As estate planners, we often are called upon to prepare estate-planning documents for married couples. The planning can take many forms, but often includes a will and revocable trust for the husband and wife. The revocable trust serves as the main dispositive vehicle.
For U.S. citizens who are still married on the day they die, the estate tax treatment of assets in the revocable trust differs dramatically depending upon where the decedents resided. That's because in the nation's eight community property states — including California and Texas — each spouse has a present one-half interest in property acquired (other than by gift or inheritance) during marriage.1 This gives each spouse a legally enforceable present interest in half of the marital property. But the rest of the states are common law jurisdictions that do not give spouses an automatic present interest in marital property.
Perhaps most importantly, spouses in community property states receive a statutorily created step-up in basis for all marital property, while those in common law states do not. Clearly, spouses in common law states would be better off if they could use the community property technique of a joint revocable trust, receiving the attendant estate tax treatment for marital property and the step-up in basis. But can they?
We have a strategy that may achieve both goals: including property in the estate of the less-propertied spouse, and creating a basis step-up for the marital property. If this technique works, these concepts can be extended to achieve full inclusion and full basis step-up for all assets that a couple has accumulated — both separate and marital property.
LAY OF THE LAND
Imagine a couple in which the wife has $500,000 of separate property titled in her name, while the husband has $8 million in marital property and $2 million worth of separate property — all of which is in his name. The wife dies first.
Let's look at tax consequences both in a common law and a community property state. Based on the traditional planning of separate revocable trusts for each spouse, in a common law state:
The assets included in the wife's revocable trust (that is to say, her $500,000 of separate property) will receive a step-up in basis on the date of her death.2
There typically is no estate tax, as the revocable trust will divide the assets into two separate trusts after the payment of all administrative expenses and death taxes. One trust will equal the exemption amount (currently $1 million but scheduled to increase to $3.5 million by 2009), and the second trust will hold the remaining assets as a marital qualified terminal interest property (QTIP) trust that qualifies for the marital deduction under Internal Revenue Code Section 2056(b)(7). As the wife has just $500,000, only an exemption trust is funded and no marital QTIP Trust is needed. But if the wife's assets exceeded $1 million, a marital QTIP trust would be used for the excess amount.
There is no step-up in basis for the husband's assets as of the day the wife dies. When the husband later dies, his estate will receive a step-up in basis for those assets in his gross estate — including any marital QTIP trust.
For this plan to work on an optimal basis, both the husband and wife need to have sufficient assets in both of their revocable trusts. But in this case the wife had just $500,000 — meaning she lost the benefit of $500,000 of her exemption.
Suppose the couple resided in a community property state when the wife died. A very different tax picture typically emerges:
One-half of the marital property and all of the wife's separate assets are included in her gross estate. Even though just one-half of the marital property is included in the wife's gross estate, all of the marital property will receive a step-up in basis.3 The wife's separate property also will receive a step-up in basis. Only the husband's separate property will not receive a basis step-up upon her death. This is usually not problematic because the bulk, if not all, of their assets will be considered marital property.
Estate planners in community property states typically use the joint revocable trust, which has the effect of distributing one-half of the marital property and the husband's separate property directly to the husband (for example, into a survivor's trust); as well as utilizing both the wife's separate property and the remaining one-half of the marital property to fund an exemption trust and a marital QTIP trust.
The advantage of a community property state is that Congress allows a full step-up in basis for the marital property. Upon the husband's death, he will receive a step-up in basis for the assets included in his estate — namely, the survivor's trust and the marital QTIP trust — providing a double step-up in basis.
Including one-half of the marital property in the wife's estate minimizes the risk of the wife not using all of her exemption amount. For example, the wife's gross estate will include one-half of the marital property, or $4 million plus the $500,000 held in her name, for a total of $4.5 million. This would enable the wife's estate to fully utilize the exemption amount, even though not all of the assets were in her name. Moreover, a step-up in basis would be afforded for the full $8.5 million (the $8 million in marital property and the wife's $500,000).
JOINT REVOCABLE TRUST
What happens when a joint revocable trust is used in common law states?
IRC Section 1014(a) generally provides for a step-up in basis of any property that has been acquired or passed from a decedent. Section 1014(b) sets forth examples of what property meets this definition. In particular, Section 1014(b)(6) provides that the surviving spouse's half of the marital property is considered to have passed from the decedent.
The problem that practitioners in common law states face is that Congress has not amended the language of Section 1014 to afford a full step-up in basis for the marital property owned by spouses in those jurisdictions. It seems unfair that married couples have radically different tax treatment depending on whether they happen to reside in a common law or community property state. Practitioners in common law states have sought to achieve benefits similar to community property regimes by employing strategies such as a general power of appointment. This tactic typically involves using a joint revocable trust, but it also can be accomplished through separate revocable trusts with mirror provisions.
Specifically, both spouses create a joint revocable trust and fund it by retitling their assets in the name of the trust. Schedules attached to the trust will designate which assets are separate property and which are marital property.
Each spouse is granted a general power of appointment over the marital property contributed (by either spouse) to the joint revocable trust. This general power of appointment will provide that the first spouse to die can utilize the marital property to pay the estate taxes or any other taxes, debts or charges that are enforceable against the estate of the first spouse to die.
Either spouse can defeat this general power of appointment by exercising his or her right to revoke the joint revocable trust.
The general power should apply only to assets that would otherwise qualify for the marital deduction, and can be further tailored to apply only to assets that have appreciated in value (to prevent a possible step-down in basis).
For example: Imagine that the husband and wife transfer their property to a joint revocable trust. The husband contributes marital property worth $8 million and separate property worth $2 million to the trust. The wife contributes $500,000 of separate property. Either can revoke the trust. The joint revocable trust contains a general power of appointment, which enables the first spouse to die to direct the trustees to pay the spouse's taxes, debts and expenses from the marital property titled in the trust. The wife dies two years after the trust is created and funded. Her $500,000 worth of property is included in her gross estate pursuant to IRC Section 2038(a)(1). The $8 million of marital property also is included in the wife's gross estate pursuant to IRC Section 2041(a)(2) (because of her general power of appointment over these assets). As the $8.5 million was included in the wife's gross estate, all of those assets should receive a step-up in basis. The $8.5 million will be allocated between two trusts: $1 million (assuming no lifetime gifts have been made) to the exemption trust and the remaining $7.5 million to a marital QTIP trust. The $2 million of the husband's separate property will be held in a survivor's trust for the sole benefit of the husband; he can remove those assets at will.
The advantage of this technique is that a step-up in basis may be achieved for $8.5 million in assets and the wife was able to utilize all of her exemption. Yet the husband did not have to give up complete control over his assets while his wife was living.
THE IRS WEIGHS IN
In Technical Advice Memorandum 9308002 issued Oct. 16, 1992, the Internal Revenue Service agreed that this strategy would cause all of the marital property subject to the general power of appointment to be included in the wife's gross estate, pursuant to IRC Section 2041(a)(2). The Service also agreed that the gift tax marital deduction would offset the increase in the wife's gross estate.
But here's the rub: The IRS disputed that the inclusion of the assets in the wife's estate is sufficient to achieve a step-up in basis under Section 1014, as 1014(e) provides that there is no step-up in basis for appreciated property that a decedent acquires by a gift that passes back to the donor within one year of the decedent's death.
The IRS said such a gift is incomplete until the husband gives up dominion or control over his assets contained in the joint revocable trust by relinquishing his right to revoke the trust. Therefore, even if the trust were funded more than a year before the wife's death, the marital assets contributed by the husband (even though included in the wife's estate) arguably would not receive the step-up in basis if they revert back to the husband. However, the planning here distributed the property to the surviving spouse and not to a marital QTIP trust.
In Private Letter Ruling 200101021 issued Oct. 2, 2000, a married couple proposed to create a joint revocable trust and fund that trust with property they held as tenants by the entirety. Either spouse could revoke the trust, and upon that event the assets would be distributed to them as tenants in common. Upon the death of the first of them to die, the decedent held a general power of appointment enabling him to appoint the trust property to the decedant's estate or to any other person or entity. If the first spouse to die did not exercise his or her general power of appointment, then the trust would break down into a credit shelter trust, and the balance of the property would pass outright to the surviving spouse.
The IRS reacted somewhat favorably. It concluded that each spouse's transfers to the trust were not completed gifts, as both had retained the right to revoke the trust and revest title in themselves. The value of the whole trust would be included in the estate of the first spouse to die. The assets contributed by the decedent spouse would be included under IRC Section 2038, and the assets that were the subject of the general power of appointment would be included under Section 2041.
Upon the death of the first spouse, the surviving spouse is treated as having made a gift to the decedent, because the surviving spouse gave up dominion and control over the assets subject to the general power of appointment. This gift would qualify for the gift tax marital deduction. However, the IRS notes here that Section 1014(e) would limit the basis step-up with respect to those assets that are received outright by the surviving spouse.
As the credit shelter trust is funded with assets that are included in the decedent's estate, there is no gift from the surviving spouse to the credit shelter trust. Finally, no distributions from the credit shelter trust to beneficiaries (other than the surviving spouse) would constitute a gift from the surviving spouse to such beneficiaries, and none of the assets in the credit shelter trust would be included in the surviving spouse's estate.
The IRS came to the same conclusion in PLR 200210051 issued Dec. 10, 2001 — even though the assets were retained in a trust. A married couple created a joint revocable trust, and funded it with assets held in their individual capacities or as joint tenants with rights of survivorship. Both spouses had the right to revoke the trust. During their joint lifetimes, the net income of the trust was to be distributed to them both. Each spouse also had the right to direct how the trustees would distribute the property. Each spouse also had the right to direct the trustees to distribute the property as either directed. Upon the death of the first spouse to pass away, the assets were to be divided into an exempt trust and a marital trust. The terms of the marital trust provided: “During the life of the surviving spouse, the trustee(s) shall pay the net income to the surviving spouse at least quarter-annually, and such amounts of principal as the surviving spouse may direct.”
It is clear from the Service's TAM and PLRs that the IRS agrees that the marital property contributed by the husband in our hypothetical would qualify for the gift tax marital deduction upon his wife's death, as the husband's gift is then complete because he no longer has the right to revoke the trust. Similarly, the marital property would be included in the wife's gross estate. The only real issue is whether IRC Section 1014(e) prevents the wife's estate from receiving the step-up in basis upon the wife's death with respect to those marital assets contributed by the husband. The previous PLRs do not indicate whether a ruling on this issue was requested. The IRS simply notes that Section 1014(e) would apply to the assets that the husband receives back. There also is no ruling that Section 1014(e) applies to those assets distributed to a marital QTIP trust of which the surviving spouse is the beneficiary.
Assuming the IRS is correct, if a gift from a husband to wife is made immediately before her death, then the one-year limit set forth in Section 1014(e) is invoked. But that provision applies only to property that was gifted from the husband, then passed to him when she died. What if the property does not pass to the husband outright but instead goes to a marital QTIP trust for his benefit? Does Section 1014(e) apply? The TAM and the PLRs do not address the use of a marital QTIP trust. Rather, these IRS rulings and memorandum provide for outright distribution to the surviving spouse or distribution to a marital trust over which the surviving spouse has an unlimited right of withdrawal.
A marital QTIP trust in which the surviving spouse has no right of withdrawal should not be treated the same as a trust allowing the husband to unilaterally remove the assets in favor of himself. This argument can be enhanced by placing restrictions in the marital QTIP trust. For example, the trust provisions could prohibit him from serving as trustee, allow distributions of principal to him based only on ascertainable standards, and restrict his testamentary limited power of appointment to descendants of both him and his wife. Such limitations should be sufficient to prevent Section 1014(e) from applying, as the husband then doesn't have the same type of ownership he had when he contributed the property to the joint revocable trust.
Moreover, courts have recognized the distinction between outright ownership and beneficial interest in a marital QTIP trust. For example, courts have soundly defeated the IRS argument, in a different context, that a marital QTIP trust and a surviving spouse's assets should be aggregated for tax purposes.4,5 If this marital QTIP trust restriction is successful and not deemed to be ownership, then practitioners can achieve an optimal step-up in basis.
Despite the transfer tax advantages, a wealthy spouse is often reluctant to transfer assets to the less-propertied spouse to fund the exemption amount.
One technique that practitioners use is a lifetime QTIP trust. Simply stated, a husband, during his lifetime, transfers property to a lifetime QTIP trust for the benefit of his wife. This trust will require the wife to receive, at a minimum, all of the income annually during her lifetime. When she dies, the assets in the trust will be included in her estate, and receive a step-up in basis. If the husband survives his wife, the lifetime QTIP trust in the wife's estate may be held for the husband's benefit and qualify for the marital deduction in her estate. The IRS has specifically stated in Example 10 of Treasury Regulation 25.2523(f)-1(f) that a husband will not be considered to have retained an interest in the property used to fund the lifetime QTIP trust, because he might later benefit from the property. There are, however, a couple of disadvantages to this technique: the husband has to relinquish complete control over the property to the trustee of the lifetime QTIP trust (who cannot be himself6); and he must be comfortable with his wife receiving all of the income from the trust (which includes the wife's power to make the property income-producing if it is not generating sufficient income).
For example, if the husband transfers $2 million of his $10 million to a lifetime QTIP trust for the benefit of his wife, the transfer would qualify for the gift tax marital deduction so that the husband would not utilize any of his gift tax exemption (provided a gift tax return is filed and the QTIP election is made). The wife would receive all of the income from the trust during her lifetime. Assuming the wife dies before the husband, her gross estate will consist of the $500,000 she held individually as well as the $2 million held in the lifetime QTIP trust. This would enable the wife's estate to fully utilize the $1 million exemption and help the husband and wife equalize their estates. Upon the wife's death, her estate plan combined with the lifetime QTIP trust would provide $1 million held in the exemption trust and the remaining $1.5 million held in a marital QTIP trust for the husband. For this strategy to work, the husband had to relinquish control over, and the right to income from, the $2 million he transferred to the lifetime QTIP trust.
Using a joint revocable trust avoids the two disadvantages posed by the lifetime QTIP trust. With a joint revocable trust, the husband would have control during his life over the property he transfers to the joint revocable trust, but this property can still be utilized to fund the wife's exemption amount.
For example, a married couple could create a joint revocable trust to which the husband contributes $2 million of marital property and the wife contributes $500,000 of her separate property. This trust grants both spouses a general power of appointment over all the marital property in the trust. Either can revoke the trust at any time before one of them dies, if the trust is revoked then each spouse will receive the property he or she contributed. Both (or the husband alone) can control all aspects of this trust. Moreover, there are no mandatory income distribution provisions in this joint revocable trust (as opposed to the lifetime QTIP trust). Upon the wife's death, the full $2.5 million will be included in her gross estate. This scenario affords the same allocation and creation of trusts previously discussed — that is to say, a $1 million exemption trust and a $1.5 million marital QTIP trust. Obviously, the main difference is that the husband did not have to relinquish control of the property during his lifetime to achieve this result.
THE BEST SHOT
Congress gives married couples residing in community property states favorable income tax treatment, but has not done the same for spouses living in common law states. Techniques such as using a joint revocable trust coupled with a general power of appointment might help solve this common, common law problem. But the Service's stance makes it more challenging to obtain a step-up in basis upon the first spouse's death for all of the marital assets. Yet even if the IRS is correct in their IRC Section 1014(e) analysis, the agency has not closed the door on basis planning. A step-up in basis still may be achieved by providing that the interest passing through the first spouse's estate does not pass directly or indirectly back to the surviving spouse. By carefully crafting a marital QTIP trust, the practitioner may be able to avoid the application of IRC Section 1014(e) and obtain a full step-up in basis. Even if a full basis step-up is not achieved, the IRS has paved the way for funding a non-propertied spouse's exemption without having the propertied spouse relinquish control. The IRS rulings recognize the use of general powers of appointment as a strategy to include assets in the less-propertied spouse's gross estate without adverse gift and estate tax consequences. This can prove to be a valuable tool for an estate planner whose client is not willing to relinquish the requisite control necessary to establish a lifetime QTIP trust, but would like to take full advantage of the estate tax exemptions available to both spouses.
“Marital property” refers to the property acquired by spouses after their marriage (other than by gift or inheritance). Generally, this property is referred to as “community property” in community property states and as “marital property” in common law states.
IRC Section 1014(a).
IRC Section 1014(b)(6).
Estate of Bonner v. United States, 84 F.3d 196 (5th Cir. 1995); Estate of Mellinger v. Commissioner, 112 T.C. 26 (1999); Estate of Nowell v. Commissioner, T.C. Memo 1999-15; Estate of Lopes v. Commissioner, T.C. Memo 1999-225. The Service acquiesced to Mellinger on September 8, 1999 (AOD 99-006, 1999-35 I.R.B. 314).
IRC Section 1014(e) is an income tax provision. However, it operates exclusively upon the death of the individual and is closely associated with the estate tax considerations. Accordingly, while the income tax and estate tax provisions are necessarily construed the same way, how the estate tax code aggregates ownership appears relevant to determining whether the transfer to the surviving spouse is direct or indirect for income tax purposes under IRC Section 1014(e). Moreover, provisions such as IRC Sections 267 and 318, which require certain types of attribution and arguably would work against the foregoing argument, are only applicable in sections of the Code where they are specifically referenced. These provisions are not referenced in IRC Section 1014(e); therefore they should not apply to this analysis.
Arguably, the husband may be the trustee if the distributions of principal are limited to an ascertainable standard.