Roy M. Adams and Charles “Clary” A. Redd — partners in the New York and St. Louis offices of Sonnenschein, Nath and Rosenthal LLP — held an online teleconference July 20. Several thousand people dialed in to listen to an hour and a half chat about “Marital Deductions and How to Avoid Them,” sponsored by Cannon Financial Institute of Athens, Ga. Among the meatier issues Adams and Redd examined was the interplay between the the marital deduction and and the qualified terminable interest property (QTIP) trust. Herewith, that discussion, edited for readability.

ADAMS: I'd like to start off by mentioning that the marital deduction was first introduced in 1948, essentially to make separate property states similar to community property states. We lived with one-half the adjusted gross estate from 1948 to 1981. Then, in 1981, we got the 100 percent marital deduction. Yet, as our discussion will demonstrate, we still haven't got the marital deduction right. There still happens to be a lot of litigation and loss of the marital deduction in the first estate, but nonetheless inclusion in the second estate — which is the worst possible combination. More and more states are decoupling their estate taxes from the feds', breaking the link between these levels of government. For example, in the New York metropolitan area, one state has a $600,000 exemption as opposed to the federal exemption of $1.5 million. So if there was a $2 million estate, boilerplate language (be it fractional share or pecuniary bequest) would put $500,000 in the hands of the spouse in trust or outright and $1.5 in the family trust or outright to family members. But that $1.5 million in the family trust exceeds the state exemption by $900,000. This means that there might well be a state tax incurred by using the federal exemption, if the state exemption is lower than the federal exemption.

What about if I plan this way: Revenue Procedure 2001-38 says that if you make an unnecessary Qualified Terminable Interest Property (QTIP) election in the first estate, you will not be taxed on the property when the second-to-die spouse passes away. Let's say that I put $600,000 in my family trust, $900,000 in a QTIP and $500,000 in another, separate QTIP. I elect QTIP treatment for the $900,000 and the $500,000. I designate it as marital property and take a marital deduction. I really don't need a marital deduction as to the $900,000, do I? Because that exceeds $600,000 by $900,000, and I have an applicable exclusion amount of $1.5 million. Would I not then be able — under this revenue procedure (in the opinions of some) when the spouse passes away to argue that the $900,000 trust for which I separately elected a QTIP provision was not necessary and, therefore, the $900,000, which could now be quite a bit more than that if it's had good money management, is not included in the estate of the spouse.

What do you think Clary?

REDD: It's an imaginative idea. I've noticed a fair amount of interesting dialogue among fellows of the American College of Trust and Estate Counsel (ACTEC) about whether this structure would be successful. Highly respected ACTEC fellows weigh in on both sides of that question. So, while it might work in the manner you've just described, advisors probably wouldn't want to commit to it irrevocably without getting their own private letter ruling.

ADAMS: Getting the private letter ruling may be worth it, or premature, depending upon the differences in state taxes you would pay under this plan versus placing the full $1.5 million in the family trust. Still it's important to keep the technique in mind, as we talk about the pitfalls of the marital deduction and what happens when states freeze their exemptions at lower levels than the federal.

REDD: That's right. And in your example, as long as we make clear to the client that backing away from the QTIP election on the $900,000 piece may not generate the result you just described, we can use it for state tax purposes without being burdened by federal tax purposes. As long as the clients realize that it might work and might not, it's okay.

ADAMS: Indeed. Let's look at some general QTIP questions and recent developments regarding the marital deduction. Suppose I said that my spouse is to receive the net income at least as often as annually for life and, at the discretion of the trustee, distributions of principal to pay for her health, support, education and maintenance. The spouse is a co-trustee along with the corporate trustee of the QTIP. The principal at the death of my spouse is to go directly to our children. My question is this: If I were so inclined, could I stipulate that, should my spouse remarry, neither she nor the corporate trustee could allocate principal to her in the event of remarriage or cohabitation? Isn't it true that if I didn't have to give principal rights in the QTIP trust, or for that matter, the general power of appointment trust to my spouse in the first place, which I don't, that I can give those rights and rescind them under whatever fact pattern I choose?

REDD: Yes, that is absolutely true. We obviously would want to be very clear in our drafting that what the spouse would be forfeiting by remarriage would not in any way, shape or form be her income interest in the trust. But any other interest that was granted in the trust document may indeed be rescinded without jeopardizing the marital deduction.

ADAMS: So you don't have to limit such a provision as the principal to the credit sheltered for us. But you could take away the income from the B trust — could you not — along with the principal?

REDD: Absolutely.

ADAMS: Let's look at several contexts in which a surviving spouse can invade the principal. This breeds serious problems for the QTIP election. With welfare, comfort, happiness and best interest standards, the spouse can invade. Then, haven't you blocked making your QTIP election?

REDD: As a practical matter, you absolutely have blocked it. I think that this is an important point, not to be overlooked in the grand scheme of things when we're examining QTIP trusts, because one of the major advantages of using a QTIP-type disposition is the ability of the executor to make a partial or perhaps even no QTIP election.

If the surviving spouse already has been granted interest in the trust, that would cause the spouse to be considered to have a general power of appointment over the trust and therefore cause the entire trust property to be included in the surviving spouse's gross estate. Then you pretty much have to make the QTIP election with respect to all of the trust, because it will all be included in the gross estate of the surviving spouse. And you want to avoid the whipsaw effect that Roy described when introducing this topic: where you have property that's included in the surviving spouse's estate for estate tax purposes but you didn't get a marital deduction for it. That's always a disaster.

ADAMS: Let's follow up on that point. Suppose the spouse had the right to withdraw whatever she wanted from time to time by way of marital trust principal? That certainly puts at risk your reverse QTIP election, does it not, and, under Internal Revenue Code Section 678, leaves the spouse paying all the capital gains taxes and the trust not deemed a separate capital gains taxpayer. Aren't there at least two negative consequences?

REDD: That's probably right, although it's kind of an interesting issue you can parse through to perhaps come up with a result that's not so negative. You could make an argument, if you were faced with this situation, that the surviving spouse's lifetime withdrawal right is not a right that converts the QTIP trust into a general power of appointment trust, because the lifetime withdrawal right may not, by the terms of the governing instrument, be exercisable by the surviving spouse alone and in all events. You may remember that one of the requirements under IRC Section 2056-d(5) for a general power of appointment trust is that the surviving spouse's power of appointment be exercisable alone and in all events. So if you argue that, even though the lifetime withdrawal right is there, it isn't quite large enough in quality to constitute a general power of appointment for Section 2056-b(5) purposes, then maybe you could preserve the advantages of a QTIP trust and the requirement that a QTIP election be made. But I admit that making that argument is kind of skating on a razor's edge.

ADAMS: I think that ice is getting thinner and thinner.

REDD: You're right. It's certainly not a way that I would recommend doing estate planning. I'd only recommend making that argument if you're faced with the situation and had to deal with it.

ADAMS: We could lodge in an independent trustee the ability to invade the principal for the spouse's welfare, comfort, happiness, best interests and not worry about any of these problems.

REDD: That's quite true.

ADAMS: What about this issue under the regulations: If I say the spouse is a trustee with a corporate co-trustee or there's some independent co-trustee with the spouse, then the independent trustee will exercise this power, which is a broad general power for invasion of principal. But what if I add, in effect, that if the independent trustee resigns and the spouse remains as trustee, then the standard becomes acertainable. Then do I get into any kind of a gift problem by changing those standards?

REDD: I don't see a gift problem — as long as it is clear from the outset in the governing instrument that the surviving spouse's ability to participate in discretionary distribution decisions to, or for, herself is restricted by the ascertainable standard, and that the corporate trustee from the outset has the ability to make discretionary distribution decisions for the spouse for broader purposes.

ADAMS: All right, how would you feel if, in effect, the spouse alone is a trustee and can invade the principal of the QTIP for health, support, education, maintenance — ascertainable standards — using the IRC's language? If the spouse resigns as trustee, she can appoint a corporate trustee who can invade for welfare, comfort, happiness and support in the context of both a marital trust and a non-marital trust?

Have I caught you on that one?

REDD: I don't think you've caught me — if the governing instrument requires the spouse, in appointing a successor trustee, to follow the rules of Revenue Ruling 95-58. But if the governing instrument would allow the surviving spouse to appoint any person or entity as a trustee, including the corporate trustee that the surviving spouse ended up choosing, then there could be a problem.

ADAMS: Say you give the spouse a limited power of appointment: a power to appoint someone other than the spouse or her estate or the creditors of her estate. This power is often given to provide for descendants, their spouses and charities. If this power were lifetime, we'd lose the marital deduction. But because it is testamentary, we're okay under the Treasury regs, correct?

REDD: Totally correct.

ADAMS: Now, the spouse would normally like such a power with respect to a QTIP trust or, for that matter, for the applicable exclusion trust, because it contains an element of control. A very quick example comes to mind: A lady was shopping, at 80 years of age, for a BMW with her daughters. Her daughters, thinking that when mom passed away they'd each take a third of the marital trust created by their father, suggested that their mom buy a Hyundi instead because she was really spending “their money.” It's hardly a tactful thing to say to your mother. What they didn't realize is that their mother had the power to appoint, among descendants, spouses and charities, meaning she could have avoided giving anything to the girls; she could've given it all to charity. So she is now driving around in her BMW with the girls in the backseat, taking them along as she visits various charities. Isn't there an element of control or terrorizing your children with that kind of a power, Clary?

REDD: There certainly is, Roy. I love that story because I'm a car buff, and I'm very much in the mother's camp on this one.

ADAMS: Indeed. You have been able, in your days as a trust officer, to deny beneficiaries at your discretion a particular vehicle they wanted.

REDD: That's right, Roy, and as you notice, I'm not a trust officer anymore, but that's a story for another day.

ADAMS: Indeed! Now let's talk about an issue that I thought had been resolved. It occurs when the second spouse dies and there is undistributed income in the marital trust. You haven't yet reached the quarterly point at which you'd normally distribute the income or the annual point or the semi-annual point, whenever you said income would be distributed. So the spouse dies with a $1 million dollars in a QTIP trust and $60,000 of accrued income. The regs clearly say that accrued income, along with $1 million, can pass to the children, or, pursuant to the spouse's exercises of the power, it's included in the spouse's estate. But we had a Tax Court case, Howard, that scared the daylights out of people in 1988; it said the income had to be paid to the spouse's estate to qualify for the marital deduction. That was not the law, said the U.S. Court of Appeals for the Ninth Circuit.

Then we had another case, which did the same thing as Howard in the Tax Court, but the 11th Circuit essentially said, ‘No, the income does not have to go to the estate, it can go directly to the children.’ Are you nervous in drafting marital trusts whenever there is income in the marital trust passing directly to the next takers?

REDD: I'm personally not nervous about it, and I haven't spoken to anyone who is nervous about it. But I suppose you can make at least a theoretical argument, if you're not in the Ninth or Eleventh Circuit, that someone could come along and try to resurrect the arguments that were made in the Rose, Howard and Lucille Shelfer estate. They could say, ‘Look, I realize that there was a QTIP election that was purported to be made when dad died, but now that mom has died, we're going to take the position that this so-called QTIP trust really isn't a QTIP trust; and we're going to argue that Treasury Regulation 20-56.D.7.D.4 is an invalid regulation.’ We all know what an uphill battle that argument would be, but theoretically it is possible.

ADAMS: But doesn't the payment of accrued income in smaller amounts of a marital trust at the spouse's death sometimes unnecessarily create a probate problem for the spouse's estate?

REDD: That's right. And I suppose you could try to finesse that situation a little, instead of paying the accrued and undistributed income to the estate of the spouse, perhaps giving the spouse a general power of appointment exercisable alone and in all events, causing the income to be included in the estate and the QTIP to be valid for that purpose.

ADAMS: I'm not too worried about it. Some extra drafting would simply be a precaution.

Editor's Note: At the end of the discussion, Adams and Redd took questions from the audience. One, relating to QTIPs, came from a listener in Princeton, N.J.:

PRINCETON: Let's pretend you're planning for a married couple with less than $4 million, so we don't know how things are going to sort out with the increasing exemptions, and we're in a decoupled state. I'm gravitating towards drafting a plan in which I put everything into a B trust, which qualifies for a QTIP election under its terms, then giving the executor the ability to elect as much for a QTIP election property, given the circumstances existing at the time. My question is this: I think that my surviving spouse can be the sole executor without tax traps; would you guys agree and could you comment if you don't?

ADAMS: I think your drafting approach is sound. There was a Lindberg letter pretty much on point, from a slightly different variation, and he would agree with you as well and does a fine job in writing those letters. Clary, are you worried about tax traps if the spouse alone is the executor making these decisions?

REDD: Yes, I admit, I'm kind of worried about it within the factual context that I understand the caller presented, because of refraining from making a full QTIP election. Isn't the surviving spouse in the position of being able to move property interest among other individuals, that is to say the beneficiaries of the B trust, assuming that the B trust has beneficiaries other than the surviving spouse? I'm making that assumption. If the surviving spouse has the sole ability by making a tax election to control who gets what then, yes, I do have some concern.

ADAMS: I would point to the Clayton case, in which there is an ability to simply say, now confirmed by the regs, that I elect to treat X as non-marital property, and the non-marital property spins off to a fully funded credit shoulder trust for other beneficiaries. Would that not ease your mind, Clary?

REDD: No, because in the Clayton situation, there was no representation that the spouse was the sole executor. It is the person who's making this election that's the potential problem, not the fact that you can engage in this kind of an estate plan. We would all readily agree that there's no problem whatsoever in doing what the caller suggests and, in fact, it can often be very good estate planning to do what the caller suggests, if you have an independent executor at least for the sole purpose of making or not making the QTIP election. But in the kind of circumstance that the caller described, depending upon who the beneficiaries of the B trust are, the surviving spouse could be in a position of making a gift if the surviving spouse makes anything less than a full QTIP election.

PRINCETON: Not to monopolize your time, gentlemen, but let's assume that all the beneficiaries are the same. I probably should have said that to begin with. I'm thinking there is not a problem then.

ADAMS: This is a really good question. May I ask you to expand just a bit? When you say they're all the same, does that mean that, as to the B trust, the surviving spouse is the sole beneficiary for life?

PRINCETON: Yes. Let's say the will simply reads as follows: “Upon my death, I leave my entire estate into the following trust: Income to my wife, principal for my wife's health support and maintenance, limited power among our issue upon her death, if not exercised, to our issue per stirpes.

REDD: That's right, you said at the beginning that this trust had to be a potential QTIP, so of course that would have to be the case. I think you're right. That presents much less of a problem, if any kind of a problem exists at all. The thing I fear is when you've got separate dispositions and, by not making the QTIP election, you can actually shift assets away from the QTIP trust into a non-marital disposition where there are other beneficiaries currently. Then you've got really serious potential gift tax problems. But in your situation, you don't have a problem.

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