercise by any person of a power to appoint QTIP to the donee spouse is not treated as a disposition under Section 2519, even though the donee spouse subsequently disposes of the appointed property.").
If there is an independent trustee who holds the power to transfer the trust principal to the surviving spouse, then the commutation of the remainder interest should not be treated as a gift made by the children. However, if the children are serving as the trustees of the QTIP trust, the IRS could take the position that their exercise of the power to distribute principal to the surviving spouse is a taxable gift because it diminishes the children’s interest in the remainder. See Regester v. Commissioner, 83 T.C. 1 (1984) where the Court held that the income beneficiary made a taxable gift when she exercised her limited power of appointment to transfer trust principal to another beneficiary. See also IRS Regulation Section 25.2514-3(e) example which states that the remainderman’s causing distribution of the principal to the income beneficiary is not the exercise of a limited power of appointment but is instead a transfer of a part of the remainderman’s interest in the trust which is a taxable gift under code Section 2511.
Conclusion
In McDougal, taxpayers were seeking a way to minimize the estate tax on the assets held in a QTIP trust when the surviving spouse dies. Instead, the plan implemented by the surviving spouse and the children resulted in the imposition of a double tax: first, a gift tax imposed on the remaindermen when the parties entered into the agreement to commute the remainder interest; and second, an estate tax on the property remaining in the QTIP trust on the surviving spouse’s death. The desired result could have been achieved simply by granting an independent trustee the power to distribute trust principal to the surviving spouse in the trustee’s discretion.
Reprinted with permission from the March 11, 2025 edition of The Legal Intelligencer © 2025 ALM Global Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-256-2472 or reprints@alm.com.