The new portability provisions,1 which permit a surviving spouse to inherit the unused estate tax exemption of his deceased spouse, were supposed to make estate planning easier. Instead, they’ve only made it more difficult. Many couples are better off having the first spouse to die create a traditional credit shelter trust that uses up his estate tax exemption. Other couples should rely on portability. The facts that ultimately determine which plan will perform best may not be known until well after the first spouse’s death. Portability, it seems, forces married couples to make critical planning decisions in the dark.

We would like to introduce a strategy that combines the best features of both portability and the traditional credit shelter trust, while permitting significantly more planning flexibility than either. Called “The Section 2519 Portability Solution” (the Solution), it may be the ideal plan for many married couples, regardless of their wealth level. 

 

Background

Before portability, the estate of the first spouse to die (the first decedent) would typically be divided into two portions. The first portion, called the “credit shelter” or “bypass” portion or “portion A,” was defined by formula to be equal to the maximum amount that could pass free of estate tax at the first decedent’s death. The second portion, called the “marital” portion or “portion B,” was composed of the balance of the first decedent’s estate. Portion A would pass to a credit shelter trust, for the benefit of the surviving spouse, in a form that didn’t qualify for the estate tax marital deduction. Portion B would pass to the surviving spouse in a form that did so qualify. At the surviving spouse’s death, the credit shelter trust would pass free of estate tax, thereby ensuring that the first decedent’s estate tax exemption wasn’t wasted, even though all of his assets were bequeathed to or held for the benefit of the surviving spouse. 

 

Reasons for Credit Shelter Trust

With portability, the first decedent’s unused estate tax exemption no longer expires at death, but (if the first decedent’s executors elect) is added to the surviving spouse’s exemption amount.2 Nevertheless, many planners recommend that the first decedent use up his estate tax exemption at death.3 Reasons for the first decedent to create a credit shelter trust (apart from the uncertainty whether portability will be made permanent4) include:  

 

1. Creditor protection. With proper drafting, credit shelter trust assets can be protected against the claims of the beneficiaries’ creditors. If the first decedent gives all of his assets outright to the surviving spouse, by contrast, the surviving spouse’s creditors could attach the assets before they pass to descendants.

 

2. Use of state death tax exemption. Only the federal estate tax exemption is currently portable. For couples who live in states that impose a separate estate tax, a credit shelter trust ensures that the first decedent’s state estate tax exemption amount isn’t wasted.

 

3. Protection against decreases in the inherited exemption amount. The new portability provisions permit Congress to reduce a surviving spouse’s inherited exemption by decreasing the basic exemption amount available to all taxpayers.5 In addition, if a surviving spouse remarries and survives a second spouse, she loses the estate tax exemption inherited from the first decedent.6 A credit shelter trust ensures that the first decedent’s exemption amount as of date of death is fully used.

 

4. Transfer of post-death appreciation. Returns on credit shelter trust assets pass free of estate tax upon the surviving spouse’s death. The inherited exemption amount, by contrast, doesn’t increase during the surviving spouse’s lifetime. To the extent a credit shelter trust appreciates in value, therefore, it can protect more property against estate tax than if the first decedent’s exemption is ported to the surviving spouse.

 

5. Allocation of first decedent’s GST tax exemption. A surviving spouse can’t inherit the first decedent’s exemption from generation-skipping transfer (GST) tax. The first decedent’s GST tax exemption will be wasted, for example, if all his assets pass in a form to which GST tax exemption can’t be allocated, such as an outright bequest to the surviving spouse. A credit shelter trust ensures that the first decedent’s GST tax exemption can be allocated.

 

Why Opt for Portability?

The following considerations favor relying on portability:  

 

1. Supercharging first decedent’s exemption amount. As Mitchell M. Gans, Jonathan G. Blattmachr and Diana S.C. Zeydel discuss in “The Supercharged Credit Shelter Trust,”7 it’s possible to cause a credit shelter trust to be treated as a grantor trust with respect to the surviving spouse.8 A grantor trust is supercharged in that it can earn tax-free returns even as the grantor’s estate is depleted by income tax liability with respect to trust assets.9 Portability creates a simple way for all married couples to supercharge the first decedent’s exemption amount: Simply port the first decedent’s unused exemption amount to the surviving spouse, who then makes a gift of that amount to a grantor trust for the descendants. Given the benefits of supercharging, the first decedent should consider relying on portability rather than creating a credit shelter trust, so long as the surviving spouse is willing to make gifts up to the amount of the inherited exemption.10

 

2. Deferral of state death tax on the difference between federal and state exemption amounts. As state death tax exemptions are often lower than the federal exemption amount, a credit shelter trust funded with the full amount of the first decedent’s federal exemption may cause state death tax to be paid at the first decedent’s death. In some states, this tax can be deferred until the death of the surviving spouse if: (1) the first decedent makes a bequest equal to the amount of the difference to a qualified terminable interest property (QTIP) trust,11 and (2) the first decedent’s executors elect to qualify the trust for the state estate tax marital deduction but not the equivalent federal deduction.12 Even in states that don’t permit a “state-only” QTIP election, portability creates an easy way to defer state death tax: The first decedent simply limits the credit shelter trust to the state exemption amount and ports the remaining federal exemption to the surviving spouse. Deferral may ultimately result in state death tax being avoided altogether if, for example, the surviving spouse moves to a state that doesn’t impose a death tax.  

 

3. Protection against declines in the credit shelter trust. A credit shelter trust’s value may decline before the surviving spouse’s death if, for example, there’s a market downturn or the surviving spouse requires distributions from the trust. If all of the first decedent’s exemption ports to the surviving spouse, on the other hand, it can protect a fixed sum against future estate tax, regardless of investment performance or the surviving spouse’s living needs.13

 

4. Protection against erosion by IRD. If a credit shelter trust can only be funded with property that constitutes income in respect of a decedent (IRD), such as deferred compensation, the income tax liability on the IRD will reduce the after-tax value of the credit shelter trust assets.14 An inherited exemption, by contrast, remains fixed during the surviving spouse’s lifetime (unless the basic exemption amount is decreased). If the first decedent’s assets will consist disproportionately of IRD, therefore, a couple may be better off relying on portability.

 

5. Basis step-up at surviving spouse’s death. Property transferred to a credit shelter trust won’t receive a step-up in basis at the surviving spouse’s death. Assets owned outright by the surviving spouse, by contrast, will generally qualify at her death for a step-up in basis.15 If a couple’s combined exemption amounts exceed their net worth or if the first decedent’s assets appreciate substantially in value before the surviving spouse’s death, the couple may be better off if the first decedent doesn’t create a credit shelter trust, but instead relies on portability. 

 

Before adopting a traditional credit shelter trust plan, couples should consider: (1) the expected investment performance of the credit shelter trust, (2) the surviving spouse’s need for distributions, (3) the potential estate tax savings of a credit shelter trust versus the potential income tax savings of a step-up in basis, and (4) the extent to which a credit shelter trust must be funded at least in part with IRD. Unfortunately, when a married couple executes their wills, they can’t predict investment performance, the surviving spouse’s needs, the basis of assets at the surviving spouse’s death or the extent to which the first decedent will die holding IRD. Couples who must decide between portability and a credit shelter trust may not find out whether they made the right choice until it’s too late. 

 

The Solution

The Solution provides a way out. As discussed below, a married couple who adopts the Solution can achieve all of the following benefits of a credit shelter trust:

 

The first decedent’s exemption amount can be held for the benefit of the surviving spouse;

 

The first decedent’s exemption amount can be protected against the claims of creditors;

 

Returns on assets passing under the first decedent’s exemption amount can pass free of estate tax at the surviving spouse’s death; and

 

The first decedent’s GST tax exemption can be fully allocated.

 

In addition, by adopting the Solution, a married couple can achieve the following benefits of portability:

 

State death taxes can not only be deferred, but also entirely avoided; and

 

The surviving spouse can be treated as the owner for income tax purposes of a portion of the amount passing under the first decedent’s exemption amount.

 

Finally, the Solution enhances a married couple’s planning flexibility. In essence, it permits the surviving spouse, at any time after the first decedent’s death, to convert a simple portability plan into the equivalent of a traditional credit shelter trust. By adopting the Solution, a married couple, rather than be forced into a decision that they and their families may later regret, can defer the choice between portability and a credit shelter trust until well after the first decedent’s death.

 

Elements of the Solution 

The Solution is not only tax-efficient, but also wonderfully simple. Here are its essential elements: 

 

1. Portion A QTIP trust. First, the spouses execute wills,16 whereby the first decedent gives an amount equal to his estate tax exemption to a trust (portion A trust) for the benefit of the surviving spouse. The surviving spouse must be given a “qualifying income interest for life” in the portion A trust within the meaning of Internal Revenue Code Section 2056(b)(7)(B)(i)(II).17 In addition, the trustee of the portion A trust should be given absolute discretion to distribute or apply principal for the surviving spouse’s benefit. The surviving spouse can’t be given a special testamentary power of appointment over the portion A trust, a power to withdraw assets or a power to make distributions.18 The surviving spouse can, on the other hand, be given a power to remove and replace the trustee with a person who isn’t related or subordinate to the surviving spouse within the meaning of IRC Section 672(c).19

 

2. Portion B marital bequest. The first decedent leaves the balance of his estate (portion B) to the surviving spouse. Portion B can be bequeathed in any form that qualifies for the estate tax marital deduction. For example, portion B can be left outright to the surviving spouse or to a second QTIP trust (portion B trust) for the benefit of the surviving spouse.  

 

3. Surplus trust for descendants. Next, the first decedent’s will contains provisions for a trust for descendants (surplus trust). The first decedent doesn’t make any bequest to the surplus trust. Rather, the surplus trust serves as a receptacle to be filled at the surviving spouse’s option. The surviving spouse shouldn’t be given any powers or controls that could cause a gift to the surplus trust to be incomplete for gift tax purposes20 or included in the surviving spouse’s gross estate at her death.21 The surviving spouse can, however, be given a power to make distributions to the beneficiaries subject to an ascertainable standard22 and/or a power to remove and replace trustees with persons who aren’t related or subordinate to the surviving spouse.23 Finally, the surplus trust should contain provisions that will cause the surviving spouse, to the extent that she’s the grantor of the surplus trust for income tax purposes, to be treated as the owner for income tax purposes as well. For example, the surviving spouse could be given a nonfiduciary power to substitute property of the surplus trust with property of an equivalent value.24

 

4. Limited spendthrift exception. The first decedent’s will contains a limited exception to the standard spendthrift clause that prohibits beneficiaries from assigning their trust interests. Under this limited exception, the surviving spouse may assign the income interest in the portion A trust to or for the benefit of the couple’s descendants. An exception of this kind doesn’t jeopardize the ability of the first decedent’s executors to qualify the portion A trust for the marital deduction.25

 

5. Estate tax elections. At the first decedent’s death, his executors elect to qualify the portion A trust for the marital deduction (and, if applicable, any portion B trust). Assuming, for simplicity, that the first decedent makes no bequests that don’t qualify for an estate tax deduction, the QTIP election will typically reduce the first decedent’s taxable estate to zero.26 Next, the first decedent’s executors elect to permit the surviving spouse to use the first decedent’s unused exemption amount. Third, the first decedent’s executors allocate all of the first decedent’s GST tax exemption to the portion A trust. Finally, the executors make the reverse QTIP election to treat the first decedent as the transferor of the portion A trust for GST tax purposes.

 

6. Assignment of income interest in the portion A trust.  Finally, after the first decedent’s death, the surviving spouse assigns the income interest in the portion A trust to the surplus trust. The assignment can be a simple one-page instrument. After the assignment is made, all income of the portion A trust must be paid over to the surplus trust. The trustee of the portion A trust continues to have discretion to pay over or apply principal to or for the benefit of the surviving spouse. 

 

Example

To understand the benefits of the Solution, consider the following example: 

Husband Harry and Wife Winnie each have $15 million of assets. Neither Harry nor Winnie has made taxable gifts or allocated GST tax exemption during their lifetime. Harry dies when the basic exemption amount is $5.12 million. He bequeaths $5.12 million to a portion A trust and gives the balance of his assets (that is, portion B) outright to Winnie.

Harry’s executors elect, on a timely filed estate tax return, to qualify the portion A trust for the marital deduction. They allocate Harry’s GST tax exemption to the portion A trust and make the reverse QTIP election to treat Harry as the transferor of the portion A trust for GST tax purposes. Finally, Harry’s executors elect to port Harry’s estate tax exemption to Winnie.  

Lastly, Winnie assigns her income interest in the portion A trust to a surplus trust created under Harry’s will. Harry’s will gives Winnie a power, exercisable in a nonfiduciary capacity, to substitute property of the surplus trust with property of an equivalent value.27

The tax consequences of Winnie’s assignment are:

 

1. Taxable gift by Winnie of her income interest in the portion A trust. First, Winnie’s assignment of her income interest in the portion A QTIP trust is a taxable gift to the surplus trust equal to the actuarial value of the income interest.28

 

2. Taxable gift by Winnie of all other interests in the portion A trust. Winnie is also deemed to have made a gift of all other interests in the portion A trust. IRC Section 2519(a) provides that: 

 

... any disposition of all or part of a qualifying income interest for life in any property [for which a gift or estate tax QTIP marital deduction was allowed] shall be treated as a transfer of all interests in such property other than the qualifying income interest. 

 

An assignment of an income interest in a QTIP trust is a disposition within the meaning of Sec-
tion 2519.29 Consequently, Winnie is deemed to have made a gift of all interests in the portion A trust other than the income interest. That Winnie continues to be the discretionary beneficiary of principal doesn’t prevent a completed Section 2519 gift from occurring.30

 

3. No gift tax liability to Winnie. She has $10.24 million of gift tax exemption, which is the sum of her basic amount of $5.12 million and inherited amount of $5.12 million. Her unified gift tax credit, therefore, will more than offset any gift tax on the $5.12 million gift of the portion A trust.

 

4. No transfer of the portion A trust for GST tax purposes. Although the surviving spouse is deemed to have made a gift of all assets of the portion A trust, the first decedent remains the transferor of all portion A trust property for GST tax purposes. As explained in detail in “Using 2519 to Enhance Estate Planning” (“Using 2519”),31 the reverse QTIP election causes the creator of a QTIP trust—in this case, Harry—to be treated as the transferor of the trust property, notwithstanding any Section 2519 disposition by the beneficiary spouse—in this case, Winnie.32 Winnie’s assignment of the income interest also has no effect on the identity of the transferor of the portion A trust property.33

 

5. Portion A trust and surplus trust exempt from tax. The portion A trust remains effectively exempt from GST tax by virtue of the allocation of Harry’s GST tax exemption.34 Further, as explained in “Using 2519,” Winnie’s assignment of her income interest doesn’t cause a loss of the effective exemption from GST tax.35

 

6. Portion A trust not included in Winnie’s gross estate under IRC Section 2044. Typically, a trust for which a QTIP election is made is included in the gross estate of the beneficiary spouse under Section 2044. That section doesn’t apply, however, to any property that was deemed to have been transferred during lifetime under Section 2519.36 As discussed, Winnie’s assignment of her income interest causes her to be treated, under Section 2519, as having transferred the remainder interest in the portion A trust. Consequently, the portion A trust won’t be included in Winnie’s gross estate under Section 2044.

 

7. Portion A trust not included in Winnie’s gross estate under IRC Sections 2036 or 2038.
Sections 2036(a) and 2038(a) can cause property transferred during lifetime to be included in a decedent’s gross estate if he retains (or, in some cases, merely possesses) certain rights or controls over the transferred property. Winnie is treated as the transferor of the portion A trust property for estate tax purposes.37 As explained in “Using 2519,” however, Sections 2036(a) and 2038(a) don’t apply when a purely notional transferor retains no more than a discretionary interest in the “transferred” property. Even in the case of an actual transfer of property, a long line of authority now supports the proposition that the property isn’t included in the transferor’s gross estate merely because he remains a discretionary beneficiary.38 While those authorities leave open the possibility that the property can, nonetheless, be included under Section 2036(a)(1) if there was an understanding, express or implied, that the transferor would retain access to the property,39 an implied understanding is difficult to infer when the notional transferor acts unilaterally, without any communication with the notional transferee and without any ability to change or indirectly influence the terms under which the transferred property is held.40

 

8. Portion A trust not included in Winnie’s gross estate under IRC Section 2041. Winnie is treated, under Section 2519(a), as the transferor of the portion A trust for gift and estate tax purposes. Consequently, she can’t be treated as having a power of appointment over the portion A trust under Section 2041.41 Winnie, therefore, can be given a power to remove and replace the trustee of the portion A trust without risk of gross estate inclusion under Section 2041. To avoid risk of gross estate inclusion under Sections 2036(a) or 2038(a), the removal and replacement power should meet the requirements of Revenue Ruling 95-58.

 

9. Surplus trust not included in Winnie’s gross estate. Winnie’s assignment of her income interest is likely a transfer within the meaning of IRC Sections 2036(a) and 2038(a). However, the surplus trust is designed so that Winnie doesn’t retain any rights or powers that could cause gross estate inclusion under those sections. Consequently, the surplus trust isn’t included in Winnie’s gross estate at her death. 

 

10. Winnie treated as grantor of surplus trust for income tax purposes. By assigning her income interest in the portion A trust, Winnie funds the surplus trust with a gratuitous transfer. Consequently, she should be treated as the grantor of the surplus trust for income tax purposes.42

 

11. Winnie treated as owner of the surplus trust for income tax purposes. Winnie has a power to substitute property of the surplus trust with property of an equivalent value. Consequently, as Winnie is the grantor of the surplus trust, she should be also treated as the owner of the surplus trust for income tax purposes.43

 

12. No state gift tax (except in Connecticut or Tennessee).  Except in those states that still have a gift tax, Winnie’s assignment isn’t subject to state gift tax. 

 

13. No state death tax on surplus trust or portion A trust. State estate taxes generally come in two forms: pick-up taxes based on the (now inapplicable) federal credit for state death taxes and stand-alone estate taxes.44 Pick-up taxes generally tax property that’s included in a decedent’s federal taxable estate.45 Likewise, the three states that have a separate estate tax only tax property that’s included in the federal taxable estate. Here, neither the portion A trust nor the surplus trust will be included in Winnie’s federal gross estate. Consequently, although local counsel should confirm the conclusion, it appears that neither trust is subject to state estate tax at Winnie’s death.

 

Solution Achievements

Let’s summarize what the Solution has achieved so far. 

 

1. Winnie is a discretionary beneficiary of the portion A trust;  

 

2. All returns on the portion A trust and surplus trust will pass at Winnie’s death free of estate tax;

 

3. The portion A trust and the surplus trust are both effectively exempt from GST tax; and

 

4. The portion A trust and the surplus trust are protected against claims of Winnie’s and descendants’ creditors.46

 

Considered together, the portion A trust and the surplus trust constitute a discretionary trust for the surviving spouse and descendants that: (1) uses up the first decedent’s estate and GST tax exemptions; and (2) passes free of estate tax at Winnie’s death. In that way, they function almost identically to a conventional credit shelter trust. The only difference is that the surviving spouse can receive discretionary distributions only from principal (that is, from the portion A trust corpus), whereas descendants can only receive distributions out of accumulated income (that is, from the surplus trust). As discussed below, however, the surviving spouse’s cash flow need not even be affected by the loss of the income.

Harry and Winnie also have achieved unique benefits that aren’t available with a traditional credit shelter trust. First, Harry and Winnie have eliminated state death taxes on Harry’s exemption amount. Had Harry created a conventional credit shelter trust, by contrast, state death tax might have been payable at Harry’s death (if the credit shelter trust exceeded the state exemption amount) or Winnie’s death (if the credit shelter trust was limited to the state exemption amount and the difference between the federal and state exemption amounts passed to the surviving spouse in a form that qualified for the state estate tax marital deduction). The Solution avoids this tax altogether by: (1) qualifying the first decedent’s entire estate for the marital deduction; but (2) removing property passing under the first decedent’s exemption amount from the surviving spouse’s gross estate. States that impose a death tax, therefore, never have an opportunity to collect tax on the difference between the federal and state exemption amounts.

Finally, unlike with a conventional credit shelter trust, Harry and Winnie have partially supercharged Harry’s exemption amount. The surplus trust is a grantor trust with respect to Winnie. Consequently, she should continue to be taxed on income distributions from the portion A trust, even after the assignment of the income interest.47 Winnie will also be liable for tax on any income or gains earned by the surplus trust as the income is reinvested. Not only will the surviving spouse’s estate be depleted by the income tax liability, but also, the surplus trust can earn tax-free returns during the surviving spouse’s lifetime.  

The surviving spouse can also enter into transactions with the surplus trust that are ignored for income tax purposes.48 For example, the surviving spouse can sell assets to the surplus trust that are expected to appreciate in value and/or acquire low basis assets from the surplus trust to obtain a step-up in basis at the surviving spouse’s death. None of these benefits is available with a credit shelter trust, as a credit shelter trust will almost always be liable for its own income tax.

 

Making the Choice

As discussed below, the Solution also permits far more planning flexibility than a conventional credit shelter trust. In addition, the  Solution enables a couple to defer the decision to fund the equivalent of a credit shelter trust with IRD. 

 

1. Surviving spouse’s flexibility. As discussed above, the portion A trust and the surplus trust function together almost exactly likely a credit shelter trust. Unlike a credit shelter trust, however, they’re created by a combination of the first decedent’s will, post-mortem elections by the first decedent’s executors and the actions of the surviving spouse. Only after: (1) the first decedent’s executors qualify the portion A trust for the marital deduction, and (2) the surviving spouse assigns the income interest, does the portion A trust convert into the equivalent of a credit shelter trust.

Unlike many gift and estate tax elections, the surviving spouse’s power is personal and not subject to a fiduciary duty. Nor is there a time limit on the exercise of the power. The surviving spouse’s freedom to assign the income interest in the portion A trust makes it possible for a couple to defer the decision whether to create a credit shelter trust. After considering all of the factors discussed in “Reasons for Credit Shelter Trust,” p. 14, the surviving spouse can, at any time after the first decedent’s death, make the ultimate decision whether to rely on portability or convert to the equivalent of a credit shelter trust.  

 

2. First decedent’s executors’ flexibility. By choosing not to qualify the portion A trust for the marital deduction, the first decedent’s executors can cause the portion A trust to use up the first decedent’s remaining exemption amount. The portion A trust then becomes, in effect, a credit shelter trust. The surviving spouse will still have the freedom to assign the income interest in the portion A trust to the surplus trust. (Alternatively, the first decedent’s will could contain Clayton provisions that automatically convert the portion A trust to a discretionary trust for the spouse and descendants if the QTIP election isn’t made). As the portion A trust won’t qualify for the marital deduction, however, it won’t trigger Section 2519. Although not as efficient as qualifying the portion A trust for the marital deduction and triggering Section 2519, the option to assign the income interest in a credit shelter trust that hasn’t qualified for the marital deduction gives the surviving spouse some planning flexibility to put his own exemption amount to work.

 

3. Flexibility to create an inter vivos grantor trust. The most tax-efficient plan of all is to port the first decedent’s exemption amount to the surviving spouse, who then uses the inherited exemption to make a gift to a grantor trust for descendants. The Solution makes this plan very easy to implement: The surviving spouse can simply direct the first decedent’s executors (or the trustees of any portion B trust, if they’re willing to make principal distributions to the surviving spouse to facilitate estate planning) to pay over portion B assets directly to the surplus trust. In order not to waste the first decedent’s GST tax exemption, the portion A trust should continue to be held in trust for the surviving spouse. Even if the surviving spouse wishes to make a gift of the inherited exemption amount to a grantor trust, she should still consider using up her basic exemption amount by assigning the income interest in the portion A trust to the surplus trust. In that way, the first decedent’s GST tax exemption won’t be wasted on income distributions to the surviving spouse, who’s not a skip person with respect to the first decedent.

 

IRD Planning Flexibility

A credit shelter trust is inefficient if it can only be funded with IRD. To maximize flexibility, the first decedent’s will should contain funding formulas that divide the portion A trust into two separate trusts, one of which consists solely of IRD assets and the other of which consists solely of non-IRD assets.49 The surviving spouse can then choose to assign the income interest in one or both portion A trusts.50 In this manner, the surviving spouse can decide whether it’s better to hold IRD assets in the equivalent of a credit shelter trust or, instead, to use the inherited exemption for other purposes.

 

More Benefits 

Here are some additional benefits and potential issues regarding the Solution. A full discussion of these issues, however, is beyond the scope of this article.51

 

1. GST tax flexibility. If the first decedent’s GST exemption is greater than his estate tax exemption, portion B should be divided into GST tax-exempt and GST non-tax-exempt QTIP trusts. The first decedent’s executors can then allocate any excess GST tax exemption to a GST tax-exempt portion B Trust. The GST tax-exempt portion B trust should be structured like the portion A trust, so that the surviving spouse can assign the income interest to the surplus trust and, thereby, prevent GST tax exemption from being wasted on income distributions to the surviving spouse. 

 

2. Enhanced flexibility. Additional flexibility can be created if the first decedent bequeaths portion A to multiple separate QTIP trusts rather than a single portion A trust. The surviving spouse can then fine-tune the amount of her taxable gifts by assigning the income interest(s) in some, but not all, portion A trusts.52

 

3. Complete elimination of state death taxes. State death taxes on all of a couple’s assets (not just the first decedent’s exemption amount) can be eliminated if:
(1) portion B is held in a portion B trust that’s structured in the same manner as the portion A trust; and (2) the surviving spouse, prior to her death, assigns the income interest in the portion B trust to the surplus trust.

 

4. The surviving spouse can get access to the surplus trust. The surviving spouse can, in effect, retain access to the assets in the surplus trust if the trustees are willing to make loans to her. This strategy isn’t without risks. Planners should take precautions to ensure that any loans to the surviving spouse will be considered bona fide for gift and estate tax purposes.

 

5. Adjust the supercharged amount. The surplus trust should be structured so that grantor trust status can be “turned off” at any time, in case the income tax liability becomes a burden for the surviving spouse or the use of grantor trusts is curtailed. To increase the taxable income (including capital gains53) attributed to the surviving spouse, the trustees of the portion A trust should consider converting it into a unitrust pursuant to a state statute.54

 

6. Watch timing issues. To ensure that the assignment of the income interest in the portion A trust is treated as a gift under Section 2519 that uses up inherited exemption, the surviving spouse shouldn’t make the assignment until after the first decedent’s executor has filed an estate tax return making the portability and QTIP elections.

 

7. Consider remarriage issues. If the surviving spouse survives a second spouse, the surviving spouse loses the exemption amount inherited from the first decedent.55 For this reason, and others, the Solution may not be best plan if the surviving spouse is expected to remarry.

 

8. Disregard the QTIP election of the portion A trust. Some have contended that, at the surviving spouse’s death, the Internal Revenue Service may, on its own initiative, disregard an unnecessary QTIP election under Revenue Procedure 2001-38. It seems unlikely, however, that the IRS would seek to undo a Section 2519 taxable gift occurring during lifetime. In any event, it seems certain that the IRS will eventually revoke or modify Rev. Proc. 2001-38, for, as currently written, it potentially permits a couple to obtain the benefit of three exemption amounts by: (1) porting unused exemption to the surviving spouse; but still
(2) undoing an unnecessary QTIP election at the surviving spouse’s death.

  

—The views expressed herein are the authors’ own. The authors thank Daniel S. Rubin, Gideon Rothschild and David J. Stoll for their helpful comments.  

 

Endnotes

1. Internal Revenue Code Section 2010(c).

2. IRC Section 2010(c)(2).

3. See Daniel S. Rubin, “Seven Good Reasons Credit Shelter Trusts Remain Relevant,” Journal of Accountancy (June 2011).

4. The new portability provisions expire after 2012. P.L. 107-16 Section 901 (as amended by P.L. 111-312 Section 101(a)(1)). Nevertheless, there appears to be strong bipartisan support for making portability permanent. For an excellent overview, see “American Bar Association Estate and Gift Tax Committee,Portability—Part One” at 6, available at www.americanbar.org/content/dam/aba/events/real_property_trust_estate/he....

5. IRC Section 2010(c)(4)(A).

6. IRC Section 2010(c)(4)(B) (containing the “last deceased spouse” rule).

7. Jonathan G. Blattmachr, Mitchell M. Gans and Diana S.C. Zeydel, “The Supercharged Credit Shelter Trust, 52 Probate & Property (July/August 2007).

8. In a grantor trust, the assets are treated as owned by the grantor for income tax purposes. See IRC Sections 671-77, 79.

9. Despite the significant transfer of wealth that occurs because of grantor trust status, the grantor’s payment of income tax isn’t treated as a taxable gift. Revenue Ruling 2004-64.

10. To avoid wasting the first decedent’s generation-skipping transfer (GST) tax exemption, the first decedent should create a “reverse” qualified terminable interest property (QTIP) trust for the surviving spouse, who should make the gift out of his own assets.

11. A QTIP trust qualifies for the estate tax marital deduction to the extent that the executors so elect. IRC Section 2056(b)(7).

12. See Mitchell M. Gans and Jonathan G. Blattmachr, “Quadripartite Will: Decoupling and the Next Generation of Instruments,” 32 Estate Planning 3 (April 2005).

13. Given that portability can protect against market risk, it may no longer be advisable to define portion A as a fraction (or all) of the residue of the first decedent’s estate and thereby subject the credit shelter trust to market risk during the administration of the first decedent’s estate.

14. Income in respect of a decedent doesn’t qualify for a step-up in basis at death. IRC Section 1014(c).

15. IRC Section 1014(a).

16. For purposes of this article, unless otherwise noted, the term “will” refers to a will or will substitute, such as a revocable trust.

17. The bequest to the portion A trust is defined by formula to be equal to the first decedent’s unused exemption amount. For a comprehensive discussion of such reduce-to-zero formulas, see Sebastian V. Grassi, Jr., “A Practical Guide to Drafting Marital Deduction Trusts (With Sample Forms and Checklists),” published by ALI-ABA, Philadelphia (Supp. 2008), Chapter 15.

18. Each of these powers can cause gross estate inclusion under IRC Sec-
tion 2036(a) and/or IRC Section 2038(a) to the extent that the surviving spouse is treated for estate tax purposes as the transferor of the portion A trust.

19. Retention of such a power by a transferor doesn’t cause gross estate inclusion under IRC Sections 2036(a)(2) or 2038(a). Rev. Rul. 95-58; see also Estate of Wall v. Commissioner, 101 T.C. 300 (1993).

20. A gift of property is complete so long as the donor has “so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or for the benefit of another.” Treasury Regulations Section 25.2511-2(b).

21. For example, the surviving spouse shouldn’t have any power described in Sections 2036(a)(2) or 2038(a).

22. A retention of such a power doesn’t prevent a completed gift from occurring.  Treas. Regs. Section 25.2511-2(c). Nor does it cause property to be included in the transferor’s gross estate under IRC Sections 2036(a)(2) or Section 2038. Jennings v. Smith, 161 F.2d. 74 (2d. Cir. 1947); Rev. Rul. 73-143.

23. Retention of such a power by a transferor doesn’t cause gross estate inclusion under IRC Section 2036(a)(2) or Section 2038(a). Rev. Rul. 95-58; see also Wall, supra note 19.

24. A retained power to substitute property of an equivalent value won’t generally cause the property of a trust to be included in the transferor’s gross estate under IRC Sections 2036(a) or 2038(a), provided that the power meets the requirements of Rev. Rul. 2008-22 and Rev. Rul. 2011-28.

25. See Treas. Regs. Section 25.2519-1(g) Examples 3-5 (assuming that trusts qualified for the marital deduction even though the spouse could assign the income interest).

26. The taxable estate won’t be reduced to zero if property passing outside of the first decedent’s will is included in his gross estate under IRC Sections 2035 through 2042 and doesn’t qualify for the marital or charitable deduction. 

27. Assume, further, that the power meets the requirements of Rev. Rul. 2008-22 and 2011-28.

28. Treas. Regs. Section 25.2519-1(g) Example 3. The value of the gift of the income interest will be determined under the rules of Treas. Regs. Sec-
tion 2512-5(d)(2)(iii).

29. Treas. Regs. Section 25.2519-1(g) Example 3.

30. In Treas. Regs. Section 25.2519-1(f) Example 5, the income beneficiary transferred a portion of the income interest, but remained, thereafter, a discretionary beneficiary of principal. The example concludes that the deemed transfer under Section 2519 is a gift to which the valuation rules of IRC Section 2702 apply. As Section 2702 doesn’t apply to incomplete gifts (see IRC Section 2702(b)(3)(A)(i)), the example assumes that the deemed transfer is complete for gift tax purposes, notwithstanding the retained discretionary principal interest.

31. Austin W. Bramwell, “Using 2519 to Enhance Estate Planning,” Estate Planning, Vol. 38, No. 10 (October 2011).

32. See Treas. Regs. Section 26.2652-1(a)(3). 

33. See Treas. Regs. Section 26.2652-1(a)(5) Example 4. Any attempted allocation by Winnie would be ineffective.

34. A taxpayer can only allocate GST tax exemption to property of which he’s the transferor. IRC Section 2631(a).

35. Compare Treas. Regs. Section 26.2652-1(a)(5) Example 4 (describing the consequences of an assignment of an income interest without noting any change in the inclusion ratio) with Treas. Regs. Section 26.2642-4 (describing events causing a change in the applicable fraction). The Internal Revenue Service revoked regulations that had been designed to attack certain modifications to zero inclusion ratio trusts. T.D. 8720. The revocation may be a tacit concession that the IRS doesn’t have the power to increase a trust’s inclusion ratio based on factors not listed in the IRC or Treasury regulations.

36. IRC Section 2044(b)(2).

37. IRC Section 2519(a); Treas. Regs. Section 25.2519-1(a).

38. See, e.g., Estate of Uhl, 241 F.2d 867 (7th Cir. 1957); Estate of German v. United States, 55 A.F.T.R.2d 85-1577 (Ct. C1. 1985); Rev. Rul. 76-103; Private Letter Ruling 200944002 (July 15, 2009); see also Rev. Rul. 2004-64.

39. Rev. Rul. 2004-64; PLR 200944002 (July 15, 2009).

40. It may be prudent, in any case, to negate any implied understanding by:
(1) not notifying the trustee that the interest has been assigned until well afterwards, (2) having the surviving spouse write a letter to the trustee stating that she doesn’t expect to request any principal distributions from the portion A trust and/or, (3) changing trustees before any principal distributions are made to the surviving spouse.

41. Treas. Regs. Section 20.2041-1(b)(2).

42. Treas. Regs. Section 1.671-2(e)(1). As discussed in technical detail in Bramwell, supra note 31, there’s a possible counterargument that the first decedent should be treated as the grantor of the surplus trust on the theory that when property (such as income of the portion A trust) is transferred from one trust to another, the identity of the grantor generally doesn’t change. Treas. Regs. Section 1.671-2(e)(5). The better view, however, is that the surviving spouse is the grantor of the surplus trust. It’s also possible that both the first decedent and the surviving spouse are grantors of the surplus trust for income tax purposes. Cf. Treas. Regs. Section 1.671-2(e)(1). In that case, the surviving spouse could still be treated as the owner of the surplus trust under the grantor trust rules of IRC Sections 671-77 and 679.

43. IRC Section 675(4)(C). 

44. In addition, some states impose an inheritance tax on legatees. As neither the portion A trust nor the surplus trust pass from the surviving spouse, neither should be subject to inheritance tax.

45. See, e.g., New York’s Tax Law 961 (“A final determination as to the . . . the inclusion in the federal gross estate of any item of property or interest in property . . . shall also determine the same issue for purposes of [New York State estate tax]”).

46. A discretionary interest in a trust created by another person is generally protected under state law from claims of the beneficiary’s creditors. See Restatement (Second) of Trusts Section 155.

47. See Rev. Rul. 85-13.

48. Ibid

49. The funding of the portion A trust consisting solely of income in respect of a decedent (IRD) assets doesn’t cause IRD to be accelerated. Treas. Regs. Section 1.691(a)-4(b).  

50. The assignment of an income interest in one QTIP trust doesn’t trigger a Section 2519(a) disposition with respect to another QTIP trust.

51. The authors will discuss these in detail in a separate forthcoming article elaborating on the Section 2519 Portability Solution.

52. An assignment of an income interest in one such QTIP trust doesn’t cause a deemed transfer of the principal of the other QTIP trusts. Rev. Proc. 2001-38 (stating that, when two QTIP elections were made, one of which was unnecessary to reduce the first decedent’s estate tax to zero, only the property of that trust “would be subject to gift tax under § 2519” if the spouse disposes of the income of that trust); PLR 200319002 (Jan. 13, 2003).

53. Treas. Regs. Section 1.643(a)-3(e) Example 13.

54. Such a conversion isn’t a taxable gift or a gain recognition event. Treas. Regs. Section 1.643(b)-1.

55. IRC Section 2010 (c) (4)(B)(I).